A financial ratio for a stock (or a bond) gives the investor a simple way for measuring a company's fundamental quality.
Investors can do a ratio analysis easily based on a company's financial statements, found in a company's quarterly release (10-K) and available for free on the SEC site . All ratio calculation can be done using the numbers found on one of the financial statements (income statement, balance sheet, and cash flow statement).
Why are financial ratios important to investors?
Investors can do a ratio analysis easily based on a company's financial statements, found in a company's quarterly release (10-K) and available for free on the SEC site . All ratio calculation can be done using the numbers found on one of the financial statements (income statement, balance sheet, and cash flow statement).
Why are financial ratios important to investors?
- help select and hold quality stocks for long term investment
- help decide when to sell a stock if its quality starts to deteriorate
- help evaluate hot stock tips from newsletters which are often unreliable
- help understand fundamental value of equity investment
Earnings Per Share
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Earnings Per Share (EPS) is the amount of profit that accrues to each shareholder on a per share basis. When the earning is positive (profit), Price to Earnings Ratio (P/E) can then be easily calculated to compare companies within the same industry. P/E is simply the price you will pay for $1 of earnings and thus it is meaningless if there is no earnings.
The EPS is often a good measure of how a company is doing from year to year and is used by many investors in the market. However, companies know that the EPS is often a measure of how they are handling their businesses. This leads some companies may manipulate the EPS. The ratio can be manipulated if the company were to buy or sell its own shares in the market, referred to as Treasury Stock. The net income aspect can also be manipulated through the recognition of revenue as well as other ways. EPS Formula EPS = (Net Income – Preferred Dividends) ÷ Shares Outstanding |
Price to Sales Ratio
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Price to Sales Ratio (P/S) indicates how much investor paid for a share compared to the sales a company generated per share. It measures the value placed on sales by the market. P/S is the price you will pay for $1 of sales. The P/S ratio is a great tool because sales figures are considered to be relatively reliable while other income statement items, like earnings, can be easily manipulated by using different accounting rules. .
A higher ratio means that the market is willing to pay for each dollar of annual sales. In general, the lower the P/S, the better the value is because investors are paying less for each unit of sales. However, the value of the ratio varies across industries. A better benchmark is to compare with its own historical performance and market competitors. Note that P/S alone does not take into account any expenses or debt and a company with high sales maybe unprofitable. P/S Formula P/S = Market price per share ÷ Sales per share = Market Cap ÷ Total sales |
Quick Ratio
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Quick Ratio, also known as the acid test ratio, reveals a company’s ability to meet short-term operating needs by using its liquid assets. It is considered a very reliable indicator of a company’s short-term financial strength. The Quick Ratio subtracts inventory from current assets and compares the liquid asset to the current liabilities. Note that value for the Quick Ratio analysis varies widely by company and industry. In theory, the higher the ratio is, the better the position of the company is. However, a better benchmark is to compare the ratio within the same industry.
Quick ratios are often explained as measures of a company’s ability to pay their current debt liabilities without relying on the sale of inventory. For bond holders, the Quick Ratio is very helpful because it reveals a company’s ability to pay off under the worst possible condition. Quick Ratio Formula Quick Ratio = (Cash + Accounts Receivable + Cash equivalents) ÷ Current liabilities |
Other Notable Ratios for Equity Evaluation
While there are quite a few financial ratios, the most important three financial ratios are list above. There are other ratios that could also be indispensable tools for investor's in-depth research process. The analysis of financial ratios can greatly influence investors' decision to purchase, hold, or sell a stock (or a bond). Other significant ratios for equity evaluation include
While there are quite a few financial ratios, the most important three financial ratios are list above. There are other ratios that could also be indispensable tools for investor's in-depth research process. The analysis of financial ratios can greatly influence investors' decision to purchase, hold, or sell a stock (or a bond). Other significant ratios for equity evaluation include
- PEG Ratio = (P/E Ratio) ÷ Projected Annual Growth in Earnings per Share. PEG ratio uses the basic format of the Price to Earnings Ratio (P/E ratio) for a numerator and then divides by the potential growth for EPS, which you'll have to estimate. The two ratios may seem to be very similar but the PEG ratio is able to take into account future earnings growth. A very generally rule of thumb is that any PEG ratio below 1.0 is considered to be a good value.
- P/B Ratio = Price per Share ÷ Book Value per Share. Book value per share is calculated by dividing the book value by the number of shares outstanding gives you . Book value is listed on the balance sheet as shareholder equity. Equity is the portion of the company that owners (i.e. shareholders) own free and clear. Like P/E, the P/B ratio is essentially the number of dollars you'll have to pay for $1 of equity.
- Profit Margin = Net Income ÷ Sales. Profit margin calculates how much of a company's total sales flow through to the bottom line. Obviously, higher profit margin is better for shareholders.
- Debt to Equity Ratio = Total Liabilities ÷ Total Shareholder Equity. Total liabilities and total shareholder equity are both found on the balance sheet. The debt-to-equity ratio measures the relationship between the amount of capital that has been borrowed (i.e. debt) and the amount of capital contributed by shareholders (i.e. equity). When a firm's debt-to-equity ratio increases, it becomes more risky because if it becomes unable to meet its debt obligations, it will be forced into bankruptcy.