There are dozens of fundamental tools for analyzing the price of stocks. One of the more traditional methods for performing security analysis is based on the use of financial ratios. Financial ratios provide a relatively quick way to get a broad overview of specific company related metric. Although it is beyond the scope of this article to list all the financial ratios, we will look at ten key ratios for investors.
Financial Ratios For Investors
There are five main groups of financial ratios that are used for security analysis. This includes valuation ratios, leverage ratios, performance ratios, activity ratios, and liquidity ratios.
Valuation ratios, are also called market ratios and they are used to analyze the value of a given company stock price. Some examples of valuation ratios that we will be covering include the price to earnings ratio, the price to sales ratio, and the price to book ratio.
Leverage ratios are used to gauge the level of debt that a company has on its books by analyzing data points such as current equity, assets and debt position. A few of the leverage ratios that we will be discussing include the debt ratio, and the debt to equity ratio.
Performance ratios, also referred to as profitability ratios allow an investor to understand a company’s metric as it relates to its abilities to generate profits. Some of the performance ratios that we will be covering here include return on assets, and return on equity.
Activity ratios help measure the relative efficiency of a business operation. Essentially, it gauges how well a company is able to manage its assets. One of the most important activity ratios is the asset turnover ratio, which we will be reviewing here.
Last but not least, are liquidity ratios. Liquidity ratios provide an investor the ability to gauge how well a company is likely to service its debt. The current ratio is one of the most important liquidity ratios, and one that we’ll be looking at as well.
So let’s now begin learning the most important fundamental ratios for stocks.
Market Valuation Ratios
Price to Earnings (P/E) Ratio
The price-to-earnings ratio compares a company’s stock price to its earnings per share. This information provides a metric for understanding how much the investor would pay per dollar of earnings. It is a primary ratio used by fundamental analysts in gauging the relative value of a stock.
A high P/E ratio would suggest that the price of the stock is overvalued, while a low P/E ratio would suggest that the price of the stock is undervalued. P/E ratios should be considered in a relative manner. More specifically, the P/E ratio of a company stock should be compared with its direct competitors, peers within the industry, and broad market benchmark. It is among the most important financial ratios for investors.
The P/E ratio is calculated as follows:
P/E ratio = Stock price / Earnings-per-share
So, if Company XYZ is currently trading at $50, and it earnings-per-share is $2, then the P/E ratio for this company would be 25.
If you were to average the P/E ratio of its top five competitors and find that these competitors had an average P/E ratio of 20, then on a relative basis Company XYZ could be considered as overvalued. Alternatively, if the average P/E ratio of its top five competitors was 30, then on a relative basis Company XYZ could be considered as undervalued.
Price/Earnings to Growth (PEG) Ratio
The price earnings to growth ratio is a variation of the price earnings ratio discussed above. More specifically, the PEG ratio takes into account the future earnings growth potential. As such, it provides an investor with a metric that can often be more indicative of the real value based on its current growth trajectory.
The PEG ratio is calculated as follows
PEG ratio = P/E ratio / Earnings per share growth
As such, if Company XYZ has a P/E ratio of 30 and is expected to grow by 20%, then the PEG ratio would be 1.5. This is calculated by dividing 30, the current price to earnings ratio, by the expected growth, 20.
Generally speaking, a PEG ratio of 1.25 and below is considered within the undervalued range.
Let’s look at another example of the PEG ratio.
If Company ABC has a P/E ratio of 20 and is expected to grow by 25%, then the PEG ratio would be .80. This is calculated by dividing 20, the current price-to-earnings ratio, by the expected growth of 25, In this case, Company ABC which has a PEG ratio of .80 would be considered undervalued.
Price to Book (P/B) Ratio
The Price-to-Book ratio is another financial ratio that helps a stock investor determine the valuation of a company. The price-to-book measures a company’s stock price by comparing it to its book value.
The price-to-book ratio is calculated as follows:
PB ratio = Stock price / Book value per share
Let’s take a look at an example. Assume that company stock ABC is trading at $50. Additionally it has a total book value of $5 million with 200,000 shares outstanding. As such, the book value per share would be $25. This is calculated by dividing the $5 million total book value by 200,000 shares outstanding . Now that we know the share price and the book value per share, we can calculate the actual PB ratio. The PB ratio for company ABC would be 2. Again this is arrived at by dividing the current traded price for the stock of $50 by the book value per share of $25.
Obviously the lower the price-to-book ratio the more it is said to be undervalued. Similarly the higher the price-to-book ratio the more it is said to be overvalued. The P/B ratio of a specific company is best analyzed on a relative basis by comparing it to its peers within an industry.
Price to Sales (P/S) Ratio
The price to sales ratio provides investors with insight into a company stock price as it relates to its overall sales per share. The PS ratio essentially allows an investor to know how much they are paying for each dollar unit of sales.
The PS ratio is useful, particularly when a company has not posted profits on their sales. As such, the P/S ratio can be seen as an alternative to the P/E ratio. All that is required to calculate the PS ratio is the stock’s current price and the sales per share.
The Price to Sales ratio is calculated as follows
PS ratio = Stock price / Sales per share
Let’s assume company XYZ is currently trading at $200 and it has posted $5 million in sales over the last year. If company XYZ has 200,000 shares outstanding, the sales per share would equal $25. This is calculated by dividing the total sales of 5 million by the 200 K outstanding shares.
Now that we have the required information for the stock price and the sales per share, we can calculate the PS ratio. In this case, the PS ratio for company XYZ would equal 8. We arrived at this by dividing the current stock price by the sales per share. So what this tells us is that the investor would be paying eight dollars for XYZ stock for every one dollar in sales. The PS ratio is best use on a relative basis by comparing PS ratios of companies within a specific industry or sector.
One way to calculate the return on investment of a stock security is by analyzing its dividend yield. The dividend yield metric provides information, based on a percentage, on the amount of payout in the form of a dividend. Along with the capital appreciation of a stock, dividend yield payments contribute to the total earnings from a stock holding.
Dividend yield is calculated in the following manner:
Dividend Yield = ( Dividends per share / Stock price ) X 100
Not all companies pay a dividend, but for those that do a higher dividend yield translates to a higher payout relative to the stock price, while a lower dividend yield translate to a lower payout relative to the stock price. As a general guideline, most dividend paying stocks will yield 2 to 5% annually.
Let’s illustrate an example of a dividend yield. Let’s assume that the share of company XYZ is trading at $40. If XYZ has paid out to $2,500,000 in dividends and currently has 1,250,000 shares outstanding, the dividend per share would be calculated as $2. Now that we have the required data points for calculating the dividend yield let’s plug-in the numbers.
Dividend yield = ( $ 2 / $40 ) x 100 = 5%
In this case, company XYZ is paying out a dividend of 5%, which would be considered the higher end of the range for most dividend paying stocks.
The debt ratio provides insight into the company’s debt position relative to its existing assets. The debt ratio tells an investor on a percentage basis how much of a company’s total assets are a function of its debt total.
Debt Ratio = Total liabilities / Total assets
The debt ratio is a fairly simple financial ratio to calculate. It simply arrived at by dividing the total liabilities by the total assets. A value of one or greater means that the company has more debt than assets. Similarly a value of less than one would indicate that the company has less debt than assets.
If company ABC has $500,000 in total liabilities and $1.5 million in total assets what would its debt ratio be? Well we know that the debt ratio is calculated by dividing the total liabilities by the total assets. As such in this case we would divide 500,000 by 1 .5 million to arrive at 0.33. Based on this number, the debt ratio tells us that company ABC as about one third of its entire assets funded by debt.
Obviously, a strong healthy company will exhibit a lower debt ratio, whereas companies that are highly leveraged will exhibit higher debt ratios. Since many early-stage and growth companies will take on a high level of debt in an attempt to gain market share, it is important to rely on other related metrics as well when gauging the overall viability of these types of companies.
Return on Assets (ROA)
Financial ratio analysis using ROA provides valuable insight into a company’s profitability. More specifically, it tells us how much profit the company has generated from its total assets.
Return on Assets is calculated in the following manner:
ROA = ( Net income / Total assets ) X 100
If company XYZ has earned $50,000 over the last 12 months, and it has total assets of $600,000, then if we plug in the numbers we would get an ROA for company XYZ of 8%, rounded to the nearest whole number. We arrive at this by dividing the net income for company XYZ which is 50,000, by its total assets which is $600,000. Essentially what this means is that the company is providing an 8% return on its total assets of $600,000.
Let’s look at another example of ROA.
If company ABC has reported $100,000 in net income over the last year, and it has total assets of $400,000, then if we plug in the numbers we would get an ROA for company ABC of 25%. Based on this, company ABC is providing $25 of net income for every $100 invested in the company. Generally speaking, longer term investors should seek a return on assets figure that exceeds 7% or so.
Return on Equity (ROE)
The Return on equity performance metric is similar to the ROA financial ratio discussed previously, however, the ROE ratio relies on shareholders equity instead of total assets.
ROE tells us the amount of profit in percentage terms generated per every dollar of shareholders equity.
Here’s how you would calculate the ROE financial ratio:
ROE = ( Net income / Shareholders equity ) X 100
Let’s run through an example of a company’s return on equity calculation. Assuming that company XYZ has reported a net income of $200,000. And its balance sheet reflects $5 million in equity, then the ROA financial ratio would equate to 4%. Stated another way, company XYZ has managed to earn a 4% return on its internal shareholder equity of $5 million.
While ROE figures can vary from one company to the next, and even from one industry to the next, a good ROE number would be in the range of 10 to 12% and higher.
Asset Turnover Ratio
Asset turnover ratio is one of the best financial ratios for measuring a company’s business activity. It can tell us how effective the management is in converting its assets into sales. The higher the asset turnover ratio the more efficient the company is in managing its assets and creating a healthy turnover from those assets.
The Asset Turnover Ratio is calculated per below:
Asset turnover ratio = Net sales / Average total assets
The asset turnover ratio is particularly useful for analyzing inventory intensive businesses such as retail. Although the asset turnover ratio can vary greatly depending on the industry, most retail businesses strive for an asset turnover ratio of two or higher.
Let’s look at an example of the asset turnover ratio. Assume that company XYZ has reported $4 million in sales over its last 12 months. In addition, its financial statement revealed that company XYZ has $2.5 million in average total assets for the period. As such, if we divide the company’s net sales of $4 million by its average total assets of $2.5 million, we will be able to calculate that the asset turnover ratio in this case is 1.6. In other words, company XYZ generates $1.6 in sales per dollar in owned assets.
The current ratio is one of the most useful liquidity ratios that investors look at. The current ratio measures a company’s ability to cover its shorter-term obligations which include things such as accounts payables, employee wages, and income taxes. The current ratio is also referred to as the working capital ratio.
The Current Ratio is calculated using the below formula
Current Ratio = Current assets / Current liabilities
Let’s look at an example of the current ratio. Let’s assume that a company is showing $300,000 in current assets and it has $150,000 in current liabilities. Based on this the current ratio would equate to 2. Said another way, this company could pay its current liabilities two times over based on its current assets.
A current ratio that falls below one can be problematic for a company from the cash flow perspective. This is because with a current ratio less than one, a company would not have sufficient cash to pay for its current liabilities, which could result in a cash crunch. Companies that have a current ratio exceeding 1.5 will typically be able to service its short-term liabilities fairly easily, and avoid concerns relating to short-term liquidity.
We have looked at 10 main ratios for financial analysis that every stock investor should know about. We’ve detailed at least one financial ratio within each of the five main categories. All investors are encouraged to evaluate these different fundamental analysis ratios as part of their due diligence process.
Additionally, as we’ve touched upon earlier, many of these fundamental ratios should be analyzed on a relative basis. This is because different industries and sectors will have different metrics, and as such, relying on the absolute number by itself, can prove to be much less useful.
A perfect example of this would be the price to earnings ratio. As we know the P/E ratio tells us whether a company is overvalued, undervalued, or within an expected range. P/E ratios for technology companies tend to be very high in relation to companies in consumer staples, for example.
As such it would not make much sense to compare the P/E ratio of a company such as Apple with a company such as Kellogg. The more appropriate comparison of the P/E ratio as it relates to Apple would be to compare it to the P/E ratio of Google for example. This would make more sense since both of these companies are in the technology sector.
Now that we’ve presented the best ratios for financial analysis, it up to you to start using them in your investment decision making process.