Financial Ratios that you Need to Know
There are three very well known financial ratios that are widely used in stock valuations. These three ratios will be the key ones that you will find useful in your stocks selection process. You will quickly see how you can do valuations without the need to spend time scrutinizing financial statements. First, let’s understand what these key ratios do.
Price to Earning Ratio
Price to Earning ratio is commonly referred to as P/E ratio. It is calculated by dividing the stock’s market price by its earnings per share.
P/E ratio = Common stock market price / earnings per common share (EPS)
This ratio is used to measure the extent of which investors are willing to pay for the future growth.
Take for example if a stock price is $15 while the earnings per share is $1, then the P/E ratio will be equal to 15. This means that investors are willing to pay 15 times the earnings per share and shows that they are confident in the company and sees potential to pay a higher price for the stock at the current moment in view of future growth.
Contradictions and what’s a good P/E ratio
Theoretically, the lower the P/E ratio, the better because you are paying a low price for a relatively big earnings per share. However, if the P/E gets too low, then it can also signal danger as the company may be in trouble. The fall in P/E ratios can be related to falling earnings per share.
A high P/E can mean that investors are confident that a stock has good prospects, on the other hand, it can also mean that the price has overruned.
There is no sweet spot for P/E ratios. In general, a P/E of above 10 is a healthy stock but the lower the P/E ratio compared to its peers the more bargain you get. P/E ratios tend to be different for different industries. This is due to the nature of the businesses. So the best way to measure P/E is to compare a stock to its peers in the same industry.
Price to Book Ratio
Price to book ratio is commonly referred to as the Price to Equity ratio. It is calculating by dividing the stock price with the book value per share. The book value of a company is the value of the company’s books based on its assets, less all liabilities. Divide the book value by the total number of shares and you’ll get the book value per share which gives you a rough idea of the stock’s asset value.
Price to Book ratio = Common stock price / Book value per share
This ratio is constantly changing depending on the stock price. The book value consist of asset values on a company’s books based on the historical value of the assets when they were originally purchased, minus depreciation. Hence for some companies, the assets used for calculation may not be reflecting the true value of the current assets.
How to use Price to Book ratio
General rule of thumb, if the Price to Book ratio is more than 1, it shows that investors are confident in the growth of the stock. Anything less than 1 is a sign that there may be a problem with the company. On the other hand, we also do not want to have a stock with Price to Book ratio that is insanely high as it will mean that the price have overshot.
Note also that this ratio is to be used against other stocks in the same industry. Take for example a service provider like a web business, the assets it hold will tend to much lower. So if you use a web business to compare one which needs heavy assets like a rental company, then you will not be able to make any fair comparison.
Price to Cash Flow Ratio
Price to cash flow ratio is sometimes known simply as P/CF. It is the ratio of the stock price to the cash flow per share. As this ratio uses cash flow instead of earnings, it is thought to be a better measure than earnings as non-cash earnings are factored in for example depreciation and amortization.
Price to Cash Flow = Share Price / Cash Flow per Share
How to use Price to Book ratio
There is no magic number for the ratio but in general, a single digit is a sign that a company is undervalued while a higher number is considered to be possibly overvalued. Note that this ratio become invalid when the cash flow is negative. Again this ratio is relative to its peers in the same industry, so always compare it with other stocks in the same industry.
Now that you have caught a glimpse of the three key ratios, let’s find out how to obtain these info in the quickest manner.