Financial ratios are mathematical calculations used to determine a company’s valuation. Each ratio uses different measures in its calculations. Values used in calculating financial ratios are taken from the balance sheet, income statement, statement of cash flows or the statement of retained earnings. The valuation ratios can help investors gain some understanding of a company’s value and quickly aid in the process of deciding whether or not the company is undervalued or overvalued. Below we will take a look at the most common ratios.
The Quick Ratio is used to measure a company’s short-term liquidity. It is calculated by dividing current assets, minus inventories, by current liabilities. The higher the quick ratio, the better the company is positioned. Simply put, the quick ratio indicates a company’s ability to meet its short-term obligations with its most liquid assets.
Return on Equity reveals how much profit a company generates with the money shareholders have invested. The calculation is performed by dividing net income by shareholder’s equity. The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investors.
Debt-Equity Ratio divides total liabilities by stockholders’ equity to measure a company’s financial leverage. A high debt/equity ratio usually means that a company has been aggressively financing its growth with debt. This easy-to-calculate ratio gives investors an idea of a company’s equity-liability relationship and a quick glance at the company’s leverage.
Price/Book Value Ratio, also known as price-to-book, compares a stock’s market value (current trading price) to its book value, giving investors an indication of how much they are paying for the net assets of a company. A lower P/B ratio might mean that the stock is undervalued, but it could also mean that something is fundamentally wrong with the company. Never rely on a single ratio without doing proper due diligence!
Price/Earnings Ratio (“P/E”) is the best known investment valuation indicator. Although it has imperfections, the ratio is used by investment professionals as well as the investing public. Historically, the average P/E ratio for the broad market has been around 15 although when evaluating a company be sure to compare to the appropriate industry’s P/E. If the stock’s P/E is lower than the average, it is generally considered to be undervalued.
Price/Sales Ratio (“P/S”) divides a company’s stock against its annual sales (instead of earnings like the P/E ratio). Many investors consider a company’s sales figure more reliable in calculating a stock’s price multiple than the earnings figure. A lower price to sales ratio generally indicates a better investment since the investor is paying less for each unit of sales.
Price to Cash Flow Ratio is calculated by taking the current share price and dividing the total cash flow from operations. This ratio is similar to the price/earnings ratio, but is recognized by some as more reliable since it is not easily manipulated. Keep in mind that this ratio will vary from industry to industry.
The price-to-earnings-to-growth ratio divides the P/E ratio by a company’s growth in EPS (earnings per share). A PEG ratio of more than one suggests the market anticipates growth higher than consensus estimates or the stock is overvalued, while a PEG ratio of less than one suggests analysts’ consensus estimates are currently set too low or the stock is undervalued.