6 Most Important Ratios Every Investor Should Know
Fundamental analysis means analyzing the company’s finances and operations and estimating its growth trajectory. Being familiar with different factors that affect the company can help you decide whether you want to invest in the company or not.
In 2015, When I had just stepped into finance, I knew nothing. Studying business models was a tedious process, and hard to get an accurate image of the financial position of a company just from the balance sheet. It would take weeks to figure out the company’s performance until I learned about Ratio Analysis on YouTube. It was by far the most time-saving thing I learned. Now would only take two days after collecting data to analyze any company.
“I make no attempt to forecast the market — my efforts are devoted to finding undervalued securities.”
Warren Buffett
Here are some primary ratios in investing that everyone should know (even if you are not an investor).
Current ratio
The current ratio measures a company’s ability to pay its short-term debts using its assets.
Current assets are expected to be converted into cash within one year, such as cash, accounts receivable (money owed to the company by its customers), and inventory.
And current liabilities are debts due within one year, such as accounts payable (money the company owes to its suppliers), short-term loans, and taxes owed.
A current ratio of 1 indicates that a company has enough assets to cover its current liabilities. A ratio above one may exhibit that the company has excess liquidity and is in a healthy financial position. While a ratio below one may indicate that the company may have difficulty paying its short-term debts.
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Return on Equity
Return on equity, or ROE, measures the shareholders’ return from the business and overall earnings. You can calculate ROE by dividing the company’s net income by shareholder equity.
Net income is the company’s total profits, including all revenue and expenses for a given period. A company’s assets owned by shareholders represent Shareholder equity. You can calculate Shareholder equity by subtracting the company’s total liabilities from its total assets.
ROE is used to measure how well a company is using its equity to generate profits. A high ROE indicates that the company generates a ton of profit from its equity. A low ROE suggests that the company is not using its equity as effectively to generate profits.
For example, if a company has a net income of $100,000 and shareholder equity of $500,000, its ROE would be 20% ($100,000 / $500,000). It means that for every dollar of equity, the company is making 20 cents in profits.
ROE is a crucial measure of a company’s financial performance, and investors use it to evaluate the potential returns they might receive from investing in a company.
Debt-Equity ratio
The debt-to-equity ratio compares a company’s total liabilities to its shareholders’ equity. It measures a company’s financial leverage.
You can calculate it by dividing the total liabilities by the shareholder’s equity.
The debt-to-equity ratio can assess the financial risk of a company. A high debt-to-equity ratio indicates that a company relies on borrowed money and may be more prone to financial distress in a downturn or economic recession. On the other hand, a low debt-to-equity ratio suggests that shareholder’s equity funds a company and may be more financially stable.
It is important to note that no “ideal” debt-to-equity ratio applies to all companies. The appropriate debt-to-equity ratio will depend on the industry in which a company operates, as well as its financial goals and risk tolerance.
Dividend Yield
If you are into dividend investing, this ratio is one of the most crucial ratios you must know about.
Dividend Yield is expressed as a percentage of the stock’s price.
For example, if a company’s stock trading at $50 per share pays an annual dividend of $2 per share, the dividend yield would be 4% (2 / 50). It means that an investor who owns one share of the stock would receive an annual return of 4% in the form of dividends.
P/B ratio
The price-to-book (P/B) ratio is a financial ratio used to evaluate the relative value of a company’s stock price compared to its book value. The book value is the value of assets recorded on the balance sheet & represents the amount that shareholders would theoretically receive if a company were to liquidate all its assets and pay off all its liabilities.
To calculate the P/B ratio, you divide the market price per share of a company’s stock by its book value per share. For example, if a company’s stock is trading at $50 per share and its book value per share is $20, its P/B ratio would be 2.5 (50/20).
The P/B ratio compares the relative value of different companies’ stocks and compares a single company’s stock price to its historical P/B ratios. A P/B ratio of less than 1.0 may indicate the stock is undervalued, while a ratio greater than 1.0 may indicate the share is over-valued.
P/E ratio
The price-to-earnings ratio, or P/E ratio, evaluates the relative value of a company’s stock.
For example, if a company’s stock is currently trading at $100 per share and its EPS for the past 12 months was $20, its P/E ratio would be 5 (100 / 20 = 5).
This means that investors are willing to pay $5 for every $1 of the company’s earnings.
A high P/E ratio might indicate that investors are willing to pay a premium for the stock because they believe the company has strong growth prospects. Whereas a low P/E ratio suggest that the stock is undervalued, or that the company has lower growth prospects.
It’s important to note that P/E ratio can vary widely depending on the industry, so it’s best to compare a company’s P/E ratio to those of its peers to get a sense of whether it is relatively expensive or cheap.
This write-up is for informational purposes only. It does not serve the purpose of any legal advice. You are solely responsible for making your own investment decisions. If you choose to engage in such transactions with or without seeking advice from a licensed and qualified financial advisor or entity, then such decision and any consequences flowing therefrom are your sole responsibility.
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