8 Financial Ratio Analysis that Every Stock Investor Should Know. The valuation of a company is a very tedious job. It’s not easy to evaluate the true worth of a company as the process takes the reading of company’s several years’ financial statements like balance sheet, profit and loss statements, cash-flow statement, Income statement etc.
Although it really tough to go through all these information, however, there are various financial ratios available which can make the life of a stock investor really simple. Using these ratios they can choose right companies to invest in or to compare the financials of two companies to find out which one is better.
This post about ‘8 Financial Ratio Analysis that Every Stock Investor Should Know’ is divided into two parts. In the first part, I will give you the definitions and examples of these 8 financial ratios. In the second part, after financial ratio analysis, I will tell you how and where to find these ratios. So, be with me for the next 8-10 minutes to enhance your financial knowledge.
So, let’s start the first part of this post with the financial ratio analysis.
If you are a beginner and want to learn stock market, I will highly recommend you to read this book first: Everything You Wanted to Know About Stock Market Investing
Quick note: You don’t need to worry about how to calculate these ratios or remember the formulas by-heart, as it will be already given in the financial websites. However, I will recommend you to go through this financial ratio analysis as it’s always beneficial to have good financial knowledge.
Financial Ratio Analysis that Every Stock Investor Should Know:
Earnings Per Share (EPS):
This is one of the key ratios and is really important to understand Earnings per share (EPS) before we study other ratios. EPS is basically the profit that a company has made over the last year divided by how many shares are on the market. Preferred shares are not included while calculating EPS.
Earnings Per Share (EPS) = (Net income – dividends from preferred stock)/(Average outstanding shares)
From the perspective of an investor, it’s always better to invest in a company with higher EPS as it means that the company is generating greater profits. Also, before investing in a company, you should check it’s EPS for the last 5 years. If the EPS is growing for these years, it’s a good sign and if the EPS is regularly falling or is erratic, then you should start searching another company.
Price to Earnings Ratio (P/E)
The Price to Earnings ratio is one of the most widely used financial ratio analysis among the investors for a very long time. A high P/E ratio generally shows that the investor is paying more for the share. As a thumb rule, a low P/E ratio is preferred while buying a stock, but the definition of ‘low’ varies from industries to industries. So, different sectors (Ex Automobile, Banks etc) have different P/E ratios for the companies in their sector, and comparing the P/E ratio of the company of one sector with P/E ratio of the company of another sector will be insignificant. However, you can use P/E ratio to compare the companies in the same sector, preferring one with low P/E. The P/E ratio is calculated using this formula:
Price to Earnings Ratio= (Price Per Share)/( Earnings Per Share)
It’s easier to find the find the price of the share as you can find it at the current closing stock price. For the earning per share, we can have either trailing EPS (earnings per share based on the past 12 months) or Forward EPS (Estimated basic earnings per share based on a forward 12-month projection. It’s easier to find the trailing EPS as we already have the result of the past 12 month’s performance of the company.
Price to Book Ratio (P/B)
Price to Book Ratio (P/B) is calculated by dividing the current price of the stock by the latest quarter’s book value per share. P/B ratio is an indication of how much shareholders are paying for the net assets of a company. Generally, a lower P/B ratio could mean that the stock is undervalued, but again the definition of lower varies from sector to sector.
Price to Book Ratio = (Price per Share)/( Book Value per Share)
Debt to Equity Ratio
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). Generally, as a firm’s debt-to-equity ratio increases, it becomes riskier A lower debt-to-equity number means that a company is using less leverage and has a stronger equity position.
Debt to Equity Ratio =(Total Liabilities)/(Total Shareholder Equity)
As a thumb of rule, companies with a debt-to-equity ratio more than 1 are risky and should be considered carefully before investing.
Return on Equity (ROE)
Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity. ROE measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders has invested. In other words, ROE tells you how good a company is at rewarding its shareholders for their investment.
Return on Equity = (Net Income)/(Average Stockholder Equity)
As a thumb rule, always invest in a company with ROE greater than 20% for at least last 3 years. A yearly increase in ROE is also a good sign.
Price to Sales Ratio (P/S)
The stock’s price/sales ratio (P/S) ratio measures the price of a company’s stock against its annual sales. P/S ratio is another stock valuation indicator similar to the P/E ratio.
Price to Sales Ratio = (Price per Share)/(Annual Sales Per Share)
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.
The current ratio is a key financial ratio for evaluating a company’s liquidity. It measures the proportion of current assets available to cover current liabilities. It is a company’s ability to pay its short-term liabilities with its short-term assets. If the ratio is over 1.0, the firm has more short-term assets than short-term debts. But if the current ratio is less than 1.0, the opposite is true and the company could be vulnerable
Current Ratio = (Current Assets)/(Current Liabilities)
As a thumb rule, always invest in a company with a current ratio greater than 1.
A stock’s dividend yield is calculated as the company’s annual cash dividend per share divided by the current price of the stock and is expressed in annual percentage.
Dividend Yield = (Dividend per Share)/(Price per Share)*100
For Example, If the share price of a company is Rs 100 and it is giving a dividend of Rs 10, then the dividend yield will be 10%. It totally depends on the investor whether he wants to invest in a high or a low dividend yielding company.
If you want to read further in details, I will recommend you to read this book: Everything You Wanted to Know About Stock Market Investing -Best selling book for stock market beginners.
Now that we have completed the key financial ratio analysis, we should move towards where and how to find these financial ratios.
For an Indian Investor, you these are 3 big financial websites where you can find all the key ratios mentioned above along with other important financial information:
I, generally use money control to find the key financial ratio analysis. The mobile app for Money control is also very efficient and friendly and I will recommend you to use the mobile app.
Now, let me show you how to find these key ratios in Money Control. Let’s take a company, Say ‘Tata Motors’. Now, we will dig deep to find all the above-mentioned rations.
Financial ratio analysis -Steps to find the Key Ratios in Money Control:
- Open http://www.moneycontrol.com/ and search for ‘Tata Motors’.
- This will take you to the Tata Motor’s stock quote page.
Scroll down to find the P/E, P/B, and Dividend Yield.
- Now go to the ‘Financials’ tab and select ‘Ratio’ option [i.e. Financial Ratio]
Scroll down to find all the remaining financial ratios.
That’s all! These are the steps to do the key financial ratio analysis. Now, let me give you a quick summary of all the key financial ratios mentioned in the post.
8 Financial Ratio Analysis that Every Stock Investor Should Know:
- Earnings Per Share (EPS) – Increasing for last 5 years
- Price to Earnings Ratio (P/E) – Low compared to companies in the same sector
- Price to Book Ratio (P/B) – Low compared companies in the same sector
- Debt to Equity Ratio – Should be less than 1
- Return on Equity (ROE) – Should be greater than 20%
- Price to Sales Ratio (P/S) – Smaller ratio (less than 1) is preferred
- Current Ratio – Should be greater than 1
- Dividend Yield – Depends on Investor/ Increasing preferred
In addition, here is a checklist (that you should download) which can help you to select a fundamentally strong company based on the financial ratios.
Feel free to share this image with ones whom you think can get benefit from the checklist.
I hope this post on ‘8 Financial Ratio Analysis that Every Stock Investor Should Know’ is useful for the readers. If you have any doubt or need any further clarifications, feel free to comment below. I will be happy to help you.
Hi, I am Kritesh, an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting