7 Financial ratios that help you pick great stocks (Analysis)

Fundamental Analysis plays a major role while picking a stock for investment. Typically the present financial decisions are taken keeping in view of the past performance of the company, to decide the future value that it brings to the investors.

Financial Ratios give us information about the company’s past performance and form a significant part of the fundamental analysis.

Financial Ratios List

Here are some of the financial ratios that can be looked at while picking up great stocks for investing.

1. Price to Earnings (PE): It is a comparison between share price to the earnings per each share. It gives an idea of whether the share of a company is cheaper or costly in terms of its earning capacity.

PE = share price/ earnings per share price

For example, if a stock price is $10 each and it makes $1 earnings per share, then the P/E ratio stands as 10. i.e., an investor has to spend $10 to earn money of 1$. High P/E indicates that one needs to spend large money to get meaningful returns and is not usually preferable.

According to Benjamin Graham, optimum P/E should be less than 15. But high PE isn’t always expensive and Low PE isn’t always cheap and good. Understanding why PE is low or high in business terms can help in making a rational decision.

2. Price to Book Value (PB): It represents the true value of the company business. It is a ratio between market share value to the book value. Book value is the total value of all assets present on the balance sheet that can be liquidated.

To put it simply, In case if the company is broken up and sold today, then the book value is what the creditors and investors get irrespective of the market share value. Benjamin Graham suggests P/B be equal to 1.5 or less.

Book Value per share = Total Assets – Intangible Assets & Liabilities

3. Earnings per Share(EPS): This indicates the net income per each share that the business received.

Typically high EPS is preferred.

EPS = (Net Income – preferred dividends) / average outstanding shares

Preferred shares = Class of stocks with higher claims on assets and earnings compared to common stocks

4. Debt to Equity Ratio: It indicates how much debt is present as a proportion of the shareholder’s equity. Even if the company is dissolved, at first debt amount must be deducted from the Book Value, and the remaining is paid to the shareholder.

Usually, a lower D/E is preferred.

D/E = (Total Assets – Total Liability) / Equity

5. Return on Equity (ROE): It is the ratio of Net Income to that of shareholders Equity. It gives info on how much each investor gets per share.

It is calculated before dividends are paid to common shareholders and after dividends to preferred shareholders and interest to lenders.

Typically, a high ROE is preferred.

This indicates a true picture than EPS on how much each investor gets, as it is calculated after the dividends paid to preferred shareholders and lenders.

6. Return on Capital Employed (ROCE): It measures how efficiently the company uses its capital while generating returns. To put it simply it is the ratio of profits to that of capital employed in the business.

Usually, a high ROCE is preferred.

ROCE = Earnings before interest and Tax/ (Total Assets – Current Liabilities)

7. Dividend Yield: It is the annual dividend received per each share price. High dividends are attractive but the downside of it is, the company may not be able to reinvest in growing and generating future capital gains.

High dividends are though profitable but considering the capital gains tax and the company’s inability to reinvest, the optimum dividend yield is preferred.

Apart from the above financial ratios, in his book The Intelligent Investor, Benjamin Graham suggested optimum PE(15) and PB(1.5) values for choosing a particular stock. It is represented as,

Graham Number = PE * PB = 15 * 1.5 = 22.5

As finding the optimum PE and PB values is not always possible, their combination can be verified to check if it is equal to or less than the Graham Number.

Conclusion

Financial Ratios, as mentioned, can provide a better picture of how the business performed in the last few quarters to a few years.

Although past performance is no guarantee of the future success of a company, it still provides valuable insights into the business aiding successful investing in the stock market.

Happy Investing..!!