What are Key Investment Ratios?
One aspect of smart investing is being able to determine whether or not a company is a healthy company in general and not just this past year. You also want to know if a stock is really a bargain or not. Stock price and dividends are good to know, but not the only pieces of information you need to make sound, long-term investment decisions. A good year of either doesn’t mean there will be more.
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Provides a straightforward primer to calculating and interpreting 33 key investment ratios. The book is organized into five sections that explain market-based ratios (e.g., market capitalization, P/E ratios), income statement ratios (margins, earnings per share), balance sheet rations (price/cash ratio, burn rate), cash flow ratios, and risk and volatility ratios. Each chapter clearly shows the inputs necessary to calculate a particular ratio and explains its relevance in evaluating a company's performance. |
Magic Numbers: The 33 Key Ratios That Every Investor Should KnowWhen making a decision about where to put their money, savvy investors use ratio analysis. There are three kinds of ratio analysis:
- Profitability Ratios: measure how much profit a company generates
- Gearing Ratios: assess a company’s leverage
- Liquidity Ratios: measure the ability of a company to meet its debts
- Investment Ratios: measure the performance of the overall business.
This article focuses on investment ratios. There are countless ratios you can know about, but those referred to as the key investment ratios are the ones that will help the basic investor get the information they need to make a sound decision. The good thing is that most of the information you need to do these ratio’s calculations can be found in the financial statement, annual report or balance sheet of the company whose stock you’re investigating.
P/E Ratio is the ratio most people are familiar with and helps one determine whether or not a stock is too expensive or a really good deal by looking at the earnings relative to stock price. You divide the current stock price by the last four quarter’s earnings. If your company’s stock is trading at $20 a share with a .50cent EPS (earnings per share), your P/E Ratio is 40. A low P/E ratio means the company is undervalued and the stock is probably a good deal. If the P/E ratio is too high, the company is overvalued and you probably don’t want to pay more for a stock than its worth.
Return On Equity is a simple calculation that allows an investor to look into the profitability, asset management and financial leverage of a company. A company’s ability to maintain good levels within these groups signify a good investment for many. For ROE, you divide a year’s worth of earnings by the average shareholder’s equity (found on the company balance sheet) for that same year.
Earnings per share (EPS) is the most basic ratio and probably the simplest. You divide the number of average shares outstanding by net income minus the dividends on preferred stock. So, if a company’s post-tax profits are $1.2 million and there are 20 million shares issued, the EPS is .06. You’re looking for smooth, consistent growth here.
Dividend Payout Ratio calculates the percentage of earnings paid to shareholders by dividing earnings per share by yearly dividends per share or dividing net income by dividends. More mature companies have a higher payout ratio and if you’re looking to use dividend payments as income, this is important.
P/E Growth Ratio is used to determine a stock’s value while considering earnings growth. You divide annual EPS growth by the P/E ratio. A lot of managers prefer this to the P/E ratio because of the growth component.
Net Asset Value (NAV) is a ratio for mutual funds and equals the total value of the fund’s portfolio less liabilities. You’ll get this dollar amount by dividing the current market value of a fund’s net assets by the number of shares outstanding. So, if your fund has net assets of $100 million and there are one million shares in the fund, the NAV is $100.
Return On Investment (ROI) is what a company does with assets to generate additional value for shareholders. It is a percentage ratio calculated as net profit divided by net worth. It is also defined as a measure of a corporation’s profitability. If a $100 stock returns $15 a year, your ROI is 15%. Obviously, you want this percentage to be as high as possible.
Profit Margin is a calculation that fits into investment ratios as a key indicator of profitability. Usually displayed as a percentage, profit margin is calculated as net earnings after taxes divided by revenues and is useful when you want to compare stocks within a particular industry to those in similar industries. As you’ve guessed, a higher margin indicates a more profitable company.
Turnover Ratio is a measure of the number of times a company's inventory is replaced during a given time period. Turnover ratio is calculated as cost of goods sold divided by average inventory during the time period. A high turnover ratio is a sign that the company is producing and selling its goods or services very quickly.
Leverage Ratio (also referred to as Debt To Equity Ratio) is found by dividing the company’s total amount of long-term debt (debts with interest rates that have a maturity longer than one year) by the total amount of equity. A company is likely able to make its interest payments on debt regardless of a moderate sales decline if their leverage ratio is under 50 percent. A company with a higher leverage ratio can offer greater returns to shareholders but can also be riskier.
Dividend Yield is a percentage ratio of a company’s annual cash dividends divided by its current stock price. To get your annual cash dividend, you multiply the next expected quarterly dividend by four. If a $100 stock pays $2.50 quarterly, then your annual cash dividend is $10. Divide this by $100 and you get your dividend yield: 10%.
Market Capitalization, the current market value of a company’s outstanding shares, can be found by multiplying the number of outstanding shares by the current price of each share. A company with 1 million shares outstanding, trading at $75 per share, has a market cap of $75 million.
Current Ratio can be calculated by dividing current assets by current liabilities. You would use this ratio to see if the company can pay their current debts without going against future earnings. You’ll want to see a ratio of 1 or higher here.
Price To Book Value Ratio is calculated by dividing the current price of a stock by the book value. Book value, an accounting term, is the net asset value of a company. Whether the ratio is high or low could be a result of a company being old or a new start up with stock that hasn’t yet depreciated. It’s not a tell-all ratio, but does help in your overall research.
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