Many financial ratios are used to to evaluate investments. Which ratios are most important can depend on your personal investing goals and the industry of the companies you’re researching. Generally, investors look to ratios to determine the profitability of a company and the value of its shares, but financial ratios can also be used to evaluate operations, liquidity and leverage.
Return on Equity (ROE)
One common measure of profitability is return on equity. ROE is calculated by dividing the annual net income by shareholder equity, which is the liquidated value of the company and its assets minus its liabilitites. The result is a percentage that shows how efficiently the company is using its money and assets to generate profits. Because a shareholder only owns the equity in a company, ROE can be a useful measure of the value of the stock.
Price to Earnings (P/E)
The price to earnings ratio tells investors how expensive a company’s stock is at its current market price. P/E can be calculated by dividing the market capitalization of the company by its after-tax earnings or by dividing the share price by the earnings per share. The higher the P/E, the more the market is willing to pay for a dollar of the company’s earnings. P/E ratio norms are very industry-specific, so a comparison against competitors is usually essential.
Advanced investors use additional ratios to “check under the hood” of a company’s operations and anticipate future profitability. In some industries, a useful measure of performance is inventory turnover. This is calculated by dividing sales by inventory. The result is a rough estimate of how many times inventory was used and then replaced. Other figures, like profit margins, can then be used to calculate profits.
Investors and analysts use a variety of other ratios to poke and prod companies. Some ratios, such as debt to equity, provide a picture of how the company is financed, and whether its debts are manageable. Price to cash flow is a common measure of liquidity, showing liquid capital each share represents, that for some investors is more important that price to earnings. Other ratios measure the solvency of a company, or its ability to cover its liabilities and avoid going bankrupt.