Financial ratios give you insight into a company's fundamentals. These financial performance measures let you assess a company's health on its own or compared to an industry peer group.
Here's what you need to know to put some of the most popular stock ratios to work.
Qualitative and quantitative analysis
When investing, you should never buy or sell based on a single input. Instead, you should look at the company holistically to assess whether you think the share price is headed up or down.
Technical analysis focuses on how the stock has performed recently, compared to other stocks. Fundamental analysis zeros in on the financial metrics behind the company, not just what the stock price is doing.
Personally, I'm a huge fan of fundamental analysis and make my own investment decisions based on fundamentals. You can take your fundamental analysis a step further by separating qualitative and quantitative aspects of the underlying business.
Use quantitative analysis
Quantitative analysis means a pure focus on the numbers. Financial ratios are generally based on these. The numbers you get from the income, balance sheet and cash flow statements are all sources of data for quantitative analysis. That's what we'll focus on with the ratios below.
But don't forget about qualitative analysis. You can't put everything into a number. The qualitative analysis takes you through other important aspects of the company. For example, the numbers alone won't tell you a lot about competitors, technology changes or other market threats or opportunities.
Look at the whole package when your money is on the line. Never just a single number or factor — or gut instinct — alone.
Key financial ratios when buying stocks
Before you click the “Buy” button, you'll want to check out some key financial ratios and compare them to industry peers. The most important ratios look at the company's income and its ability to remain solvent.
The most commonly cited ratio may be the price-to-earnings ratio, also called P/E or PE ratio. This ratio looks at the share price compared to the earnings per share. It's a great way to compare stocks with peers to get an idea of whether it may be overpriced, underpriced or in line with other companies in the industry.
Stock ratio categories
The two most common categories of stock ratios look at earnings and the balance sheet. These are essential indicators of a business's financial health. Here's a glance at some of the stock market ratios you are most likely to come across and how to put them to work. These are the ones that help us understand the valuation, profitability and liquidity of a company.
Valuation — Price to Earnings (P/E)
This is a hugely popular metric. To calculate P/E, divide the market value per share (stock price) by the company's earnings per share.
Valuation — Price to Earnings Growth (PEG)
The PEG ratio is a favorite of growth and GARP investors. PEG divides the P/E by the growth rate of the company's earnings. A low PEG — below 1 — indicates a stock may be undervalued. A high PEG indicates a stock could be overpriced.
Valuation — Price to Sales (P/S)
The price-to-sales ratio divides the market capitalization by the company's 12-month revenue. A low P/S compared to other companies in the industry indicates a company may be an attractive investment.
Valuation — Price to Book (P/B)
One of my favorite ratios is the P/B. (I'm a money nerd — I have a favorite ratio — what can I say?) This ratio compares the stock price to the company's book value (assets minus liabilities). A low P/B could indicate a good buy. If the book value per share is higher than the stock price, it's a solid indication of an undervalued stock.
Valuation — Dividend Yield
The dividend yield is the percentage return of a stock's price. It is determined by dividing the annual dividend by the current stock price. While stocks are riskier than bonds and savings accounts, you could compare dividend yield to the payout on a bond or savings account. A high dividend yield is a good thing if you care about earning cash flow from your portfolio. However, very high yields may not be sustainable.
Valuation — Dividend Payout
This ratio compares the company's dividend payout to its net income. It tells you what percent of profits are paid to investors. This isn't necessarily a good or bad thing, but it's good information to know. If a company gives too much in dividends, it is less likely to grow. If it isn't paying any dividends, it is reinvesting every dollar back into growing the business.
Profitability — Return on Assets (ROA)
This ratio helps investors judge how much money a company makes compared to its assets. It tells you how lean and nimble a company is. Or how much it has wrapped up in the business itself. Comparing companies across an industry, you can use this metric to judge how efficient a company is with its resources.
Profitability — Return on Equity (ROE)
ROE is a stricter measure of how well a company uses its resources. ROE is found by dividing the company's net income by shareholders' equity. You could also call ROE a return on net assets.
Profitability — Profit Margin
This is another hugely popular metric. Profit margin shows what percent a company earns in profits compared to its total revenues. A high profit margin means a company is keeping a larger percentage of the revenue it brings in. Higher profit margins than industry peers can indicate that a company is better at managing costs.
Liquidity — Current Ratio
The current ratio divides current assets by current liabilities. Current assets are highly liquid, like cash and equivalents. Current liabilities are debts due within one year. This tells you if a company has enough money to pay the bills. The acid test, sometimes called the quick ratio, takes into account fewer of the company's assets and divides that by the current liabilities. This is an even stricter measure of financial health.
The numbers tell a story
Even if you're not a numbers person, you shouldn't just ignore financial ratios when investing. Instead of staring blindly at them, look for a story. Every single part of a company's financial statement and every ratio gives you insight into the real-life performance of a business. Use an online brokerage firm if you need the help.
If you can invest in good businesses, you should make money in the long term. You shouldn't invest based on the result of one ratio alone. But when you add ratios to the total package of quantitative, fundamental and technical analyses, they could be a major source of success for your investments.