There are a number of financial ratios that investors need to be familiar with in order to assess the financial strength of a company. Understanding these different ratios can help you become a better investor in the share market.
These are the top 6 financial ratios that share investors need to be familiar with
1. Price to Earnings Ratio
The P/E ratio represents how much stock investors are willing to pay for each dollar of earnings.
The formula is: Current Share Price /Earnings Per Share
This ratio can show what level the share price is compared to the firm’s current earnings. It is the price investors are paying for the stock with $1 of the company’s profit.
For example, if a stock is trading at $80 and the earnings per share is $5 then the PE is 16. That is, 80/5. So this means the investor is investing $16 for every dollar of earnings. Investors can use the P/E ratio from different companies and compare them to determine which company is cheaper compared to others in the industry.
A high P/E means the stock is expensive compared to what it is earning. This is because investors believe that the company will grow over time and are willing to pay the premium. A low P/E means the stock is cheap and investors believe that the growth will be slow or low in the future.
2. Debt to Equity Ratio
This ratio shows how much capital has been borrowed compared to the amount of capital which has been generated by shareholders.
The formula is: Total Liabilities/Total Shareholder Equity
If a firm’s debt to equity ratio is too high then it could mean the firm may not be able to meet debt repayments. A lower debt to equity ratio may represent a more financially stable company.
3. Return on Equity (ROE)
This ratio measures how much share holders receive from their investment in the company.
The formula is : Net Income / Average Shareholder Equity.
The higher the ROE, the more shareholders are rewarded for their investment in the company. If a company has an ROE of 20%, it means that for every $1 that shareholders own, the company rewards the investor $0.20 in profits each year.
4. Return on Capital Employed
This is reflected by the formula ROCE = Earnings Before Interest and Taxes/Capital Employed.
This ratio shows how effectively the company uses all the capital to generate earnings. It also takes into account the long-term financing of the company. The capital employed figure is calculated by summing up ordinary and preferred share capital as well as all debt obligations.
5. Net Profit Margin
This is calculated from the formula: Net Profits/Net Sales. It represents what revenue is remaining after expenses have been deducted from sales. The ratio indicates how successful a business is. A net profit over 10% is considered good.
6. Dividend Yield
The dividend yield formula = Dividend Per Share / Share Price. A high dividend yield means that the company pays a large dividend as a portion of its earnings. A low one means the company pays out a smaller dividend. Investors looking for income will find this ratio useful as higher yield means higher income.
Lauren Hua is a private client adviser at Fairmont Equities.
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