5 Investment Ratios Everyone Should Know
What comes to your mind when you hear the word ‘ratio,’ most probably your boring math classes in the school, which you hated the most and usually like to skip! Well, don’t worry, that’s not the case here.
When it comes to investing your money, there are certain ratios that will help you in assessing the value of the company's stock and are used as a primary tool for fundamental analysis.
It is always good to know about these different types of investment ratios while performing fundamental analysis. However, if you want to have an in-detail understanding, you can click here for investment guides.
Section of financial statement
Before starting to calculate any financial ratio, it is important to understand different financial statements first. These statements include various sections like:
- Assets and liabilities
- Sales revenue
- Gross profits
- Operating expenses
- Operating profits
- Net profits before taxes and after
- And stock dividends
Types of financial ratios
First, let’s understand the types of ratios before jumping towards the investment ratio section.
- Price ratios
The relative value of a stock is basically called the price ratio. Such ratios are great for comparing within the same zone.
- Profitability ratios
As the name describes, the profitability ratio is all about your individual or company's profit.
- Liquidity ratio
If a business is able to meet its short-term obligations, the liquidity ratio will display it.
- Debt ratios
This ratio controls the long-term health of a business and the effect of the capital and financing structure of the business.
- Efficiency ratios
This ratio shows how a business uses its resources that are invested in fixed assets like machines and equipment, property, etc.
Well-known financial ratios
Now, it is time to know the different types of financial ratios available in the market.
- Price-to-earnings or P/E ratio
According to Michael Fairbourn, education coach at TD Ameritrade, the price-to-earning or P/E ratio is the “most heavily used stock ratio in the world.” How much an investor is willing to pay for a stock above its per-share earnings is known as the P/E ratio.
For instance, if a P/E ratio of a stock is 10, it simply means that investors are ready to pay up to 10 times their earnings per share for owning it i. But is it an expensive or cheap option?
Whether the P/E ratio of 10 is cheap or expensive depends on the capability of the company if it is ready to fulfill them in terms of future earnings. However, you can check a stock's P/E ratio by comparing it with that of the S&P 500 historical average.
Michael explains that “if a company with 35 P/E has a higher growth rate than a company with a 10 P/E, the company on the higher end of the ratio might actually be ‘cheaper.’”
- Price/earnings-to-growth or PEG ratio
In terms of popularity, price/earnings-to-growth or PEG is not like the P/E ratio, but it may provide an even clearer picture of a stock’s future growth prospects.
So, now you are able to know a stock’s P/E ratio. Now you are thinking, how does that number stand relative to its projected growth rate? So, if the company’s P/E is ‘cheap’ and it doesn’t grow, what is the point of holding that stock with a low P/E?
Fairborn stated that “in this ratio, you are comparing the P/E to the analyst consensus estimate of projected earnings, which typically project as early as quarterly to as long as five years.” So, how will you know about that value?
As per Fairbourn, investors will generally consider it undervalued if the PEG ratio is less than one.
So, why is it important to know the growth component? “You don’t want to buy something that will forever be a bargain,” Michael said. He further added that “investors will often want to see a history of growth combined with projected growth. This could help to validate an undervalued PEG ratio.”
- Price-to-sales ratio or P/S ratio
Let’s understand this P/S ratio. So there is a company with strong quarterly sales, but still, they aren’t getting enough earnings because you might be spending too much.
Then there are investors who are ready to give up their profits now for stronger returns. Companies share their quarterly sales or most of their profits to build a bigger and better company for the future because sales are the most important thing.
Here the P/S ratio shows how much investors are ready to pay above a company’s “revenues” (here, revenue is without liabilities means gross revenue).
- Price-to-book or P/B ratio
The price-to-book or P/B ratio is the worth of a company’s stock in relation to its net asset value, or book value.
Talking about the P/B ratio, it’s an effective metric that can compare a stock’s market cap to “what it owns versus what it owes,” said Fairborn.
- Debt-to-equity or D/B Ratio
The D/E ratio should be less than one, according to the investors. While a reading of two or more might translate as carrying more risk, at the same time, it also depends on the industry.
Michael Fairbourn says that “some companies like big industrial energy and mining companies, tend to carry more debt than businesses in other industries.”
So, if you know any companies that carry a higher debt, it might offer greater return, but that carries more risk.
Analysing stocks may look simple but are very complicated in nature. Sometimes, even calculations don’t give you a clear answer. In such situations, you can get answers from experts. So it is best to hire an expert to work for you.