Basic Financial Ratios#
- Properly understood and applied, ratios can help make you a more informed investor
- There are six basic ratios that are often used when selecting stocks for investment portfolios
- These include working capital ratio, quick ratio, earnings per share (EPS), price/earnings ratio (P/E), debt to equity ratio and return on equity (ROE)
- Most ratios are best used in combination with others, rather than alone, to get a complete picture of a company’s financial health
ROE#
Return on equity or ROE is a metric used to analyze the return on investment. It is a measure of how effectively a company uses equity capital to generate income. You can consider a good ROE that grows steadily over time. This may indicate that the company is doing a good job of using shareholder funds to increase profits. In turn, this can increase shareholder value.
Fundamental Analysis#
Fundamental analysis is the analysis of a security to determine its true (or intrinsic) value. It includes the study of economic, industry and corporate information. Fundamental analysis can be useful because by comparing a security’s true value with its market value, an investor can determine whether a security is fairly valued, overvalued, or undervalued.
Fundamental analysis contrasts with technical analysis, which focuses on determining price behavior and uses various tools to do so, such as chart patterns and price trends.
Which is better: a higher or lower P/E ratio?#
It depends on what you are looking for in an investment. The P/E ratio measures the ratio of a share’s price to earnings per share. A lower P/E ratio may indicate that the stock is undervalued and might be worth buying. However, it may be low because the company is not financially sound.
A higher P/E may indicate that the stock is expensive, but it may be because the company is doing well and it may continue.
Often the best way to use P/E is as a tool to compare the relative value of the stocks you are interested in. Or you can compare the P/E of one or more stocks to the industry average.
Value Investing#
Value investing is not a new strategy and involves a number of calculations and assumptions about the future performance of a business compared to its current share price. At its core, value investing is about looking for stocks that, even in a strong bull market, are considered undervalued by the market. This usually happens when the market changes significantly and the share price follows the market without the underlying business being affected. A valuable investor will notice that the price of a stock is low relative to its true value and will buy the stock.
A long-term strategy#
Value investing is usually a long-term strategy, although some traders base short-term trades on a value strategy. Because value investing looks at certain aspects of a publicly traded company that tend to move slowly, value investing is commonly used as a buy and hold strategy and sometimes as a swing trade, but is not usually the basis for short-term trading. styles such as intraday trading or high frequency trading.
Who is the father of value investing?#
Value investing is a strategy that Benjamin Graham attributed to Benjamin Graham and used with great success. Because Graham lost his entire investment portfolio in the stock market crash of 1929 (which led to the Great Depression), he developed a system to determine the intrinsic value of stocks rather than simply taking into account the current market price of those stocks. His book, The Intelligent Investor, was a highly circulated book and inspired the great investor Warren Buffett.
Bottom Line#
Financial ratios can help you choose the best stocks for your portfolio and increase your wealth. Dozens of financial ratios are used in fundamental analysis. We have briefly highlighted six of the most common and easy to calculate.
Remember that a company cannot be properly evaluated using a single isolated ratio. Therefore, do not forget to use various ratios for more confident investment decisions.
No stock metric can determine with 100% certainty whether a stock is valuable or not. The basic premise of value investing is to buy quality companies at a good price and hold those stocks for a long time. Many value investors find they can do this by combining multiple ratios to form a more complete picture of a company’s financials, earnings, and stock valuation.