List of Important Financial Ratios for Stock Analysis
When you're research individual stocks for investing, you have to look beyond the basics like share price, number or shares, and market capitalization. Here are some important financial ratios to help you better understand the company you are about to invest in.
Common Investment Valuation Ratios
- Book Value Per Share - The book value of a company divided by the number of shares outstanding.
- Dividend Payout Ratio - Dividends paid divided by company earnings over some period of time, expressed as a percentage.
- Dividend Yield - The yield a company pays out to its shareholders in the form of dividends.
- Price to Earnings Ratio - The most common measure of how expensive a stock is. The P/E ratio is equal to a stock's market capitalization divided by its after-tax earnings over a 12-month period, usually the trailing period but occasionally the current or forward period. The value is the same whether the calculation is done for the whole company or on a per-share basis. Companies with high P/E ratios are more likely to be considered "risky" investments than those with low P/E ratios, since a high P/E ratio signifies high expectations. Comparing P/E ratios is most valuable for companies within the same industry. The last year's price/earnings ratio (P/E ratio) would be actual, while current year and forward year price/earnings ratio (P/E ratio) would be estimates, but in each case, the "P" in the equation is the current price. Companies that are not currently profitable (that is, ones which have negative earnings) don't have a P/E ratio at all. Also called earnings multiple.
- PEG Ratio - A stock's price/earnings ratio divided by its year-over-year earnings growth rate. In general, the lower the PEG, the better the value, because the investor would be paying less for each unit of earnings growth.
- Price to Sales Ratio - A stock's capitalization divided by its sales over the trailing 12 months. The value is the same whether the calculation is done for the whole company or on a per-share basis. A low price to sales ratio (for example, below 1.0) is usually thought to be a better investment since the investor is paying less for each unit of sales. However, sales don't reveal the whole picture, since the company might be unprofitable. Because of the limitations, price to sales ratio are usually used only for unprofitable companies, since such companies don't have a price/earnings ratio (P/E ratio).
The Liquidity RatiosLiquidity of a company is an important indicator of its health. It measures the ability of a company to convert its assets into cash quickly without any price compromise. Here are a few ratios to look at when measuring liquidity:
- Cash Ratio - The total dollar value of cash and marketable securities divided by current liabilities. The cash ratio measures the extent to which a company can quickly liquidate assets and cover short-term liabilities, and therefore is of interest to short-term creditors. Also called Liquidity Ratio or Cash Asset Ratio.
- Current Ratio - The value of current assets divided by current liabilities. The current ratio measures a company's ability to meet short-term debt obligations; the higher the ratio, the more liquid the company is. If the current assets of a company are more than twice the current liabilities, then that company is generally considered to have good short-term financial strength. If current liabilities exceed current assets, then the company may have problems meeting its short-term obligations.
- Quick Ratio - A measure of a company's liquidity and ability to meet its obligations. Quick ratio, often referred to as acid-test ratio, is obtained by subtracting inventories from current assets and then dividing by current liabilities. Quick ratio is viewed as a sign of company's financial strength or weakness (higher number means stronger, lower number means weaker).
- Cash Conversion Cycle - The length of time between the purchase of raw materials and the collection of accounts receivable generated in the sale of the final product.
ProfitabilityIn general, you want to invest in companies that are profitable. Here are a few ratios to look at when measuring profitability:
- Profit Margin - Net profit after taxes divided by sales for a given 12-month period, expressed as a percentage.
- Effective Tax Rate - Actual income tax paid divided by net taxable income before taxes, expressed as a percentage.
- Return on Assets (ROA) - A measure of a company's profitability, equal to a fiscal year's earnings divided by its total assets, expressed as a percentage.
- Return on Capital Employed (ROCE) - A measure of the returns that a company is realizing from its capital. Calculated as profit before interest and tax divided by the difference between total assets and current liabilities. The resulting ratio represents the efficiency with which capital is being utilized to generate revenue.
- Return on Equity (ROE) - A measure of how well a company used reinvested earnings to generate additional earnings, equal to a fiscal year's after-tax income (after preferred stock dividends but before common stock dividends) divided by book value, expressed as a percentage. It is used as a general indication of the company's efficiency; in other words, how much profit it is able to generate given the resources provided by its stockholders. investors usually look for companies with returns on equity that are high and growing.
DebtSome debt is good, but too much debt could be bad. In general, you want to invest in companies that can manage its debt well and can effectively leverage debt to its advantage. Here are a few ratios to look at:
- Capitalization Ratio - Ratios that express each component of a firm's capital (common stock or ordinary share, preferred stock or preference shares, other equities, and debt) as a percentage of its total capitalization. These ratios are used in analyzing the firm's capital structure.
- Debt to Asset Ratio - Debt capital divided by total assets. This will tell you how much the company relies on debt to finance assets. When calculating this ratio, it is conventional to consider both current and non-current debt and assets. In general, the lower the company's reliance on debt for asset formation, the less risky the company is since excessive debt can lead to a very heavy interest and principal repayment burden. However, when a company chooses to forgo debt and rely largely on equity, they are also giving up the tax reduction effect of interest payments. Thus, a company will have to consider both risk and tax issues when deciding on an optimal debt ratio.
- Debt to Equity Ratio - A measure of a company's financial leverage. Debt to equity ratio is equal to long-term debt divided by common shareholders' equity. Typically the data from the prior fiscal year is used in the calculation. Investing in a company with a higher debt to equity ratio may be riskier, especially in times of rising interest rates, due to the additional interest that has to be paid out for the debt. It is important to realize that if the ratio is greater than 1, the majority of assets are financed through debt. If it is smaller than 1, assets are primarily financed through equity.
- Interest Coverage Ratio - A calculation of a company's ability to meet its interest payments on outstanding debt. Interest coverage ratio is equal to earnings before interest and taxes for a time period, often one year, divided by interest expenses for the same time period. The lower the interest coverage ratio, the larger the debt burden is on the company.
ProductivityYou also want to look at how well the company utilizes its resources. Here are a few ratios to look at:
- Fixed Asset Turnover Ratio - A way of determining the productivity of a business, expressed as the ratio between money spent on fixed assets and the total amount of revenue generated from sales. The less money spent on fixed assets for any given amount of sales revenue, the more efficiently the business is operating.
- Operating Cycle - The average time between purchasing or acquiring inventory and receiving cash proceeds from its sale.
- Revenue per Employee - Ratio of sales at a company in relation to the amount of current employees. The figure is computed by taking the total earnings of a company and dividing it by the number of current employees.
Cash FlowYou probably have heard this before: "Cash Flow is King." In business, you want to invest in companies with good cash flow. Here are a few ratios to look at:
- Operating Cash Flow Ratio - This is a determination of whether current cash flow can support the amount of expenses the company has generated.
- Sales to Cash Flow Ratio - An indicator of the financial strength of a company. This ratio looks at sales in relation to cash flow. The higher the value of this ratio, the stronger the company. Formula: sales per share divided by cash flow per share (or equivalently, total sales divided by total cash flow).
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