Commonly Used Financial Ratios

Financial statements contain a wealth of information that investors can use to evaluate the performance and prospects of a company. While the massive amounts of data in these financial statements can be intimidating to most investors, they can be simplified into various financial ratios to help investors better understand and review the various aspects of a company. However, not all financial ratios are created equal. We present some commonly used financial ratios in this section to help you get started.

1. Price-To-Earnings Ratio

Price-To-Earnings Ratio = Price / Earnings Per Share

The price-to-earnings (PE) ratio is probably one of the most widely used valuation metric to determine if a particular stock is overvalued or undervalued. In essence, the ratio indicates the price that investors are willing to pay for every dollar of earnings generated by the company. It is calculated by dividing the share price of the company by its earnings per share (EPS). The EPS denominator can be based on either trailing or forward earnings. The trailing PE ratio, which uses the past four quarters of earnings and can be found in the income statement, is preferred when forecasted earnings are not available. The forward PE ratio, on the other hand, is calculated based on future estimated earnings and is preferred when trailing earnings are not representative of future performance. A company's current PE ratio, when compared against its historical value over an extended period (e.g. ten years) or against the PE ratios of its other peers in the same industry, can give investors clues on where the company currently stands in terms of valuations.

While the PE ratio provides us with a yardstick to gauge the valuation of a company, making investment decisions solely based on PE ratios can have its pitfalls. Just because a company has a low PE ratio relative to its historical average does not mean it represents good value for an investor. Conversely, a company with a high PE ratio is not necessarily overvalued. Investors should find out the reasons behind the company's low (or high) PE ratio, and assess whether they are likely to be short-term or permanent. Also, comparing the PE ratios of companies in different industries to determine their relative attractiveness can be misleading as they can have very contrasting characteristics and fundamentals. While the PE ratio is useful in giving investors a glimpse of where a company is in terms of its valuations, it should not be a definitive guide for any investment decision.

2. Price-To-Book Ratio

Price-To-Book Ratio = Price / Book Value Per Share

Unlike the PE ratio, which is directly related to profitability, the price-to-book (PB) ratio measures the monetary value of the common shareholders' residual claim on a company's net assets at a given point in time. The PB ratio is calculated by dividing the share price of a company by its book value of equity per share. The book value of equity is stated on a per share basis and is derived by taking the total value of assets minus total liabilities and preference shares. In a similar fashion as the PE ratio, the PB ratio, when compared against its historical average, gives investors a sense of whether a stock is cheap or expensive. It is a particularly appropriate measure of net asset value for companies with substantial tangible assets, such as financial institutions and capital-intensive firms. As book value is a cumulative amount that is generally positive, the PB ratio can also be an alternative valuation metric to the PE ratio, especially when negative earnings result in a meaningless PE ratio, or when investors do not have a clear grasp of a company's future earnings prospects.

Despite its merits, the PB ratio is not without its shortcomings. As book value does not recognise the value of non-physical assets, such as business reputation and intellectual property, PB ratios can be misleading when used to assess the valuation of companies that do not have significant tangible assets recorded on their balance sheets, such as companies in the service industry. As the usefulness of the PB ratio can be compromised by differences in accounting standards, using it to compare companies across different geographies can be difficult. As share repurchases generally reduce book value, periods of increased share buyback activity can also artificially inflate PB ratios, making historical comparisons difficult. The PB ratio, however, remains a useful valuation metric that should not be used in isolation, as with the PE ratio.

3. Debt-To-Equity Ratio

Debt-To-Equity Ratio = Total Liabilities / Shareholders' Equity

Debt is not inherently bad. Some companies take on debt to expand their businesses, especially if they are not able to finance the expansion on their own, while others utilise debt in their capital structures to lower their weighted average cost of capital, as debt requires lower financing costs as compared to stocks. However, excessive amounts of debt can lead to drastic outcomes, including bankruptcy, if they are mismanaged. This is where the debt-to-equity ratio comes in. It is calculated by dividing a company's total debt, including operating liabilities, short-term debt and long-term debt, by its shareholders' equity. The easy-to-calculate ratio helps investors assess the riskiness of a company's capital structure, and provides investors with an indication of a company's leverage position.

In general, a company that has too high a debt-to-equity ratio may be a signal of financial distress, in which case investors should carefully assess its ability to meet debt obligations before making any investments in the company's stock. On the other hand, if a company's debt-to-equity ratio is too low, it could mean that it is overly reliant on the more costly equity capital to finance its business, and that curtails profitability. The key is to strike a healthy balance between the usage of debt and equity in a company's capital structure. While there is no universal definition of what constitutes a high or low debt-to-equity ratio, investors can compare the debt-to-equity ratio of a company to its other peers that are operating in the same industry, as different industries rely on different amounts of financial resources to operate. It is not uncommon to see relatively higher debt-to-equity ratios in capital-intensive companies, such as oil and gas refiners, while non-capital intensive companies, such as service companies, tend to have lower debt-to-equity ratios. As such, it is very important to consider the industry in which a company operates when assessing its debt-to-equity ratio.

4. Dividend Yield

Dividend Yield (%) = Dividend Per Share / Price

Income investors need no introduction to dividend yield as a valuation metric. For the uninitiated, dividend yield is a measure of how much returned cash investors are getting for every dollar that they have invested. It is represented as a percentage and is calculated by taking the dividend per share of a company divided by its share price. A company that has a high dividend yield relative to its historical average may indicate undervaluation as the dividends paid out by the company are high relative to its current market price.

However, it is probably a bad idea to invest in stocks with high dividend yields without considering other valuation metrics such as the PE and PB ratios. While a high dividend yield may be a sign of undervaluation, it could also be a sign of a risky investment, especially if the high dividend yield is a result of deteriorating fundamentals, in which case future dividend payments by the company may be reduced or suspended. Conversely, a low dividend yield may also not be an indication of overvaluation. Investors who place their focus solely on dividend yields may miss out on potential capital appreciation, especially if the company is significantly undervalued based on PE and PB ratios. Investors should also pay close attention to the amount of free cash flow generated by the company to assess if dividends are funded by recurring cash flows, and whether future dividend pay-outs are sustainable.

5. Return On Equity

Return On Equity = Net Income / Shareholders' Equity

Return on equity (ROE) is one of the most important profitability metrics that measures how efficient a company is at generating profits from the money that shareholders have invested. It is derived by taking the net income of a company (from the income statement) divided by its shareholders' equity (from the balance sheet). A company that has a high or rising ROE is generally one that is capable of generating profits on new investments efficiently. On the other hand, a low or falling ROE may be an indication of the management's lack of ability to deploy shareholders' capital effectively. When evaluating the investment potential of competing stocks, the company with a higher ROE should be considered the superior choice as it can generate more profits from every dollar of shareholders' equity, assuming all other things being equal. As ROEs vary across business types, comparisons of ROEs are most meaningful among companies operating in the same industry. Investors should also check on the trend of ROE overtime, as it could be a sign of where a company's financial health is headed.

While ROE is an important indicator of profitability, it is not without its flaws. The ratio can be artificially inflated by actions such as share buybacks, which decreases shareholders' equity (the denominator in ROE) and causes a subsequent rise in a company's ROE without any improvements in its business operations. Also, ROE does not take into consideration the amount of debt that a company has taken to finance its operations. A company may have been taking on excessive debt to drive profitability, rather than raising capital through share issuance, leading to a high ROE that can be misleading as the risky amount of debt taken on by the company is not reflected in its ROE. The use of ROEs to evaluate newer and smaller companies may also be challenging as such companies may have negative earnings, even though they have huge earnings potential in the future.

Going Beyond Quantitative Data

While financial ratios can provide investors with clues on the performance and prospects of a company, as well as where it stands in terms of valuations, they are not everything. Other qualitative factors, such as the strength of a company's management, business model and industry dynamics, also play important roles in stock analysis. Investors who use both quantitative and qualitative data in their investment strategies are likely to increase their odds of success in the long-run.