The Investor’s Toolkit: 10 Must-Know Financial Ratios

  • AUTHOR: editor
  • POSTED ON: June 9, 2023

When it comes to investing in stocks, deciphering a company’s financial health can be quite challenging, even with a massive array of data at your disposal. There are numerous ratios and metrics available, but which ones truly matter? Don’t worry; we’ve got you covered.

In this article, we’ll introduce you to ten crucial financial ratios that will provide you with most of the information you need when scouring the market for promising stocks to invest in.

1. Price-Earnings Ratios (PE)

Let’s start with the PE ratio, which tells you how many years’ worth of profits you’re paying for a stock. To calculate the PE ratio, simply divide the stock price by the EPS (earnings per share). Generally, a lower PE ratio is considered better. However, it must be noted that the ideal PE ratio varies across industries and market conditions.

2. Price/Earnings Growth (PEG) Ratios

Next up is the PEG ratio, an invention of Benjamin Graham. It helps measure the premium or discount you’re paying for growth. To calculate the PEG ratio, divide the PE ratio by the expected annualized earnings growth rate. A PEG ratio of less than 1 suggests the company may be undervalued. Remember that predicting future growth rates can be challenging, so exercise caution when relying solely on this ratio.

3. Price-to-Sales (PS) Ratios

The price-to-sales ratio is a valuable metric popularized by investment manager Ken Fisher. It compares a stock’s market capitalization to its sales over the past 12 months. This ratio can be a better indicator of a company’s relative value, especially in cases where earnings are not available or can be easily manipulated. As always, compare the PS ratio with competitors and historical multiples to gain meaningful insights.

4. Price/Cash Flow (PCF) Ratios

The PCF ratio provides a straightforward comparison by dividing the stock’s share price by its operating cash flow over the previous 12 months. Unlike the PE ratio, the PCF ratio excludes noncash expenses such as amortization and depreciation, making it a reliable metric for assessing value. A lower PCF ratio is generally preferable.

5. Price-To-Book Value (PBV) Ratios

The PBV ratio reveals how much you’re paying for each dollar of assets owned by the company. To calculate this ratio, divide the market capitalization by the difference between total assets and liabilities. PBV is particularly useful for asset-heavy companies but may be less meaningful for service-based businesses or those without substantial property, plant, and equipment.

6. Debt-to-Equity Ratios

The debt-to-equity ratio helps gauge a company’s financial structure by comparing its total debt to shareholder’s equity. A lower percentage indicates a better balance between debt and equity financing. It’s important to compare a company’s debt-to-equity ratio within its industry and against its historical ratios to gain a clearer understanding of its financial position.

7. Return On Equity (ROE)

ROE measures a company’s efficiency in generating profits from the money invested in it. To calculate ROE, divide the net income by shareholders’ equity. A higher ROE is generally considered favourable, as it indicates that the company generates more profit from each dollar of equity on its balance sheet.

8. Return On Assets (ROA)

Similar to ROE, ROA is another measure of management effectiveness. It determines how efficiently a company can grow its profits from a given base of assets. Calculate ROA by dividing the net income by the total assets. Comparing a company’s ROA over a multiyear period can provide more valuable insights.

9. Profit Margin

Profit margin reveals how much a company earns from each dollar of sales. You can use different profit numbers in the calculation, such as gross profit, operating profit, or net profit. Profit margins vary widely by industry, and it’s essential to consider the trend over time to determine the company’s profitability trajectory.

10. Dividend Payout Ratios

This financial ratio indicates the percentage of a company’s earnings paid out as dividends to its shareholders. This ratio helps assess the sustainability of a company’s dividend. While payout ratios vary by industry and business model, it’s generally advisable to see this number below 80% to ensure the company can maintain its dividend payments even during economic downturns.

The Takeaway

By using these ten essential financial ratios, you’ll have a powerful toolkit for analyzing individual companies and the overall stock market. It’s important to remember that stock prices can be influenced by various factors in the short term, but over time, true value tends to prevail.

Remember to conduct thorough research, consider the specific industry and market conditions, and keep an eye on historical trends for meaningful comparisons so you’re better equipped to make informed investment decisions.


Updated June 9, 2023
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