8 important financial ratios to know when analyzing a stock
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For investors who are looking to invest beyond diversified mutual funds or ETFs, individual stocks can be a profitable option. But before you start buying individual stocks, you’ll need to know how to analyze their underlying businesses.
A good place to start is a company’s filings with the Securities and Exchange Commission. These filings will provide a great amount of information, including financial statements for the most recent year. From there you can calculate financial ratios to aid your understanding of the business and where the stock’s price might be headed.
Here are some key ratios to know when looking at a stock.
1. Earnings per share (EPS)
Earnings per share, or EPS, is one of the most common ratios used in the financial world. This number tells you how much a company earns in profit for each outstanding share of stock. EPS is calculated by dividing a company’s net income by the total number of shares outstanding.
Knowing this ratio is important for stock investors, but understanding its limits is also crucial. Executives have a lot of control over various accounting practices that can impact net income and earnings per share. Make sure you understand how earnings are calculated and don’t just take EPS at face value.
2. Price/earnings ratio (P/E)
Another common ratio is the P/E ratio, which takes a company’s stock price and divides it by earnings per share. This is a valuation ratio, meaning it’s used by investors to determine how much value they’re getting relative to what they’re paying for a share of stock.
Profitable businesses with average or below-average growth prospects tend to trade at lower P/E ratios than businesses expected to grow at high rates. One of the world’s most successful investors, Warren Buffett, has made a fortune buying shares in businesses with solid growth prospects that trade at low P/E ratios. An investment in Coca-Cola (KO) in the 1980s and a more recent investment in Apple (AAPL) when each was selling for a low P/E ratio have made billions for Berkshire Hathaway shareholders.
P/E ratios can be calculated using trailing earnings, or earnings that have already been earned, as well as forward earnings, which are projections for what the company may earn in the future. For fast-growing companies, looking at the forward P/E ratio may be more useful than using historical earnings that can cause the ratio to be elevated. But remember that projections are not guaranteed and many stocks of companies that were once thought of as fast-growers suffered when that growth failed to materialize.
The P/E ratio can also be inverted to calculate an earnings yield. By taking earnings per share and dividing by the stock price, investors can compare the yield easily to other investment opportunities.
3. Return on equity (ROE)
One of the most important ratios to understand is return on equity, or the return a company generates on its shareholders’ capital. In one sense, it’s a measure of how good a company is at turning its shareholders’ money into more money. If you have two companies that each earned $1 million this year, but one company invested $10 million to generate those earnings while the other only needed $5 million, it’d be clear that the second company had a better business that year.
In its simplest form, return on equity is calculated by dividing a company’s net income by its shareholder equity. Generally, the higher a company’s return on equity is, the better its underlying business. But these high returns tend to attract other companies who’d also like to earn high returns, potentially leading to increased competition. More competition is almost always a negative for a business and can drive once-high returns on equity down to more normal levels.
4. Debt-to-capital ratio
In addition to tracking a company’s profitability, you’ll also want to understand how the business is financed and whether it can support the levels of debt it has. One way to look at this is the debt-to-capital ratio, which adds short- and long-term debt, and divides it by the company’s total capital. The higher the ratio is, the more a company is indebted. In general, debt-to-capital ratios above 40 percent warrant a closer look to make sure the company can handle the debt load.
The type of financing a company uses will depend on the individual circumstances of that company. Businesses that are more cyclical should rely less on debt financing to avoid potential defaults during economic downturns when revenues and profits tend to be lower. Conversely, businesses that are steady, consistent performers can often support above-average levels of debt due to their more predictable nature.
5. Interest coverage ratio (ICR)
The interest coverage ratio is another good way to measure whether a company can support the amount of debt it has. Interest coverage can be calculated by taking earnings before interest and taxes, or EBIT, and dividing by interest expense. This number tells you the extent to which earnings cover interest payments owed to bondholders. The higher the ratio, the more coverage the company has for its debt payments.
Remember, though, that earnings don’t always stay the same. A cyclical company operating near a peak might show great interest coverage due to its elevated earnings, but that can evaporate when earnings fall. You’ll want to make sure a company can meet its obligations during a variety of economic conditions.
6. Enterprise value to EBIT
The enterprise value to EBIT ratio is essentially a more advanced version of the P/E ratio. Both ratios are a way for investors to measure how much value they’re getting compared to what they’re paying. But using enterprise value instead of the share price allows us to incorporate any debt financing used by the company. Here’s how it works.
Enterprise value can be calculated by adding a company’s interest-bearing debt, net of cash, to its market capitalization, which is the total value of all its outstanding stock. Next, by using EBIT you can more easily compare the actual operating earnings of a business with other companies that may have different tax rates or debt levels.
7. Operating margin
Operating margin is a way of measuring the profitability of a business’ core operations. It’s calculated by dividing operating profit by total revenues and shows how much income is generated by each dollar of sales.
Operating income takes revenue and subtracts the cost of sales and all operating expenses, such as employee and marketing costs. Calculating an operating margin can help you compare with other businesses without having to make adjustments for differences in debt financing or tax rates.
8. Quick ratio
Also known as the acid test, the quick ratio measures whether a company can meet its short-term obligations with assets that can quickly be converted into cash. The ratio is useful for analyzing companies facing financial difficulties or during economic downturns when profits may be hard to come by.
The ratio sums a company’s cash, marketable securities and accounts receivable and divides by its current liabilities. All of these figures can be found on the company’s most recent balance sheet. Importantly, inventory is excluded from the list of assets because it can’t be relied upon for a quick conversion to cash.
If the ratio is one or less, the company may need to raise additional funds from investors or hope to see an improvement in its business quickly.
These ratios and others will aid your understanding of a business, but they should always be looked at in totality rather than focusing on just one or two ratios. Financial analysis using ratios is just one step in the process of investing in a company’s stock. Be sure to also research management and read what they’re saying about a business. Sometimes the things that can’t be easily measured matter most for the future of a business.