One of the major tools used by value investors to evaluate the companies they are considering is ratios. When evaluating the variety of financial information available for publicly traded companies, it’s helpful to use ratios for comparisons. Ratios allow you to make more accurate evaluations of different companies. If all you know is that two stocks have the same price, it’s hard to discern any useful information about their relative value; however, ratios like price-to-earnings and return on equity enable you to gain a deeper understanding of the company’s worth. Here are some of the most commonly used ratios, as well as the significance of each to investors:
Price-to-Earning (P/E): The ratio of the stock price divided by the earnings for the company, usually over the last twelve months. The P/E ratio is one of the most widely used, and is helpful in determining how ‘expensive’ a stock is; higher P/E values indicate more expensive stocks. Just what constitutes a high P/E value will vary depending on the particular type of stock, although a P/E value of around 15 is considered average for the S&P 500 index. The P/E ratio also tells you how long it will take for your investment to be returned, assuming the company’s earnings stay constant.
Earnings Yield (Price-to-Earnings): The ratio of earnings divided by the stock price, the inverse of the P/E. It’s called the earnings yield because it shows how much the stock earns for its price. This can be used to compare the effective rate of return for investing in that stock to the dividend yields offered by bonds. In the case of a stock with a P/E ratio of 15, the earnings yield would be 6.67%.
Current Ratio: The current assets of the company divided by the current liabilities. It’s useful in determining if the company can meet it’s current obligations. A closely related ratio is the quick ratio, where the inventory is subtracted from the current assets before the result is divided by the current liabilities. The quick ratio may be a more adequate indicator of the company’s ability to pay its debts, as some inventory can prove difficult to liquidate.
Return on Equity: The net earnings of the company divided by the owner’s equity. This is a measure of how much money the company returns to investors. Similar to the earnings yield, this ratio enables you to compare the return gained by investing in a given stock to other stocks as well as investments such as bonds.
These are just a few of the many ratios you can find or calculate while studying stocks for potential investments. Understanding the information that these ratios can provide and how to interpret it is vital to becoming a good value investor.