Ratio. The term conjures up complex and frustrating high school math problems. When it comes to investing, though, that need not be the case. In fact, there are ratios that, properly understood and applied, can help make you a more informed investor.
- Fundamental analysis relies on data from corporate financial statements to compute various ratios.
- Fundamental analysis is used to determine a security's intrinsic, or true, value so it can be compared with the security's market value.
- There are six basic ratios that are often used to pick stocks for investment portfolios.
- These include the working capital ratio, the quick ratio, earnings per share (EPS), price-earnings (P/E), debt-to-equity, and return on equity (ROE).
- Most ratios are best used in combination with others, rather than singly, for a comprehensive picture of company financial health.
1. Working Capital Ratio
Assessing the health of a company in which you want to invest involves measuring its liquidity. Liquidity refers to how easily a company can turn assets into cash to pay short-term obligations. The working capital ratio can be useful in helping you measure liquidity.
Working capital is the difference between a firm’s current assets and current liabilities. It represents a company's ability to pay its current liabilities with its current assets.
The working capital ratio, like working capital, compares current assets to current liabilities and is a metric used to measure liquidity. The working capital ratio is calculated by dividing current assets by current liabilities.
Say that XYZ company has current assets of $8 million and current liabilities of $4 million. The working capital ratio is 2 ($8 million/$4 million). That's an indication of healthy short-term liquidity. However, if two similar companies each had ratios of 2, but one had more cash among its current assets, that firm would be able to pay off its debts more quickly than the other.
A working capital ratio of 1 can imply that a company may have liquidity troubles and not be able to pay its short-term liabilities. However, the trouble could be temporary and later improve.
A working capital ratio of 2 or higher can indicate healthy liquidity and the ability to pay short-term liabilities. On the other hand, it could also point to a company that has too much in short-term assets (e.g., cash), some of which could be better used to invest in the company or pay shareholder dividends.
It can be a challenge to determine the proper category for the vast array of assets and liabilities on a corporate balance sheet in order to decipher the overall ability of a firm to meet its short-term commitments.
2. Quick Ratio
Also called the acid test, the quick ratio is another measure of liquidity. It represents a company's ability to pay current liabilities with assets that can be converted to cash quickly.
The calculation for the quick ratio is current assets minus inventory minus prepaid expenses divided by current liabilities. The formula removes inventory because it can take time to sell and convert inventory into liquid assets.
XYZ company has $8 million in current assets, $2 million in inventory and prepaid expenses, and $4 million in current liabilities. That means the quick ratio is 1.5 ($8 million - $2 million/$4 million). It indicates that the company has enough to money to pay its bills and continue operating.
A quick ratio of less than 1 can indicate that there isn't enough in liquid assets to pay short-term liabilities. The company may have to raise capital or take other actions. On the other hand, it may be a temporary situation.
3. Earnings per Share (EPS)
When buying a stock, you participate in the future earnings (or risk of loss) of the company. Earnings per share (EPS) is a measure of the profitability of a company. Investors use it to gain an understanding of company value.
The company's analysts calculate EPS by dividing net income by the weighted average number of common shares outstanding during the year.
If a company has zero or negative earnings (i.e., a loss), then earnings per share will also be zero or negative. A higher EPS indicates greater value.
4. Price-Earnings Ratio (P/E)
Called P/E for short, this ratio is used by investors to determine a stock's potential for growth. It reflects how much they would pay to receive $1 of earnings. It's often used to compare the potential value of a selection of stocks.
To calculate the P/E ratio, divide a company's current stock price by earnings-per-share.
If, for example, a company closed trading at $46.51 a share and the EPS for the past 12 months averaged $4.90, then the P/E ratio would be 9.49 ($46.51/$4.90). Investors would spend $9.49 for every generated dollar of annual earnings. Investors have been willing to pay more than 20 times the EPS for certain stocks when they've felt that a future growth in earnings will give them an adequate return on their investment.
If a company has zero or negative earnings, the P/E ratio will no longer make sense. It will appear as N/A for not applicable.
When ratios are properly understood and applied, they can help improve your investing results.
5. Debt-to-Equity Ratio
What if your prospective investment target is borrowing too much? This can increase fixed charges, reduce earnings available for dividends, and pose a risk to shareholders.
The debt-to-equity (D/E) ratio measures how much a company is funding its operations using borrowed money. It can indicate whether shareholder equity can cover all debts, if needed. Investors often use it to compare the leverage used by different companies in the same industry. This can help them to determine which might be a lower risk investment.
To calculate the debt-to-equity ratio, divide total liabilities by total shareholders' equity. Let's say company XYZ has $3.1 million worth of loans and shareholders' equity of $13.3 million. That works out to a modest ratio of 0.23, which is acceptable under most circumstances.
However, like all other ratios, the metric has to be analyzed in terms of industry norms and company-specific requirements.
6. Return on Equity (ROE)
Return on equity (ROE) measures profitability and how effectively a company uses shareholder money to make a profit. For common stock shareholders, ROE (which is expressed as a percentage) is calculated by taking net income (income less expenses and taxes) figured before paying common share dividends and after paying preferred share dividends, and dividing the result by total shareholders' equity.
Let's say XYZ company's net income is $1.3 million. Its shareholder equity is $8 million. ROE then is 16.25%. The higher the ROE, the better the company is at generating profits using shareholder equity.
What's a Good ROE?
Return-on-equity, or ROE, is a metric used to analyze investment returns. It's a measure of how effectively a company uses shareholder equity to generate income. You might consider a good ROE one that increases steadily over time. That could indicate a company does a good job using shareholder funds to increase profits. In turn, that can increase shareholder value.
What Is Fundamental Analysis?
Fundamental analysis is the analysis of a security to discover its true (or intrinsic) value. It involves the study of economic, industry, and company information. Fundamental analysis can be useful because by comparing a security's true value to its market value, an investor can determine if the security is fairly priced, overvalued, or undervalued.
Fundamental analysis contrasts with technical analysis, which focuses on determining price action and uses different tools, such as chart patterns and price trends, to do so.
Is a Higher or Lower P/E Ratio Better?
That depends on what you're looking for in an investment. A P/E ratio measures the relationship of a stock's price to earnings per share. A lower P/E ratio can indicate that a stock is undervalued and perhaps worth buying. However, it could be low because the company isn't financially healthy.
A higher P/E can indicate that a stock is expensive, but that could be because the company is doing well and could continue to do so.
Often, the best way to use P/E is as a relative value comparison tool for stocks you're interested in. Or, you might want to compare the P/E of one or more stocks to an industry average.
The Bottom Line
Financial ratios can help you pick the best stocks for your portfolio and build your wealth. Dozens of financial ratios are used in fundamental analysis. We've briefly highlighted six of the most common and easiest to calculate.
Remember that a company cannot be properly evaluated using one ratio in isolation. So be sure to put a variety of ratios to use for more confident investment decision-making.