Before any major investment, it’s imperative to evaluate stock ratios.
If investing in single stocks is your chosen path, it’s important to understand that you can’t make calls based on your gut. The moves that you make need to be based on precise calculations of financial ratios.
These calculations give you insight into the health of the companies that you put your money into. How do you make sense of common stock ratios? Here’s what you need to know.
Quantitative and qualitative analysis
It’s important to internalize the rule that buying and selling stocks is never something that you do based on a single signal. You need to learn to assess companies, instead, based on multiple inputs that give you the whole picture of where their stocks are headed.
Quantitative analysis focuses singularly on numbers – ones obtained from balance sheets, income statements, and cash flow statements. Qualitative analysis has you focusing on factors other than numbers — the key people in a company, the technology that a company has access to, the competition that it deals with, the market opportunities and threats that it faces, and so on.
The different categories of stock ratios
Stock ratios commonly either analyze the earnings of companies or focus on their balance sheets, both primary indicators of the financial health of businesses. What follows are descriptions of stock ratios, in three basic categories, that investors often use to evaluate stocks.
The valuation category
Price-to-earnings (P/E): A commonly used metric, you obtain the P/E of a company by dividing its stock price by its earnings per share. It’s possible to use the P/E of different stocks to compare them for competitive pricing.
Price-to-earnings growth (PEG): The PEG ratio is commonly used by investors interested in growth at a reasonable price (GARP). To arrive at the PEG ratio of the company, you divide its P/E by the company’s rate of earnings growth. When a company’s PEG is below 1, it’s a sign that its stock is undervalued, and could be a good buy. Higher PEGs indicate overpricing, and poor investment potential.
Price-to-sales: This stock ratio compares a company’s market capitalization to its revenue over 12 months. The lower a company’s P/S number when compared to similar companies, the more attractive it promises to be to invest in.
Price-to-book: The P/B ratio takes the stock price of a company, and compares it to its book value, which is the value of its assets, once its liabilities have been subtracted away. The lower the P/B of a company, the better it is to invest in. If a company’s book value per share happens to be higher than the price of its stock, it clearly tells you that the company is undervalued, and could potentially be a good buy.
Dividend yield: To arrive at the dividend yield of a stock, you divide the dividends announced each year, by the price of the stock. To be sure, stocks are riskier investments than bonds. Nevertheless, it can be meaningful to compare the dividend yield of a stock to the payout that you get with a bond. If strengthening your cash flow from your portfolio is important to you, you should look for a healthy dividend yield.
Dividend payout: When you compare the dividend payout of a company to its net income, you learn something about what ratio of the company’s profits are distributed to investors. While investors may appreciate healthy dividend payout levels, a level that is too high can point to a lack of planning for the future.
The profitability category
Return on assets (ROA): Looking at the ROA of a stock tells you what kind of profits it makes for every dollar invested. The higher the ROA of a company, the more efficient it is. Comparing the ROAs of different companies within an industry can help you pick the leanest organization.
Return on equity (ROE): The ROE of a company is a less flexible way to determine how efficiently a company makes use of its resources. You obtain the ROE of a company by taking its net income and dividing it by the equity that shareholders hold.
Profit margin: This widely used metric expresses the ratio of a company’s profits, to its total revenues. The higher the profit margin, the better a company is at keeping its costs in check.
The liquidity category
Current ratio: You get the current ratio of a company by dividing its current liquid assets by its current or short-term liabilities. The current ratio of a company gives you information about its ability to pay its bills on a day-to-day basis.
There’s a lot that you can learn from a company’s numbers
You may not be very comfortable with numbers; nevertheless, you should look at these stock ratios as a way to uncover a narrative about different companies. A story is what you should look for when you view an array of ratios. If you are able to find companies with good stories, you should come out on top of your investments.
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