Five Key Financial Ratios for Analyzing Stocks

 5 Financial Ratios that an investor must know

Five Key Financial Ratios for Analyzing Stocks

There are several stock ratios, but these five financial ratios are so fundamental to analyzing stocks that you really should know them like the back of your hand. If anything, they can help give you direction when trying to figure the “value” of a stock. You’re probably asking yourself: Valuation relative to what? Well, that’s the point.

You might want to view a stock’s value from many different angles. But certainly you want to make sure you have all the basics covered. And that’s what these five financial ratios are designed to do. So, let’s get started.

Price-to-Earnings (P/E) Ratio

Price-to-earnings (P/E) ratio is quite possibly the “most heavily used stock ratio in the world,” said Michael Fairbourn, education coach at TD Ameritrade. The P/E ratio tells you how much investors are willing to pay for a stock above its annual per-share earnings.

For example, if a stock has a P/E ratio (also called the “multiple”) of 20, it means investors are willing to pay up to 20 times its annual earnings per share to own it. But is that too much or too little? Expensive or cheap?

Ultimately, it can depend on what a company is capable of accomplishing in terms of future earnings. You can always compare a stock’s P/E to that of the S&P 500 historical average, which, according to Fairbourn, is currently near 20. Besides that, the P/E ratio can’t really tell you much beyond what investors are willing to pay now.

“If a company with a 35 P/E has a higher growth rate than a company with a 10 P/E, then the company on the higher end of the ratio might actually be ‘cheaper,’” Fairbourn explained. And this brings us to the next stock ratio.

Price/Earnings-to-Growth (PEG) Ratio

Not as popular as its P/E relative, the price/earnings-to-growth (PEG) ratio may provide an even more comprehensive and clear 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 be “cheap,” but if the company can’t seem to grow, what’s the point of holding on to a stock with a low P/E?

“With this stock 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,” Fairbourn explained. So, how might you read this? Fairbourn suggested that if the PEG ratio is less than one, it may be considered undervalued based on expected earnings.

Why is the growth component so important? “You don’t want to buy something that will forever be a bargain,” Fairbourn said. “Investors often want to see a history of growth in combination with projected growth. This could help validate an undervalued PEG ratio.”

Price-to-Sales (P/S) Ratio

Some companies might have strong quarterly revenue (another word for “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 here is sales.

The price-to-sales (P/S) ratio shows how much investors are willing to pay above a company’s “revenues.” 

“Sales are generally subject to less manipulation by management in comparison to earnings,” Fairbourn said. In other words, sales are sales, period. Although earnings can be affected by various expenses, what a company makes in sales is quite straightforward.

“The P/S helps us understand the relationship between the current stock price and the annual sales of a company. So, if a ratio gives us a reading of, say, .53, then the ratio is telling us that we are paying 53 cents per share for every dollar the company makes in sales,” Fairbourn explained. 

How to Calculate Financial Ratios

P/E Ratio Formula: P/E Ratio = Share Price ÷ Earnings per Share

PEG Ratio Formula: PEG Ratio = P/E Ratio ÷ EPS Growth

P/S Ratio Formula: P/S Ratio = Stock Price ÷ Sales per Share

P/B Ratio Formula: P/B Ratio = Stock Price ÷ Book Value per Share

D/E Ratio Formula: D/E Ratio = Total Liabilities ÷ Total Shareholders’ Equity

Price-to-Book (P/B) Ratio

How much is a company’s stock worth relative to its net asset value (book value)? That’s what the price-to-book (P/B) ratio attempts to show us.

On the surface, it’s an effective metric that can compare a stock’s market cap to “what it owns versus what it owes,” said Fairbourn.

But he also pointed out a big caveat: “Depending on the industry, many companies’ asset costs are priced not according to market value but value carried at the time of acquisition.” For example, if a company that’s been around purchased real estate decades ago, the book value of that property may be decades old, not marked-to-market. So, to find the real book value of a company, you might have to dig a lot deeper, beyond the books.

Debt-to-Equity (D/E) Ratio

Similar to a company’s book value, we reverse the term for this last financial ratio, seeking to find out what a company owes relative to what it owns. The calculation is pretty simple.

Generally, investors prefer the debt-to-equity (D/E) ratio to be less than one. A reading of two or higher might be interpreted as carrying more risk. But it also depends on the industry. According to Fairbourn, “Some companies, like big industrial energy and mining companies, tend to carry more debt than businesses in other industries.”

So, if you find an industry that typically carries a higher debt load, it may offer greater return but at the expense of more risk.

Finding Your Way

Analyzing the value of a stock may not be all that simple. Calculations won’t give you a clear answer, but if you treat them as coordinates on a map, they might point you in the right direction. As with every map, you can’t always see the road or weather conditions. That’s where you’ll have to make your own adjustments and decide whether an opportunity is favorable or too risky. These five key financial and stock ratios should help you get started.

Thank you Ameritrade