Important Financial Ratios

Each Tuesday we produce a research document called “The Dynamic Investor” where we analyse various stocks fundamentally as well as technically. Each stock which is covered also has 5 fundamental metrics. Whilst there are many other important metrics that investors need to understand, these 5 are a good starting point. In this article we explain what each metric means and why they are important when analysing stocks.

Market Cap

A market cap (“market capitalisation” in full) of a stock is what the market value is for the company’s outstanding shares. This is determined by multiplying the company’s outstanding shares by the current price of the shares.

Why is this important?

Investors like to use the number to determine the size of the company. This can also reflect how risky an investment is. Large cap stocks on average don’t offer as much growth as smaller companies because they tend to be more mature businesses. This means that they can be considered a safer investment. Smaller cap stocks offer high returns but can be a lot more risker. The smaller market cap could also lead to a lack of liquidity.  Large cap stocks are classified as having a market cap of $10 billion or more. Mid cap stocks are classified as between $2 billion and $10 billion. Small cap stocks are between $300 million and $2 billion.

Return on Equity

The return on equity is a ratio that compares the company’s annual net income against the average shareholder’s equity. Share holder’s equity is calculated by summing up the company’s total assets minus its debts.

Why is this important?

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This ratio can be used to demonstrate to investors how effective the company is investing funds from company assets. To evaluate whether a company has a good or bad ratio, investors can compare the ROE to industry averages as well as other companies in the same industry. 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.

12 month forward PE

We have previously written on this blog on price to earnings ratio and how it can determine how expensive a stock is “How do you know a stock is expensive? Part 1”. The 12 month forward PE uses the same formula but instead of past earnings it uses estimated futures earnings per share. The forward P/E formula is current share price/estimated futures earnings per share.

Why is this important?

The share market is forward looking so it is more relevant to look at what is expected to happen as opposed to what has already occurred. The 12 month forward PE will use the estimated future EPS calculated by analysts. If the forward P/E ratio is lower than the current P/E ratio, it can indicate that analysts are expecting earnings to be higher in the future.

1 year EPS growth

This means the growth rates of earnings for that company for a year.

Why is this important?

The EPS is a useful metric to look at as it can show how much profit a company can make for each outstanding share. If the 1 year EPS growth is positive it means the company is becoming more profitable over time.

Dividend Yield

Dividend yield is calculated by dividend per share, divided by the price per share. This metric can show the ratio of the dividend paid compared the share price of the stock.

Why is this important?

It can help investors identify which company pay a good income. For investors who use their share portfolios to fund their living expenses, dividend yield is important to them as it can help them find income producing stocks.

Lauren Hua is a private client adviser at Fairmont Equities.

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