Financial Ratios

Following are the most common and widely used financial ratio.

Earnings per Share (EPS):

  • EPS is the ratio of net earnings of a company to its number of shares that are floated in the market.
  • EPS=Net Earnings / Outstanding Shares
  • This ratio is generally used to compare two companies belonging to the same industry. The ratio serves as a common ground for comparison as it is not practical to compare two companies by merely comparing their current stock prices. For example the net earnings of company ABC and XYZ both is 1000 Rs but the company ABC has 100 shares while company XYZ has 500 shares.
    • EPS for ABC = 1000/100 which is 10.
    • EPS for XYZ = 1000/500 which is 2.
  • That means Earning per share for ABC is higher than that of XYZ and hence buying shares of ABC makes more sense. However note that making a decision just on the basis of EPS is a bad idea as the ratio doesn’t indicate that the stock of the company is good for buying. EPS has its own limitations and one of them being that preferred shares are not included. Other one being, the total number of shares keeps changing throughout the year. EPS can easily be found on any good financial website or the company’s website for that matter.

Price to Earning (P/E):

  • P/E is the ratio of a company’s stock price to its EPS.
  • P/E = Stock Price / EPS
  • So if a stock is trading at 1000 Rs and its EPS is 10 then P/E would be 1000/10 = 100.
  • Thus, this ratio is technically telling an investor what price the market is ready to pay for the company’s earnings. In other words, the higher the P/E, the more price the market is willing to pay for it. Now how a P/E is interpreted totally depends on the analyst. Some view a high P/E as an overpriced stock while others may view it as a stock on which the market has high confidence. Similarly, some view a lower P/E as a potential stock to buy while others may view it as an ignored and dormant counter. The P/E is one of the most sought after ratio but still it technically cannot enable you to take a investment decision.

Book Value:

  • Book value tells an analyst the net worth of a company.
  • Book Value = Assets – Liabilities
  • There are several ways to define a company’s worth or value. One of the ways you define value is market cap or how much money would you need to buy every single share of stock at the current price. A company’s balance sheet reflects its book value. Other way to find the net worth would be to calculate the total amount one would need to purchase all the shares of the the company at the current price.
  • A company that is really doing good and has growth prospects will definitely be worth more than its book value.

Price to Book (P/B):

  • P/B is the ratio of a company’s stock price to its book value per share.
  • P/B = current stock price / Book Value Per Share
  • This ratio is generally used by those value investors who wish to park their money in the company right at the beginning. These companies generally have a low P/B and are thus seen as potential good candidates for investments by these value investors.

Return on Equity (ROE): 

  • It is the ratio of net income generated by the company to the shareholder’s equity.
  • Return on Equity = Net Income/Shareholder’s Equity
  • It is expressed as a percentage value. It just conveys to an analyst the amount of money the company generated with the capital that an investor parked in it. It is used to compare the profitability generated by two companies in the same business area. Higher ROE percentages (15-17%) seen over a period of last 5-10 years reflect a good profitable and efficient company.

Price to Sales (P/S):

  • It is the ratio of the company’s market capitalization (number of shares in the market multiplied by current stock price) to the total sales(Revenue) in the year
  • P/S = Market Cap / Total Sales.
  • The lower the value of P/S the more attractive it is said to be for investment. On the contrary the higher the P/S the more overvalued it is thought to be. However like the other ratios, this ratio has its own limitations and hence no investment should be based totally on this ratio.

Debt To Equity Ratio:

  • It is defined as the ratio of total liabilities of a company to its shareholders equity.
  • Debt-to-Equity Ratio = Total Liabilities/Shareholders’ Equity
  • The ratio just gives an analyst insight into what proportion of the company assets have been financed by debts and thus the company’s liability to pay interest against it.
  • A high ratio means that the company is being financed by external lenders (at higher interest rates) and this trend is considered risky and unfavorable for investment.

Dividend Yield:

  • It is defined as a ratio of dividend per share to the price per share.
  • Dividend yield = Dividend per share / Price per share
  • The ratio gives the analyst an insight into the returns that are generated for every rupee that is invested.
  • So if two companies say A & B both have declared 3 rs as dividends and company A is trading at 60 Rs while company B is trading at 90 Rs, then A has a dividend yield of 5% while B has a dividend yield of 3.3%. A is a better investment choice compared to B.

Payout Ratio:

  • It is defined as a ratio of dividend per share to the earnings per share.
  • Payout Ratio = Dividend per share / Earnings per share
  • The ratio gives the analyst an insight into how much a company is paying as dividends (compared to its earnings) to its investors. A low ratio indicates that the company is not willing to shares its profits to its investors. These are generally high growth companies that tend to invest most of the revenue generated as against to paying its investors. On the contrary a consistently high ratio indicates a mature and a stable company with a good dividend paying track record and is mostly preferred by investors.

Current Ratio:

  • It is defined as a ratio of current assets of a company to its current liabilities.
  • Payout Ratio = current assets / current liabilities
  • The ratio gives the analyst an insight into how much liquidity a company has to pay off its debts in the short term. The greater the ratio, the more liquidity the company has and hence the more it is capable of paying off its debts. A value between 1-3 shows a healthy company with good amount of resources and liquidity. Values lower than 1 show inefficiency in paying off debts.