Investing has a set of four basic elements that investors use to break down a stock's value. In this article, we will look at four commonly used financial ratios—price-to-book (P/B) ratio, price-to-earnings (P/E) ratio, price-to-earnings growth (PEG) ratio, and dividend yield—and what they can tell you about a stock.
What financial ratios determine a stock's value?
No single financial ratio can determine whether a stock is a value or not. It's best to combine several ratios to form a more comprehensive view of a company's financials, it's earnings, and its stock's valuation.
Do You Remember Every accounting ratio and stock valuation?
I don’t. I can’t remember every accounting ratio, stock valuation method or detail about a company. But I do have a set of favorite “go to” stock valuation ratios that I like to refine and improve.
What is the price to book ratio of a stock?
Price-to-Book Ratio. The price-to-book ratio or P/B ratio measures whether a stock is over or undervalued by comparing the net assets of a company to the price of all the outstanding shares. The P/B ratio is a good indication of what investors are willing to pay for each dollar of a company's assets.
What are valuation ratios used for?
Valuation Ratios. Valuation ratios are used to analyze the attractiveness of an investment in a company. The idea is that by using these ratios, investors can gain an understanding of how cheap or expensive a company's current stock price is, compared to several different measures.
Why do we compare financial ratios?
Comparing financial ratios with that of major competitors is done to identify whether a company is performing better or worse than the industry average. For example, comparing the return on assets between companies helps an analyst or investor to determine which company is making the most efficient use of its assets.
What is the return on assets ratio?
Return on Assets (ROA) is a type of return on investment (ROI) metric that measures the profitability of a business in relation to its total assets .#N#measures how efficiently a company is using its assets to generate profit:
What is leverage ratio?
In other words, leverage financial ratios are used to evaluate a company’s debt levels. Common leverage ratios include the following: The debt ratio. Debt to Asset Ratio The debt to asset ratio, also known as the debt ratio, is a leverage ratio that indicates the percentage of assets that are being financed with debt.
What is the cash ratio?
Cash Ratio The cash ratio, sometimes referred to as the cash asset ratio, is a liquidity metric that indicates a company’s capacity to pay off short-term debt obligations with its cash and cash equivalents.
What is the purpose of financial ratio analysis?
Analysis of financial ratios serves two main purposes: 1. Track company performance. Determining individual financial ratios per period and tracking the change in their values over time is done to spot trends that may be developing in a company.
What is interest coverage ratio?
The interest coverage ratio#N#Interest Coverage Ratio Interest Coverage Ratio (ICR) is a financial ratio that is used to determine the ability of a company to pay the interest on its outstanding debt.# N#shows how easily a company can pay its interest expenses:
What is the price earnings ratio?
The price-earnings ratio#N#Price Earnings Ratio The Price Earnings Ratio (P/E Ratio is the relationship between a company’s stock price and earnings per share. It provides a better sense of the value of a company.#N#compares a company’s share price to its earnings per share:
What is the purpose of ratios in financial analysis?
Ratios—one variable divided by another—are used widely in financial analysis to understand how companies are doing internally and relative to one another. Financial ratios can be computed using data found in financial statements, such as the balance sheet and income statement, and form the basis of fundamental analysis.
Why do we use valuation ratios?
Valuation ratios are some of the most commonly quoted and easily used ratios for analyzing the attractiveness of an investment in a company. These measures primarily integrate a company’s publicly traded stock price to give investors an understanding of how inexpensive or expensive the company is in the market.
What are the four types of financial ratios?
Financial ratios are typically cast into four categories: Profitability ratios. Liquidity ratios. Solvency ratios. Valuation ratios or multiples.
What is the P/E ratio?
The price-to-earnings (P/E) ratio is one of the most well-known valuation ratios . It compares a company's stock price to its earnings on a per-share basis. Like other valuation ratio analyses, the price to earnings shows the premium that the market is willing to pay.
What is a solvency ratio?
Solvency ratios, also known as leverage ratios, are used by investors to get a picture of how well a company can deal with its long-term financial obligations. As you might expect, a company weighed down with debt is probably a less favorable investment than one with a minimal amount of debt on its books.
Why is it important to understand the variables driving ratios?
In most cases, it is also important to understand the variables driving ratios as management has the flexibility to, at times, alter its strategy to make the company's stock and ratios more attractive. Generally, ratios are typically not used in isolation but rather in combination with other ratios.
What does a 100% profit margin mean?
In general, the higher a company's profit margin, the better. A net profit margin of 1, or 100%, means a company is converting all of its revenue to net income. Profit margin levels vary across industries and time periods as this ratio can be affected by several factors.
What is the P/B ratio?
Made for glass-half-empty people, the price-to-book (P/B) ratio represents the value of the company if it is torn up and sold today. This is useful to know because many companies in mature industries falter in terms of growth, but they can still be a good value based on their assets. The book value usually includes equipment, buildings, land and anything else that can be sold, including stock holdings and bonds.
Why do stocks have high P/E?
The reason stocks tend to have high P/E ratios is that investors try to predict which stocks will enjoy progressively larger earnings. An investor may buy a stock with a P/E ratio of 30 if they think it will double its earnings every year (shortening the payoff period significantly).
Why do investors use the PEG ratio?
Because the P/E ratio isn't enough in and of itself, many investors use the price to earnings growth (PEG) ratio. Instead of merely looking at the price and earnings, the PEG ratio incorporates the historical growth rate of the company's earnings. This ratio also tells you how company A's stock stacks up against company B's stock.
Why are dividend stocks attractive?
It's always nice to have a back-up when a stock's growth falters. This is why dividend-paying stocks are attractive to many investors—even when prices drop, you get a paycheck. The dividend yield shows how much of a payday you're getting for your money. By dividing the stock's annual dividend by the stock's price, you get a percentage. You can think of that percentage as the interest on your money, with the additional chance at growth through the appreciation of the stock.
What does a PEG ratio mean?
A PEG of 1 means you're breaking even if growth continues as it has in the past.
Why is a low P/B ratio good?
In either case, a low P/B ratio can protect you— but only if it's accurate. This means an investor has to look deeper into the actual assets making up the ratio.
What is book value?
The book value usually includes equipment, buildings, land and anything else that can be sold, including stock holdings and bonds. With purely financial firms, the book value can fluctuate with the market as these stocks tend to have a portfolio of assets that goes up and down in value.
What is debt to equity ratio?
The debt-to-equity ratio (D/E) is a stock metric that helps investors determine how a company finances its assets. The ratio shows the proportion of equity to debt a company is using to finance its assets.
Why do value investors like to seek out companies with a market value less than its book value?
Value investors often like to seek out companies with a market value less than its book value in hopes that the market perception turns out to be wrong. By understanding the differences between market value and book value, investors can help pinpoint investment opportunities.
What is the P/E ratio?
The price-to-earnings ratio (P/E ratio) is a metric that helps investors determine the market value of a stock compared to the company's earnings. In short, the P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings.
What does a P/B ratio of 0.95 mean?
A P/B ratio of 0.95, 1, or 1.1 means the underlying stock is trading at nearly book value.
Why is a P/B ratio of 0.5 attractive?
To a value-seeking investor, a company that trades for a P/B ratio of 0.5 is attractive because it implies that the market value is one-half of the company's stated book value.
What is value investing?
The basic premise of value investing is to purchase quality companies at a good price and hold onto these stocks for the long-term. Many value investors believe they can do just that by combining several ratios to form a more comprehensive view of a company's financials, its earnings, and its stock valuation.
Who is the most well known value investor?
Berkshire Hathaway leader Warren Buffett is perhaps the most well-known value investor. Value investors use financial ratios such as price-to-earnings, price-to-book, debt-to-equity, and price/earnings-to-growth to discover undervalued stocks. Free cash flow is a stock metric showing how much cash a company has after deducting operating expenses ...
What does FCF/S ratio mean?
Any company that has a FCF/S ratio higher than 10% is a FCF generating machine. It tells you that the company is very profitable, has strong operations and if you dig deeper, you’ll find a moat. Take a look at how strong CSCO is. Any company that can generate FCF like CSCO does has the added benefit of being able to:
What is FCF to sales?
FCF to sales is a simple metric that tells you what percentage of sales is converted directly to FCF. Instead of FCF, you can use your own variation of FCF or owner earnings.
Why do companies take on debt?
And sometimes, a company may take on debt to cover short term difficulties. The key is identifying whether the debt is for a broken business model, or whether it is manageable and only a temporary set back. If it’s the later, you can take advantage of falling prices to make a nice entry point.
Is EBIT an after tax number?
Since EBIT is not an after tax number, you can use it to compare across industries. In the Cash Conversion example, you can’t compare Costco to a company like AAPL, but by EV/EBIT, you can compare the valuation of each. You still need to take a look at industry and historical averages though. Here’s AAPL again.
Liquidity Ratios
Leverage Financial Ratios
Efficiency Ratios
- Efficiency ratios, also known as activity financial ratios, are used to measure how well a company is utilizing its assets and resources. Common efficiency ratios include: The asset turnover ratioAsset TurnoverAsset turnover measures the value of revenue generated by a business relative to its average total assets for a given fiscal year.measures a company’s ability to genera…
Profitability Ratios
- Profitability ratiosProfitability RatiosProfitability ratios are used to measure and evaluate the ability of a company to generate income (profit) relative to revenue, balance sheet assets, operating costs, and shareholders' equity during a specific period of time.measure a company’s ability to generate income relative to revenue, balance sheet assets, operating costs, and equity. …
Market Value Ratios
- Market value ratios are used to evaluate the share price of a company’s stock. Common market value ratios include the following: The book value per share ratio calculates the per-share value of a company based on the equity available to shareholders: Book value per share ratio = (Shareholder’s equity – Preferred equity) / Total common shares outsta...
Related Readings
- Thank you for reading CFI’s guide to financial ratios. To help you advance your career in the financial services industry, check out the following additional CFI resources: 1. Analysis of Financial StatementsAnalysis of Financial StatementsHow to perform Analysis of Financial Statements. This guide will teach you to perform financial statement analysis of the income stat…