Investor Basics: Essential Financial Ratios for Investors
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Investors often look at a broad range of financial ratios to assess the value of a security and the potential returns for an investment. The breadth of available ratios can be daunting, but here are a few of the critical ones that every investor should know, and where they may be most applicable.
The price-to-earnings ratio has been an essential ratio for investors for decades and is simply calculated by dividing the price of a stock by the earnings per share (EPS). Fundamentally, the ratio tells an investor exactly how much they are paying for a dollar of earnings generated by a particular company. P/Es can also come in several varieties, such as the trailing P/E, which is the current price divided by the last four quarters of EPS, the or forward P/E, which is price divided by consensus estimates for the next four quarters of EPS. The ultimate question investors should ask is whether the P/E of a stock is too high, suggesting a stock may be overvalued, or too low, suggesting the stock may be undervalued. This question is often answered by comparing P/Es to relevant peers groups or industry averages.
Earnings yield is simply the inverse of the P/E and indicates how much of a return, in terms of earnings per share, an investment in a particular stock will provide. So, a stock with a P/E of 10x will have an earnings yield of 10%, while one with a P/E of 25x will have an earnings yield of 4%. There may be many reasons for such differences in earnings yields, but it may be helpful in terms of helping investors understand current stock valuations.
The relative P/E seems to have fallen out of favor in recent years but is a concise measure to assess the relative valuation of a particular stock against a broader market or industry benchmark. It is calculated by dividing a stock’s P/E by the broader benchmark P/E. If the result is less than 1.0, the stock may be undervalued compared to the benchmark, while a relative P/E greater than one suggests the stock may be overvalued compared to the benchmark.
The PEG ratio is simply the P/E ratio divided by the expected growth rate in earnings. It’s important to note that the calculation must use the growth rate as a whole number, rather than a decimal. So, for a stock with a P/E of 15x and a growth rate of 20%, the PEG ratio equation would be 15÷20=0.75. Similar to the relative P/E, a PEG ratio under 1.0 may indicate a stock is undervalued while a PEG ratio greater than 1.0 may indicate a stock is overvalued.
The P/S ratio is similar to the P/E, but the denominator will be sales-per-share rather than EPS. Using P/S is often advantageous for evaluating early stage or emerging growth companies that have not yet reached a mature level of profitability.
The P/B ratio is simply the stock price divided by the book value per share (equity attributable to common shareholders divided by the number of shares outstanding). You may also use tangible book value per share, which would exclude goodwill and other intangible assets, making the valuation more reflective of the cash value of the net assets. P/B is most commonly used in evaluating bank stocks, though it may also be useful for evaluating companies that have fully depreciated assets that may be undervalued on the balance sheet.
The P/CF ratio measures the stock price compared to the cash flow per share (again, there are many options for cash flow, from operating cash flow to free cash flow among others). As the value of a share of stock is generally viewed as the discounted future cash flows of the stock, this ratio may help to understand the current valuation relative to current cash flows and may be useful in understanding companies where cash flows may be very different from reported GAAP earnings.
The current dividend yield is simply the indicated annualized dividend divided by the share price. This is an indication of the expected cash dividends to be received in the coming year relative to the initial investment. This ratio can be more important and more frequently utilized by investors that are relying on cash income in their portfolios.
While this is just a primer for investors to consider, each of these important ratios may include a number of caveats and potential derivatives to help investors better assess the investment potential of a particular stock.