Financial ratios every investor should know

Introduction

Stock selection is a difficult process. You must examine the company’s financial statements, such as the balance sheet and profit and loss statement, to determine how sound they are. However, such statements are quite lengthy, and comprehension may not always be possible if you are not a financial expert. This is where financial ratios can help.

Different types of ratios

1. Earnings Per Share (EPS)

EPS represents the earnings on every unit of stock you own. It is calculated by dividing the company’s net profit by the total number of outstanding shares. EPS is calculated on a quarterly and annual basis, and preferential shares are not taken into account.

When deciding on a stock, consider the consistency in the EPS. But EPS alone will not tell much about a stock valuation as it should be compared with the stock price.

EPS formula:

(Net profit – Preferential shares dividend) ÷ (No. of outstanding shares)

2. Price-to-Earnings (PE) Ratio

The PE ratio indicates whether a stock is undervalued or overvalued compared to its peers. It is a multiplier to value a stock in the market compared to its EPS. For example, if a stock PE is 20, you need to pay 20 times a stock's earnings to buy a stock from the market.

If a company has a high PE ratio in comparison to its peers, it may be considered expensive. However, the concept of high and low PE varies depending on the industry, competition, and the company’s profile. High expectation of growth could also be a reason behind the high PE. Similarly, low PE stocks are not always cheap; poor performance could also be a reason for a stock to trade at low PE. For example, if you are evaluating the stocks of lifestyle companies, you will rarely find a good stock with a low PE.

PE Ratio formula:

= (Market Price Per Share) ÷ (Earnings Per Share)

3. Price-to-Book Value (P/BV) Ratio

P/BV ratio draws a relationship between the net asset value highlighted in the books and the company’s total outstanding shares. This ratio represents the amount you would receive if the company went out of business or is liquidated. When calculating the P/BV ratio, intangible assets such as brand recognition, patents, goodwill, and copyrights are not included. In the context of investment, it is best to buy stocks with a low PB ratio but this can’t be a sole parameter to invest in a stock.

P/BV ratio formula:

= (Market Price per Share) ÷ (Book Value per Share)

4. Debt-to-equity ratio

This is perhaps the most important type of ratio because it provides information about the company’s capital structure. The debt-to-equity ratio indicates how much portion of the capital is borrowed and how much is invested by equity investors. If a company has a higher debt-to-equity ratio, it means it is leveraging more, and it is more vulnerable to interest rates. Stocks with a high debt-to-equity ratio are considered risky compared to others.

Debt-to-equity ratio formula:

= (Total Liabilities) ÷ (Total Shareholder Equity)

5. Return on Equity (ROE)

ROE informs you of the company’s net profit in relation to the equity capital. If the company has a low ROE, it means it is not making enough profit on its equity capital. Generally, if the company’s ROE is consistently above average compared to peer group companies, it could be a good stock for investing. But again, ROE can’t be the sole metric to evaluate a stock.

ROE formula:

= (Net Profit) ÷ (Average Shareholder’s Equity)

6. Current Ratio

The current ratio is a financial metric that is used to gauge a company’s liquidity position. It computes the availability of a company’s total underlying short-term assets, such as account receivables, to cover current liabilities, such as account payables. If a company’s current ratio is less than one, it indicates that it lacks liquid assets and may fail to manage its short term liabilities in the future.

Current ratio formula:

= (Current Assets) ÷ (Current Liabilities)

7. Dividend Yield

This ratio tells you how much dividend it has previously declared to its shareholders. It is determined by dividing a company’s annual dividend from the market price of that company’s stock. Rather than paying out dividends, many companies reinvest their profits. As a result, even if the company does not declare a dividend, but its other ratios are satisfactory, it shouldn’t be seen as negative factor. 

Dividend Yield formula: 

= (Annual Dividend per Share) ÷ (Price per Share) × 100

8. Price-to-Sales (P/S) Ratio

This ratio provides information about the company’s sales figures. It essentially compares the share price in relation to the annual sales of the company. P/S ratio is important for companies because sales numbers speak about the acceptability of the company’s product and services in the market. It is also helpful for those companies which are not in profit.

P/S ratio formula:

= (Price per Share) ÷ (Annual Sales Per Share)

To conclude

Financial ratios assist you in determining which stock is best suited to meet your long-term objectives. Using the eight types of ratios mentioned above, you can gain a thorough understanding of any company’s financial position. These ratios will help you to identify the right stocks to invest and create a robust stock portfolio.