If you are here, then most probably you want to become a better investor.
That’s almost impossible if you don’t start using ratios and other financial indicators in your business. I agree that mathematics is a tough nut to crack and most people don’t like the endless and insoluble equations.
Here we are not talking about math, we are talking about practical tools that will help you understand the broader picture. Moreover, they will help you make sense of the information that comes with investing as well as make informed and justified choices. Consequently, this will improve your performance and results.
This article will be dealing with the main investment ratios, and it will provide the most useful information about them. You will also learn how and when these ratios should be implemented. Let’s get started, shall we?
Why are financial ratios so important?
If you are an investor, you know how important analysis is. Analysis cannot be conducted without the necessary tools, in our case ratios. By using them, you will be able to pick out the best assets to invest in, measure their profitability, efficiency and effectiveness.
Furthermore, they will help you evaluate the company whose assets you want to purchase. They will indicate how much the potential profit is as well as determine your risk strategy.
The Most Important Investment Ratios
There are a large number of indicators used in trading and investing. In this article, I will only discuss the most important ones and the easiest to understand. They are Earnings Per Share, Price-Earnings Ratio, Dividend Yield, Debt-To-Equity Ratio, Return On Equity, Current Ratio, Profit Margin and Price-To-Book Ratio.
I start with this one since it will be hard for you to understand the following one and calculate it. Simply said, this ratio shows how much money earns a single share of a given company.
Now, let’s be more precise. EPS shows the net income that a company’s common stock has generated over the past one year. Please note that preferred shares are not included. Also, the number of common stock may and will change during the year. However, the official website of the company will give you very accurate and precise information.
Formula: EPS=Net income/Average Outstanding Shares
For example, a company has generated net earnings of $1000 and has 50 shares. The EPS is 20 (1000/50).
2. Price-Earnings Ratio (P/E)
Price to Earnings Ratio is one of the most commonly used tools in financial matters. In a nutshell, this number shows you how the price of a stock compares to its earnings. Or in other words, we can assume that this ratio shows how much the market will pay for the company’s earnings. We calculate it by dividing the price of a stock by its earnings per share:
Formula: Price per share/Earnings per share=P/E Ratio
For example, you are considering an investment in a company whose shares are $20 and the EPS is 5. We divide $20 by five and the result is 4. The P/E ratio is 4.
There is no rule of a thumb, but according to most experts, the lower the P/E ratio, the better. A high P/E ratio might indicate that a company is overpriced. In order to use it successfully, you always need to understand the broader economic picture.
If you want to buy individual stocks, compare the current P/E with the average P/E over a period of time. Also, use in your comparison other stocks. If the P/E is lower than the average, then most probably this stock is underpriced and has a potential for growth.
3. Dividend Yield
If a company has generated some profit, it distributes part of it to its shareholders in the form of dividends. If the board of directors decides to give $3 per each share, and you have 1000 shares, then you will receive $3000 dividend.
People use this ratio to compare different stocks that pay a dividend. You can also use it to compare stocks to bonds as well as other financial instruments, such as money market accounts, certificate of deposits and others.
The dividend yield is expressed as an annual percentage.
In order to calculate it, you need to know a company’s annual cash dividend per share as well as the current price of the stock. You have to take the dividend per share and divide it by the price per share.
Formula: Dividend Yield= Dividend Per Share/Price Per Share
For instance, company X has annual dividend per share of $3 and the price of this share is $10. The result is 0,3 (3/10), which means 30% Dividend Yield.
4. Debt-to-Equity Ratio (D/E Ratio)
This is yet another very important measure.
Simply put, this ratio shows the total debt of a company compared to its net worth. Therefore, you need to know two things when computing this ratio: total debt of the company and total shareholder equity. It will show the percentage of “leverage” a company has used. You can find the above-mentioned information on the balance sheet.
Formula: D/E Ratio = Total Debt/Total Shareholder Equity
For example, a company has listed for 2017 total liabilities of $45 million and shareholder equity of $11 million. The result it 45/11=4.09 which is 409%.
The lower the ratio, the better. Investors should consider carefully companies with a D/E Ratio above 50%.
5. Return On Equity (ROE)
This ratio shows how efficient a company is when it comes to making a profit. The efficiency is measured by the invested funds. For this tool, we take the net income of a company and divide it by the average shareholder equity.
Formula: ROE= Net Profit/ Average Shareholder Equity
For instance, a company has generated $3 million net income for 2015 and has $5 million in shareholder equity. The result is 0.6 (3 million/5 million), therefore 60% return on equity. The basic rule is – the higher the percentage, the better.
Keep in mind:
You have to use this ratio only for companies that produce profits. This tool is not relevant for comparing companies which do not generate income. If you compare individual stocks using the ROE ratio, the general rule is the higher, the better. Higher ROE might be a sign that a stock can generate more profit in the future.
6. Current Ratio
Yet another financial tool that proves how strong and sound financially a company is. If we have to be precise, this ratio assesses a company’s liquidity. In order to calculate this measure, you need to know two things. The first one is the company’s current assets, and the second is the company’s current liabilities.
Formula: Current Ratio = Current Assets/Current Liabilities.
For instance, a company has $300 million in total current assets while its total liabilities are worth $100 million. The result is 3 (300 million/100 million), which is your Current Ratio.
The idea of using this tool is to make sure a company’s current assets would be able to pay off its debt. Most experts think that a ratio above 1 is a good sign – a company’s assets can pay off its liabilities. On the other hand, a Current Ratio below 1 might mean the company is not financially sound.
7. Profit Margin
Profit Margin is a ratio that shows how a company’s profit compares to its revenues. As most of the other ratios, we express this one as a percentage. Simply said, it might be indicative of how the company spends its profit. How do you calculate it? You have to take a company’s net income and divide it by its revenue (or sales).
Formula: Profit Margin= Net Profit/ Revenue
There are two types of Profit Margin in which you have to choose two different numbers. The first one is Gross Profit Margin, which uses the gross profit (revenue minus costs of revenue). The second one is Operating Profit Margin, which uses the gross profit minus overhead items.
As a rule, the higher the profit margin, the better the company spends its income. Keep in mind that this measure can vary a lot from sector to sector. When you use it in your analysis, it’s better to compare companies within the same industry.
8. Price-To-Book Ratio (P/B ratio)
Also known as a market-to-book ratio, this financial measure compares a company’s current market price to its book value.
A book value is the value of an asset that is entered in a company’s books. You can find the P/B ratio by knowing two things: market capitalization and book value.
Formula: P/B Ratio = Market Cap/ Book Value
Most people use this tool to find investments which the market has overlooked but have huge potential in the long run.
However, this is not always the case. Indeed, a P/B less than one is a sign that the price is lower than the book value. This can mean also that a company’s performance is very poor and the market reacts adequately to this.
In my opinion, using ratios and financial tools in your job as an investor is crucial.
Knowing the basic ratios can help you analyze better and make long-term investments. The above-listed 8 ratios are perhaps the most common and important. Take a look at them, understand their mechanism and make wiser financial decisions.