What are financial ratios?
How do you calculate them?
Why should you check them?
And how does all of this help you make better investment decisions?
If these questions have ever come up in your mind, read on to find the answers to them and more.
The PE Ratio
In simple terms, it measures how expensive a stock is by comparing its price to its earnings per share (EPS).
For example, if a company has a PE ratio of 20, that means it’s trading at $20 for every $1 in earnings.
In other words, if you pay $100 for one share of a company with a PE ratio of 20, you’re essentially paying $10 per dollar of profit.
This can be an important measure to look at when you want to make sure your money is being used efficiently and effectively.
The higher that number goes over 30 or 40, it becomes more and more speculative and less viable as an investment option.
The PEG Ratio
While researching a company, it’s important to compare its price with its growth rate (or fundamental value) via financial ratios.
The PEG ratio measures how much you’re paying for a stock compared to its earnings growth rate.
For example, if Company A trades at $50 and is expected to earn $2 per share next year and in each of the following two years, while Company B trades at $40 and is expected to earn $1 per share next year and in each of the following three years, which one should you buy?
Well, according to investing site Investopedia, that would be Company A: Buy company A because it has a lower PEG ratio than company B.
The Dividend Yield
Yield is a financial ratio that measures a stock’s dividend payout in proportion to its share price.
In other words, it’s an approximation of how much cash you’ll get back from your investment—in addition to any capital gains—if you bought and held onto shares for one year.
There are many different types of stocks, but most will fall under one of two categories: yielders or non-yielders.
To check your dividend yield ratio before investing, add up all annual cash dividends paid out by a company over the past year and divide that amount by its current stock price.
Since some companies don’t pay any dividends at all, subtract those firms from your analysis; only factor in companies where you can get a decent return.
Return on equity
A company’s return on equity is a measure of how well its management is using equity to generate earnings.
This number tells you what percentage of earnings were generated by using shareholders’ funds.
It’s calculated by dividing a company’s net income by its shareholders’ equity, which includes common and preferred stock, retained earnings, and other components.
To calculate ROE, first, add up a company’s total equity:
Shareholders’ Equity = (Common Stock) + (Preferred Stock) + Retained Earnings
Then divide that figure by its net income: Return on Equity = Net Income / Total Equity
The ROE for many publicly traded companies can be found in their annual report or quarterly financial statements.
The Net Profit Margin
One of several standard financial ratios, net profit margin measures how much revenue a company keeps after all expenses are paid.
To calculate net profit margin, divide net income by revenue.
The higher your ratio is, the better off you are.
If you’re looking to diversify your portfolio and invest in a wide range of companies and industries, however, look for companies with higher-than-average profit margins.
Remember: Just because one company might be making tons of money doesn’t mean it’s good at managing its finances or that it has solid growth prospects.
Look beyond any single figure when assessing a stock’s worthiness.
Use Net Profit Margin alongside other important metrics like Return on Equity (ROE) to gain valuable insight into a company’s financial health.
The Current Ratio
While other financial ratios are only calculated once a quarter or even once a year, it’s important to check your current ratio regularly.
Because it tells you how close you are to running out of cash.
A current ratio of 1:1 means you have $1 in liquid assets for every $1 in liabilities; a 2:1 ratio means you have $2 in liquid assets for every $1 in liabilities; and so on.
The higher your current ratio, the more resilient your business will be to economic shocks (or if sales suddenly drop).
If you notice that your current ratio drops below 1:1, don’t panic—but do work with management to figure out what happened and how best to address it going forward.
Free Cash Flow Yield
A company’s free cash flow yield is equal to its free cash flow, divided by its market capitalization.
It indicates how much cash a company is generating for every dollar of market value.
The best-run companies generate more free cash flow than they need to grow their business, putting excess cash to work through buybacks or dividends.
For example, if a company’s annualized free cash flow was $3 billion and its total market capitalization was $10 billion, its FCF yield would be 30 percent ($3B / $10B = 0.30).
Any number above 20 percent or so is considered healthy.
The growth rate of a company refers to its increase in earnings or revenue over a specific period.
If a company’s profits are growing faster than 10% every year, it is considered to be growing in a very healthy way.
A negative growth rate indicates that a company is losing money and could eventually go out of business.
To ensure your stock investment has longevity, always check to see if its growth rate matches up with industry standards before investing.
This will ensure you don’t make impulsive financial decisions based on emotion alone.