How to Read Stock Ratios
Reading stock ratios can help the investor rank stocks in the same industry on a relative basis. It is important to appreciate that stock prices are greatly affected by industry-wide conditions and general levels of interest ratios. Stock ratios can be greatly affected by extraordinary one-time events like tax payments, so it is wise to look at a variety of stock ratios that reveal the asset and liability sides of the balance sheet.
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Instructions
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Compare stock ratios of companies in the same industry to determine relative values. Companies in different industries, like mining and book publishing, may have greatly different capital structures and are thus not directly comparable. There are three important groups of ratios: profitability ratios, asset ratios and liability ratios.
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Compute the stock price divided by the earnings for the previous 12 months. This is the trailing price to earnings ratio. Divide the stock price by the expected 12 month earnings and get the forward price earnings ratio. Compare the two ratios to see if the stock has become relatively more expensive. Divide the stock earning by its growth rate for an estimate of a stock's reasonable value.
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Use profitability ratios to learn how effectively capital is being used. Subtract expenses from gross revenues and divide by gross revenues for the gross profit ratio. Divide the profit by the corporation's total assets for the return on assets. This ratio actively measures how well a company is using the assets it has. It can also be used as a management efficiency gauge when compared to peers in the industry. Good managers do more with less. Eliminating debt from total assets in the above equation gives the investor return on equity. This is a truer picture of asset use, since it eliminates profits earned from leverage.
Liability ratios are easy to compute. Total debt is tested by the debt to equity ratio. Subtract short term debt and divide by equity to arrive at the long-term debt to equity ratio. Short-term debt is best measured by dividing it by the cash flow so there is an indication as to how comfortable the liquidity of the company is. Liability ratios are somewhat limited, because it is short term debt that creates the greatest pressure on cash flow. Long term debt is usually asset-secured.
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Use cash flow ratios, such as stock price to cash flow, and determine the viability of a company as a going concern. Divide a stock by its cash flow to eliminate tax, depreciation and one time effects on earnings. This is a truer picture of a companies ability to whether weak economic times. Eliminate dividends, capital spending and other one time payments, and divide by the stock price to get free cash flow. This is a better measure to estimate the true cash generating power of a company.
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Use stock ratios carefully. There are over 100 key ratios that can be derived from a balance sheet that would be of use to an investor. However, these are just ratios. Learn how to read ratios with caution. Absolute levels of debt, assets, and cash flow must be considered in reading financial statements. Also, these ratios are just a snapshot of the company created at the time the balance sheet was made. Stock market conditions may improve or deteriorate which will affect company valuations.
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Tips & Warnings
Learn which ratios are key for a particular industry. Turnover ratios are important in the retail business and unimportant in the financial services business.
Stock ratios are very useful for comparison, but always understand the industry and company with fundamental research.
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