Understanding and analyzing financial ratios is key to the process of evaluating a business. These allow investors and other stakeholders to know the full story of the company’s health, sustainability, growth, and potential success. Financial ratios also offer a deeper insight to investors about the company’s stock performance and valuation and form a part of the fundamental analysis of stocks.
Financial ratios use numerical values sourced from a company’s financial statements. Since investors cannot do an in-depth study of the company’s financials at all times, they can use financial ratios to quickly gauge the overall health of the company.
Here, we will learn about the top 4 financial ratios that can be used for analyzing a company.
Price/Earnings or P/E Ratio
Investors, before investing in any company, would want to know the underlying worth of its stock. Therefore, they analyze the company from different angles, including returns, cash flows, risk, and corporate governance.
Amongst various financial ratios, the P/E ratio is one of the most essential metrics used in studying the intrinsic value of a stock.
The price-earnings or P/E ratio tells the relation between:
- a company’s stock price and
- its earnings per share (EPS)
It compares the price that the market is ready to pay for a company’s stock against its profits.
- A high P/E ratio means that a stock price is high in comparison to the company’s earnings. This is interpreted as the stock being overvalued.
- A low P/E ratio means that the stock price is low in comparison to the company’s earnings. This is interpreted as the stock being undervalued.
P/E ratio is also known as:
- earnings multiple
- price multiple
Important tip – investors or shareholders must always try to determine the reason for the stock price being low. They must try to understand if this is due to the company’s performance being low over some period.
When investing in a company’s stock, investors would want to know:
- how profitable the company is
- how valuable it can be in the future
- if the company’s growth and earnings level will remain constant
How to calculate P/E ratio
P/E ratio is calculated as:
P/E = market price of a stock divided by the earnings per share
Let’s taken an example to understand the calculation:
Market price of a stock = Rs. 90
Earnings per share = Rs. 10
Therefore, P/E = 90 / 9 = 10
The P/E ratio of stock is 10. This can be interpreted as the market is willing to pay Rs. 10 for each rupee that the company makes as earnings.
Using P/E ratio
P/E ratio acts as an indicator of the company’s value and helps investors know how much they should be paying for a stock as per the company’s current earnings.
Additionally, if the growth and level of earnings of the company remain constant, then the P/E can be interpreted as the number of years it will take for the company to repay the stock investment amount to investors.
Enterprise Value (EV)/EBITDA
EV/EBITDA is a ratio that is used to compare a company’s:
- Enterprise value (EV) and
- Earnings before interest, taxes, depreciation & amortization (EBITDA).
This ratio is one of the important valuation metrics used to compare the relative value of different companies.
How to calculate?
The formula for this financial ratio is:
EV / EBITDA = Enterprise value / Earnings before interest, tax, depreciation and amortization
Here, EV = equity value or market capitalization + debt or financial obligations – cash at hand
EV measures the value of a company. For instance, if an investor or enterprise wants to buy a company, they must pay for the equity market capitalization combined with the existing debt minus the cash balance available. Thus, Enterprise Value is the price one must pay to acquire the company.
How to use EV/EBITDA
EV/EBITDA tells investors the payback period for investing in the company.
If EV/EBITDA is 5, it means that the payback period will be 5 years. Therefore, the investor can recover the cost of acquiring the company within 5 years through the company’s EBITDA.
This ratio is often used alongside the P/E ratio while valuing a company. Since the calculation includes debt, it offers a more accurate valuation of the company as compared to P/E ratio.
Price/Earnings Growth (PEG) Ratio
The PEG, or price/earnings-to-growth ratio, is a metric that is used to value a company’s stock.
It takes into account:
- company’s market price,
- earnings and
- future growth prospects
This ratio can offer a complete picture of whether a stock is overvalued or undervalued.
How to calculate this ratio?
It is easy to calculate the PEG ratio. To calculate the PEG ratio, three factors are needed:
- Stock price
- Earnings per share
- Expected rate of growth
PEG can then be calculated by dividing a company’s P/E ratio by its expected growth rate.
For example, if a company’s P/E ratio is 20 and its expected growth rate is 10%, the PEG ratio will be = 20 / 10 = 2.
How to use PEG ratio?
- A PEG ratio of 1 or lower can be interpreted as the company’s stock being reasonably priced or, in some cases, undervalued.
- A PEG ratio of more than 1 means a stock is overvalued.
The PEG ratio is a helpful indicator that can be used in comparing similar companies and their respective growth rate. It is best to use the PEG ratio as one of the many factors while evaluating a company.
Return on equity
This financial ratio measures the rate of return that a company’s shareholders receive towards their shareholdings. Return on equity or ROE tells investors how well the company is able to generate returns against the investment it receives from shareholders.
How to calculate ROE
Return on equity = net income of a company divided by shareholder’s equity
Here,
Net income = profits
Shareholder’s equity = difference between a company’s assets and liabilities.
If a company has an ROE of 1, it means every Re. 1 of common shareholding fetches a net income of Re 1.
Let’s take an example to understand ROE.
Suppose Company ABC has earned profits of Rs. 2 lakhs. It has 2,000 shares issued to stockholders at a cost of Rs. 50 each. The company then declares a dividend of Rs. 20,000 to all shareholders. The ROE will then be:
ROE = (2,00,000-20,000) / (1,000*50) = 1.8
This means that for every rupee of investment in company ABC, investors can fetch Rs. 1.8. While this may seem like a high value, it can imply that the company may have started operations recently and could be in the fast-growth stage.
Why is ROE important?
The ROE metric is an important financial ratio for investors to analyze a company as they can gauge how efficiently the firm can use their investment in earning additional revenues.
Companies with higher ROEs are considered good for investment. However, ROE must be compared among companies within the same sector, as it can significantly differ across various sectors.
Conclusion
Financial ratios can help in gauging and estimating a company’s future performance. Companies that are financially sound often see solid ratios in all categories and are preferred by most investors. While using these financial ratios, however, investors should carefully consider the nuances and use them in combinations to arrive at a comprehensive analysis.
FAQs
Some of the commonly known categories of financial ratios include liquidity ratios, profitability ratios, efficiency ratios, leverage ratios, and market value ratios.
Yes, financial ratios can have a significant impact on stock prices since these help in determining the company’s performance and financial health.
Investors must consider various aspects while investing in a company, some of the important ones being its financial health, strength of management, competitive advantage, stock valuation, historical performance, etc.
A day trader can benefit by focusing on technical indicators of a stock including its volume, price volatility, and momentum. Stocks that are highly volatile and have larger trading volumes with a noticeable price direction can offer good profit opportunities.
Long-term investors or those looking for wealth creation through stock investments must focus on a fundamental analysis of the stock, like the company’s management quality, strength of financials, corporate governance practices, etc.
