There are a lot of different useful ratios to evaluate the overall health of a company. We will focus in this article only on a few ratios which are useful for the evaluation of stocks.
Analyzing stocks involves examining various financial ratios to gain insights into a company's financial health and performance. Different ratios provide different perspectives, and it's important to consider multiple ratios to get a comprehensive view. The following list is not exhaustive but presents some key ratios and how to interpret them.
1. Price-to-Earnings (P/E) Ratio:
Formula:
P/E Ratio = Market Price per Share / Earnings per Share (EPS)
Interpretation:
The price-to-earnings (P/E) ratio is quite possibly the most heavily used stock ratio. The P/E ratio—also called the "multiple"—tells you how much investors are willing to pay for a stock relative to its per-share earnings.
A high P/E ratio may indicate that the market has high expectations for future earnings growth, while a low P/E ratio may suggest undervaluation.
However, it's crucial to compare P/E ratios within the industry for a more accurate assessment. For example, if a company with a P/E ratio of 35 has a higher rate of
growth than a company with a P/E ratio of 10, then shares of the company
with the higher ratio might actually be considered cheaper than shares
of the company trading at the lower ratio. And this brings us to the
next ratio.
2. Price-to-Book (P/B) Ratio:
Formula:
P/B Ratio = Market Price per Share / Book Value per Share
Interpretation:
How much is a company's stock worth relative to its net asset value (also called "book value")? That's what the price-to-book (P/B) ratio indicates. On the surface, it's an effective metric that can compare a stock's market capitalization to what it owns versus what it owes. But it's not always that simple.
Figuring what a company's assets are worth can be a big sticking point. Depending on the industry, many companies’ asset costs are priced not according to market value but their value carried at the time of acquisition. For example, if a well-established company purchased real estate decades ago, the value of that property on the firm's books may be decades old, not marked-to-market. To find a company's real book value—which also is called "shareholders' equity"—you might have to dig a lot deeper, beyond the books. The P/B ratio is best suited to large, capital-intensive companies, such as automakers, rather than companies with intangible assets, such as software firms where much of the value is based on patents or other intellectual property that's not carried on the books as an asset.
A P/B ratio of 1 indicates the company's shares are trading in line with
its book value. A P/B higher than 1 suggests the company is trading at a
premium to book value, and lower than 1 indicates a stock that may be
undervalued relative to the company's assets. Industries with high intellectual property assets may have higher P/B ratios.
3. Price-to-sales (P/S) Ratio
Formula:
Interpretation:
Some companies might have strong quarterly sales but weak earnings, perhaps because they ended up spending a good portion of their revenue. Some investors are willing to forego profits now for potentially stronger returns in the future. They understand that certain companies may need to spend their cash and quarterly sales profits to build a bigger and better company for the future. The important thing these investors focus on here is sales.
The price-to-sales (P/S) ratio shows how much investors are willing to pay above a company's gross revenue, whereas investors focused on earnings are looking at revenue minus liabilities.
The P/S ratio helps investors understand the relationship between a company's current stock price and its annual sales. If a P/S ratio is .53, the ratio shows that investors are paying $0.53 per share for every dollar the company makes in sales.
4. Price/earnings-to-growth (PEG) ratio
Formula:
Interpretation:
While it's not as popular as its P/E relative, the price/earnings-to-growth (PEG) ratio can provide a more comprehensive and clearer picture of a stock's future growth prospects.
You may know a stock's P/E ratio, but how does such a number stand relative to its projected growth rate? A company's P/E may seem "cheap," but if the company doesn't grow, what's the point of holding on to a stock with a low P/E?
With the PEG ratio, you're comparing the P/E to the analyst consensus estimate of projected earnings, which typically project as early as quarterly to as long as five years.
For example, a stock with a P/E of 18 and a percentage growth rate of 15% would carry a PEG of 1.2. So, how should you read this number? Typically, stocks with a PEG ratio of less than 1 are considered undervalued.
The growth component is important because investors don't want to buy something that won't increase in value. What investors tend to look for when buying shares with a low PEG ratio is a history of growth in combination with projected growth, which can help validate an undervalued PEG ratio.
5. Dividend Yield:
Formula:
Dividend Yield = Annual Dividend per Share / Current Market Price per Share
Interpretation:
Dividend yield measures the income generated by a stock. A high dividend yield may be attractive to income-seeking investors, but it's essential to assess the sustainability of dividends.
6. Debt-to-Equity (D/E) Ratio:
Formula:
D/E Ratio = Total Debt / Shareholders' Equity
Interpretation:
Similar to a company's book value, we also reverse the term for this last ratio, seeking to find out what a company owes relative to what it owns. The calculation is simple, and the figures for a firm's total debt and shareholders' equity can be found on the consolidated balance sheet.
Generally, investors prefer the debt-to-equity (D/E) ratio to be less than 1. A ratio of 2 or higher might be interpreted as carrying more risk. But it also depends on the industry. Big industrial energy and mining companies, for example, tend to carry more debt than businesses in other industries. That's why investors typically compare a stock's D/E ratio to the D/E of other companies in the same industry.
A high D/E ratio indicates a company has borrowed heavily. That could mean the company is leveraging its assets to finance growth, but it also might signal the company is unprofitable and is surviving by borrowing rather than generating revenue. The question investors want to consider is whether the debt is increasing earnings by more than the cost of the debt, or whether the debt is weighing the firm down with loan payments and other liabilities.
7. Current Ratio:
Formula:
Current Ratio = Current Assets / Current Liabilities
Interpretation:
A ratio above 1 suggests the company can cover its short-term liabilities with its current assets. A lower ratio may indicate liquidity concerns.
8. Return on Equity (ROE):
Formula:
ROE = Net Income / Shareholders' Equity
Interpretation:
ROE measures a company's ability to generate profit from shareholders' equity. A higher ROE is generally favorable, indicating efficient use of equity capital.
9. Earnings Per Share (EPS):
Formula:
EPS = (Net Income - Dividends on Preferred Stock) / Average Outstanding Shares
Interpretation:
EPS shows the company's profitability on a per-share basis. Consistent growth in EPS is typically considered positive.
10. Operating Margin:
Formula:
Operating Margin = (Operating Income / Revenue) x 100
Interpretation:
Operating margin measures a company's profitability from its core operations. A higher operating margin indicates better efficiency.
It's important to note that no single ratio provides a complete picture of a company's health. Consider these ratios in conjunction with qualitative factors, industry benchmarks, and the company's overall strategy. Additionally, historical trends and comparisons with industry peers can enhance your analysis. Keep in mind that stock analysis is complex, and consulting with financial professionals or doing thorough research is advisable.
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