A beginner’s guide to financial ratios

Author: Michael Gable

You may already be aware that our unique philosophy to investing is to combine both fundamental and technical and technical analysis. Here we take a break from presenting a specific stock idea and run through some basic financial ratios that can help a beginner investor identify a quality company:

  1. Market Capitalization – This is a measure of a company’s size which is calculated by the current share price of a company multiplied by the number of shares issued by the company. Smaller companies tend to be more riskier than larger companies and their shares are generally less liquid. A market capitalization greater than A$100M is usually a “safer” selection.
  2. Price to Earnings Ratio (P/E ratio) – this is the calculated by the stock price divided by the forecast earnings per share. When different companies in the same industry are compared, the company with the lower P/E generally indicates the better value. However, a company with a higher P/E, while being more expensive, could be more expensive for a reason such as having a better growth profile.
  3. Return on Equity (ROE) – This represents the returns the Company generates on shareholders’ funds. ROE is calculated by dividing the net profit by the sum of shareholders’ ordinary equity and this is expressed as a percentage. ROE above 15% will indicate a good value stock.
  4. Earnings Per Share (EPS) – This is calculated by the dividing the net annual earnings of a company by the number of shares issued. It is an indicator of the profitability of a company relative to its issued capital and is a key measure used in the valuation of a Company.
  5. Net debt to equity ratio – This ratio measures the financial health of a company which is calculated by dividing debt on the balance sheet (net of cash) by total equity. A high net debt to equity ratio (i.e. above 60) may denote poor financial health, but high debt levels may be serviceable by the Company’s ability to generate consistent and increasing cash flows. Long term debt should be within the range of 3 to 4 times the net profit of the company to be in a good debt position.
  6. Dividend Yield – This ratio shows much how much income a stock pays in comparison to its stock price. It is calculated by the forecasted annual dividend divided by the current stock price. Usually only profitable companies pay out dividends, so a company which has consistently paid out dividends can be viewed as safer investments.

There is more to stock selection than a few good ratios – just as there is more to stock selection than a good looking chart.


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