5 Financial Ratios to Evaluate an Investment
5 Financial Ratios to Evaluate a Company's Stock
How do you know what makes a company's stock a good investment? While you can never predict exactly where the market is headed, there are tangible ways to measure a company’s financial health. Financial ratios are at the core of this.
These ratios are used to summarize the contents of the quarterly reports by the company, so investors interested in owning the stock can conduct a fundamental analysis of the investment. These investment ratios, like debt to asset ratio or otherwise known as debt to equity ratio, give a sneak peek into the health of the underlying business. Debt ratios can give you a look at how the company deals with debts like loans or bond sales in order to help you determine if you want to invest in what could be an over- or under-leveraged company.
What about a company's profitability? What is profitability? Metrics like profitability ratios can give you a look into how much money the company is making or if the business is growing, both important things to know if you are thinking about making a long-term investment.
Being familiar with financial ratios formulas is an important part of your growth as an investor. However, there are plenty of financial ratios cheat sheets out there to help you keep track.
There are financial ratios PDFs that can serve as this cheat sheet next time you are reviewing a company's financial reports (1). You can also make use of modern technology (such as AI assistance) and consider a handful of financial ratios to clear some of the fog, as well.
Here are five financial ratios you can take with you to expand your investing empire:
Earnings Per Share (EPS)
What it tells you: Earnings per share (EPS) is the profitability of a company or fund, measured quarterly and yearly.
EPS is a great financial ratio to start with because you may use it in your calculations for other financial ratios. Sometimes just called earnings, it’s a more transparent indicator of a company’s profitability than, say, EBITDA (earnings before interest, taxes, depreciation, and amortization), which can skew profitability to make a company look good.
When to use it: This is a solid ratio that can give you an indication of a company’s performance in the previous quarter or year. EPS estimates ahead of an earnings report can also be helpful, but take them with a grain of salt.
Downsides: Sometimes, a company does have one-off expenses that make EBITDA more reflective than EPS of the current financial state.
How to calculate it:
EPS = (Net income - Preferred dividends) / Outstanding common shares at the end of the period
How to find EPS and invest with it in mind: You can find EPS on a company’s quarterly earnings report. Magnifi’s search also makes it easy to find investments based on EPS. For example, try searching “tech companies with high EPS.”
Price to Earnings Ratio (P/E)
What it tells you: Price to earnings (or P/E, for short) tells you how much you would have to invest in a public company or fund to receive $1 in earnings.
P/E is one of the most common financial ratios that investors use. They can vary dramatically based on market performance. For reference, at the end of 2022, the S&P 500 Index had a P/E of 19.65 and the Dow Jones Industrial Average (DJIA) had a P/E of 21.13 (2).
When to use it: This is an effective ratio for companies with positive earnings for the year.
Downsides: P/E doesn’t work for companies with zero or negative earnings for the year. If this is the case, you’ll typically see N/A in place of a number.
How to calculate it:
P/E = Price of stock / Annual earnings per share (EPS)
How to find P/E ratio and invest with it in mind: You’ll often see P/E in the main section of a stock chart of an individual stock or popular ETF or mutual fund. Using Magnifi, you can compare investments with a set P/E. For example, try searching “energy companies with low p/e ratio.”
Price to Book Ratio (P/B)
What it tells you: The P/B ratio compares a public company’s market capitalization (total value of all outstanding shares) to its book value (accounting value of all of a company’s assets minus liabilities).
The price to book (P/B) ratio is sometimes called book to value ratio. It helps investors bridge the gap that often exists between share value and accounting-based company valuation. According to an NYU Stern School of Business study, the average P/B for all industries in 2022 was 4.29 (3).
When to use it: If you want to determine if a stock is overvalued, undervalued, or accurately valued on the stock market, P/B can come in handy.
Downsides: P/B ratio is less effective for comparing stock and book values of companies whose assets are not tangible on their balance sheet. This includes companies with service-based offerings.
How to calculate it:
P/B = Market price per share / Book value per share
How to find P/B ratio and invest with it in mind: You can calculate P/B ratio using the company’s market capitalization and its book value according to the latest earnings report. Magnifi lets you search for investments based on P/B ratio, using queries such as “value stocks with low price to book.”
Quick Ratio
What it tells you: The quick ratio measures a company’s liquidity, or their ability to quickly convert assets to cash to pay off liabilities. It does so by dividing current liquid assets by liabilities.
Sometimes referred to as the acid test, the quick ratio got its name because it’s a formula with a quick output that gives you some semblance of understanding a company’s financial health. Generally, a quick ratio below 1.0 is considered risky because it means the company cannot meet their current liabilities as their liquid assets stand.
When to use it: Use the quick ratio to identify companies with high liquidity risk. The lower the quick ratio, the riskier their liquidity position. More liquidity risk = a greater chance of default.
Downsides: This formula doesn’t consider future cash flow estimations, such as a company preparing to release a new product into the market.
How to calculate it:
Quick ratio = Quick assets / Current liabilities
There are two ways to calculate quick assets:
- Quick assets = Cash + cash equivalents + marketable securities + net accounts receivable
- Quick assets = Total current assets - inventory - prepaid expense
How to find quick ratio and invest with it in mind: While you can calculate quick ratio using a company’s financials (found on SEC EDGAR), you can also search Magnifi to weed out investments with risky quick ratios. For example, searching “growth stocks with high quick ratio” helps you find companies with higher liquidity.
Debt to Equity Ratio (D/E)
What it tells you: The debt to equity (D/E) ratio tells you how dependent a company’s capital financing is on debt (such as loans) versus shareholder equity (like publicly traded stocks).
What makes a good D/E ratio depends on the industry or sector you’re looking at. Generally, a D/E ratio above 2.0 means a company’s financing is overly dependent on debt compared to shareholder equity.
When to use it: D/E is helpful when you want to assess whether a company has swollen liabilities. Consider the age of the company and whether it should be more or less reliant on debt at this stage in its lifetime.
Downsides: Some form of debt is often helpful for companies for tax and other purposes, so it’s important to use D/E in tandem with others for a cohesive understanding. You should also consider norms for the industry the stock is in.
How to calculate it:
D/E = Total liabilities / Total shareholder equity
How to find D/E ratio and invest with it in mind: A company’s balance sheet shows liabilities and shareholder equity, making for a simple calculation.
Using Financial Ratios in your Investing Evaluations Using Magnifi
One financial ratio alone may not be enough to give you a clear view of where a stock is headed. But knowing which ones to look for gives you a real head start.
To make things easier, you can ask an AI investing assistant, like the one Magnifi offers users (4). Using natural language processing, the tool can answer prompts like “Technology stocks with low debt to equity ratios” or “Companies with upcoming earnings reports.” These are just examples, but you can tweak your key performance indicators based on your own unique investing strategy.
References:
- "Financial Ratios eBook," corporatefinanceinstitute.com, https://corporatefinanceinstitute.com/assets/CFI-Financial-Ratios-Cheat-Sheet-eBook.pdf
- “P/Es & Yields on Major Indexes” The Wall Street Journal, https://www.wsj.com/market-data/stocks/peyields
- Damodaran, Aswath, "Price and Value to Book Ratio by Sector (US)," January 2023, https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/pbvdata.html
- "About Us," magnifi.com, https://magnifi.com/magnifi-personal