Five Key Financial Ratios for Stock Analysis

In general, investors buy shares in anticipation of receiving gains from future profits. In effect, they are buying future earnings. Because of this, metrics for a company's valuation are price relative to earnings and price relative to growth. These are key valuation ratios. 

The price-to-earnings (P/E) ratio—also called the "multiple"—is quite possibly the most frequently cited stock ratio. It illustrates how much investors are willing to pay for a stock relative to its per-share earnings. 

Computing the P/E is simple: It's the stock's share price divided by the company's earnings per share (EPS). The EPS number—net income divided by the number of outstanding shares —can be taken straight from the company's income statement. For example, if a stock has a P/E ratio of 20, it means investors are willing to pay up to 20 times its per-share earnings to own it. But is that too much or too little? Expensive or cheap? 

Ultimately, it can depend on a company's ability to generate future earnings. Analysts often use a forward P/E, which is based on the current stock price relative to estimated EPS for the next year or the year after that. This indicates how expensive future earnings are at current prices. The earnings multiple can be compared to the earnings multiple on market benchmarks like the S&P 500^® index to see whether the company has a higher or lower valuation than stocks in the broader market. 

Companies with a higher growth rate of EPS generally have higher P/E ratios than companies with lower EPS growth rates. For example, if a company with a P/E ratio of 35 has a higher growth rate than a company with a P/E ratio of 20, shares of the company with the higher ratio might actually be considered "cheaper" than shares of the company trading at the lower ratio. And this brings us to the next ratio. 

While it's not as popular as its P/E relative, the price/earnings-to-growth (PEG) ratio can provide a more comprehensive and clearer picture of a stock's future growth prospects. This financial ratio compares the P/E to analysts' consensus estimate of projected earnings, which typically look forward as soon as the next quarter to as long as five years. 

The PEG is derived by dividing the P/E ratio by projected EPS growth. For example, a stock with a P/E of 18 and an estimated EPS growth rate of 15% would carry a PEG of 18/15, or 1.2. So, how should you read this number? Typically, stocks with a PEG ratio of less than 1 are considered undervalued. 

The growth component is important because investors don't want to buy something that isn't going to increase in value. What investors tend to look for when using a low PEG ratio in their analysis is a history of growth in combination with projected growth. 

The shareholders' stake in the company shows up on the balance sheet as shareholders' equity. This can be thought of as the company's assets minus its liabilities, or what the shareholders would own if the company sold all its assets, paid off all its short-term and long-term debts, and then distributed what was left to its shareholders. 

Because equity is so important to shareholders, several ratio benchmarks consider how it is valued in the stock market. 

Return on equity is equal to net income divided by shareholders' equity, and it is a key profitability ratio. In the long run, a company's earnings growth rate is equal to ROE minus the dividend yield (the percentage of earnings paid out as dividends), so comparing ROE to growth is one way to look at whether earnings are sustainable. If growth is higher than ROE, there's a potential challenge on the horizon. 

ROE measures the return shareholders receive for investing in the stock over the long term. When gauging a company's financial performance relative to its peers, its ROE can be compared to industry averages. In fact, an industry ROE benchmark can give investors a sense of what the long-term potential is for a given sector. 

There's another interesting aspect of ROE: Some financial analysts deconstruct it into components, including net profit margin, asset turnover ratios, and financial leverage. This breakdown is valuable for people who have some accounting knowledge. For everyone else, knowing that ROE includes many aspects of a company's financing and operating choices makes it a powerful analytical tool. 

Shareholders' equity is also known as book value, and the price-to-book (P/B) ratio measures how much stock buyers are paying for a company's net assets. On the surface, it's an effective metric that can compare a stock's market capitalization to what it owns versus what it owes. But it's not always that simple. 

Book value is equal to total assets minus total liabilities. This includes everything a company owns (cash and cash equivalents, inventory, accounts receivable, property, equipment, etc.) minus everything it owes (including accounts payable, mortgage payments, and debt obligations). 

To get the P/B ratio, divide the stock price by shareholders' equity, which is the book value per share. A company with 100 million outstanding shares, assets of $800 million, and debt liabilities of $125 million would carry a book value of $675 million, or $6.75 per share. If that stock traded at $5, the resulting P/B ratio of 0.74 ($5 divided by $6.75) would suggest the stock's valuation may be too low. 

In theory, the P/B ratio indicates how much shareholders would receive if the company were to be liquidated. The challenge is figuring out what a company's total assets are worth. Depending on the industry, many companies' asset costs are priced not according to market value, but rather at their value from the time of acquisition. 

For example, if a well-established company purchased real estate decades ago, the value of that property on the firm's books may be at the decades-old purchase price, not marked-to-market. Other assets are carried at purchase price minus depreciation, a non-operating expense that accounts for wear and tear as well as the need for eventual replacement on furnishings and equipment. Some items could therefore be worth considerably more than their purchase price—and some considerably less. Other assets, like brand names and secret formulas, might have no balance sheet value at all but would be quite valuable if sold. 

Traders hoping to find a company's real book value might have to dig a lot deeper beyond the books to find the market values of the company's assets and liabilities. The P/B ratio is best suited to large, capital-intensive companies (like automakers) rather than companies with intangible assets, such as software firms where much of the value is based on patents or other intellectual property not carried on the books as assets. 

A P/B ratio of 1 indicates the company's shares are trading in line with its reported shareholder equity. A P/B higher than 1 suggests the company is trading at a premium to book value, and lower than 1 indicates a stock may be undervalued relative to the company's assets. 

The debt-to-equity (D/E) ratio is another ratio based on a company's shareholders' equity. Unlike P/B, though, it considers equity relative to the company's debt burden, meaning it is also a leverage ratio. The calculation is simple, and the figures for a firm's total debt and shareholders' equity can be found on the consolidated balance sheet. Some analysts prefer to look only at long-term debt, while others reference the financial statements' footnotes to consider other obligations like leases. 

Generally, investors prefer the D/E ratio to be less than 1. A ratio of 2 or higher might be interpreted as carrying more risk, and it raises questions about whether the company has enough cash flow to cover its debt and interest payments. But it also depends on the industry. Big industrial energy and mining companies, for example, tend to carry more debt than businesses in other industries. That's why investors typically benchmark a stock's D/E ratio to the D/E of other companies in the same industry. 

The D/E ratio is one of the solvency ratios, which indicate whether a company can handle the burden of its borrowing. A high D/E ratio could mean the company is leveraging its assets to finance growth, but it also might signal that the company's core business is unprofitable and surviving by borrowing rather than generating revenue. The question investors want to consider is whether the debt is increasing earnings by more than the cost of the debt, or whether debt service is weighing the firm down with interest expense and other cash flow obligations. 

Using the same example as in the P/B ratio, the company with 100 million outstanding shares, assets of $800 million, and debt liabilities of $125 million would post shareholders' equity (book value) of $675 million. Dividing the total liabilities by shareholders' equity results in a D/E ratio of 0.19, indicating a company that's holding very little debt and most likely financing its growth through earnings. 

Analysts and investors use financial ratios to get a snapshot of a company's results and make comparisons across time and across financial markets. There's an overwhelming number of ratios used by stock analysts, lenders, and corporate managers to assess a company's financial health. The five metrics listed above can be used to give equity investors a good overview of a company's valuation, growth rate, and debt burdens. 

Remember, although financial ratio analysis can't reveal everything that's important about a company, it helps to see just enough of the road ahead to decide where to go and whether to speed up or slow down.