Investors use financial ratios to gauge the worthiness of an investment. There are seven key financial ratios that investors should use when evaluating a company.
By using a combination of the ratios below, you can make a more sound investment decision.
Price to Earnings (P/E)
The price to earnings ratio is one of the most commonly used ratios. The ratio tells you the multiple that you’re paying for earnings per share. For example, if a stock is trading at $20 a share and the company earns $2 per share, the price to earnings ratio is 10. To calculate the P/E ratio, take the stock price and divide it by earnings per share. Most investors compare the P/E ratio to that of the S&P 500. If the P/E ratio is lower than the S&P 500, the stock may be undervalued and vice versa.
Price to Sales (P/S)
The price to sales ratio is generally used when evaluating unprofitable or high-growth companies. The ratio tells you the multiple that you’re paying for sales (or revenue) per share. For example, if a stock is trading at $30 a share and the company generates $5 of revenue per share, the price to sales ratio is 6. To calculate the P/S ratio, take the stock price and divide it by revenue per share. Most investors compare the P/S ratio to that of the S&P 500. If the P/S ratio is lower than the S&P 500, the stock may be undervalued and vice versa.
Return on Equity (ROE)
Return on equity measures the effectiveness of the company’s management using shareholder’s equity. For example, if a company generates $200 million in profit and has $1 billion in shareholders equity, the ROE is 20%. To calculate ROE, take the company’s profit and divide it by the shareholder’s equity. Generally, a ROE above 10% is considered good, but ROE should be compared to sector peers when analyzing a company.
Return on Assets (ROA)
Return on assets measure the company’s ability to generate income from its assets. For example, if a company generates $200 million in profit and has $2 billion worth of assets, the ROA is 10%. To calculate ROA, take the company’s profit and divide it by the assets. ROA will typically be lower than ROE because companies typically have a higher asset value than equity.
Current Ratio
The current ratio measures the company’s ability to cover short-term liabilities using short-term assets. For example, if a company has $400 million in current assets and $300 million in current liabilities, the current ratio would be 1.33. To calculate the current ratio, take the company’s current assets and divide it by the company’s current liabilities. A current ratio above 1 means the company can effectively meet short-term liabilities using short-term assets. A current ratio below 1 means the company cannot effectively meet short-term liabilities using short-term assets.
Debt to Equity Ratio
The debt to equity ratio measures the company’s financial leverage by showing how much of its equity is financed by debt. For example if a company has $100 million of debt and $120 million in shareholder’s equity, the debt to equity ratio would be 0.83. To calculate the debt to equity ratio, take the company’s outstanding debt and divide it by the company’s shareholder’s equity. A debt to equity ratio above 1 means the company has more debt relative to equity. A debt to equity ratio below 1 means the company has less debt relative to equity.
Cash Flow to Debt Ratio
The cash flow to debt ratio measures the company’s ability to pay debt using 100% of cash from operations. For example, if a company generates $250 million in cash from operations and has $500 million in outstanding debt, the company’s cash flow to debt ratio is 0.5. This means the company could pay all of its debt in 2 years (1/0.5 = 2). To calculate the cash flow to debt ratio, take the company’s cash from operations and divide it by the company’s outstanding debt. It is important to note that a company having to pay all of its debt at once is very unlikely.
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