Now, we’re no experts but we do have some experience and have learned a thing or two doing our Masters in Finance. We’re bringing you the key ratios you need to learn if you want to start investing. If you’ve been following along you’ve probably seen we have an Investment Series with key information about investing. It all starts out with a crucial first step, learning your investment style. You can do this by looking back at our Think You’re A Risk Taker? article.
Once you’ve done that you can rest assure knowing your tolerance to risk and which investments to look for. That’s where knowing some simple crucial ratios comes in clutch.
If you’re anything like us we love ripping apart company’s financial statements and analysing the value of a company. If you’re not like us, but want to invest we’re going to lay it out simple for you so you too can see the value a potential stock option may have and steer away from those duds! These are the key ratios you need to know if you’re thinking of investing in the share market.
#1 Earnings Per Share (EPS)
Let’s start out simple and get your calculators ready. Don’t worry, if you’re not comfortable with maths or financial statements most financial websites will give you this value without needing to do your own calculations. However, it’s important to understand what EPS depicts. Quite simply it’s just what it sounds, it’s the profit reported on a per-share basis that a company has available to pay dividends to stockholders or to reinvest in the company itself. The calculation for EPS is (Net Income less Dividends on Preferred Stock) divided by Average Outstanding Shares
#2 Price to Sales (P/S)
Similar to the Price to Earnings (P/E), the P/S takes a look at the price of a company’s stock in comparison to its annual sales rather than its earnings like the P/E. This shows you how many times you as an investor would be paying for every dollar of the company’s sales. Some financial websites don’t show this, but you can calculate it by taking the Stock Price per Share divided by Net Sales (Revenue) per Share.
#3 Price to Earnings (P/E)
No, this isn’t physical education. It’s Price to Earnings, which as stated above is similar to the Price to Sales (P/S). This is one of the most well-known ratios in the investment world which is almost always given on any financial website, so no calculation on your part necessary. If a P/E is high that signals that investors are paying more for today’s earnings as they anticipate future earnings will grow which is a great thing. So how do you know if it’s high or low? You compare it against other stocks that you’re interested in to see which offers the most value.
#4 Debt to Equity Ratio
You may have heard us talk about leverage a time or two before, and if you haven’t we will again in the future because it’s important. This ratio is a leverage ratio that takes a look at comparing the company’s total liabilities on hand to its total shareholders’ equity. If we break it down further it’s taking a closer look at suppliers, creditors, lenders, etc, and how much they have committed to the company in comparison to how much the shareholders have committed. Some financial websites don’t show this, but looking at the financial statements which are always public you can easily calculate it. A lower number is an indication that the company doesn’t rely that much on leverage and is using less which equates to a stronger equity position, alas the opposite (higher number) would mean more leverage less equity. The calculation is the total liabilities divided by the shareholders equity.
#5 Dividend Yield
Now, some companies don’t offer dividends, but this would be for the investor that is comparing dividend yielding stocks to determine which has the better payout. In the most simple terms (as this is an extremely simple ratio), the dividend yield shows investors how much a company pays out dividends on an annual basis relative to its share price. This ratio will almost always be shown on any financial website and no calculation is necessary. It’ll be listed as a percentage. The calculation is Annual Dividend per Share divided by Stock Price per Share.
#6 Payout Ratio
This is another crucial ratio to those that consider themselves a dividend investor. It’s taking a look at how much profit from a company is going out in dividends. So, essentially it’s looking at if the company you’re interested in capable of sustaining dividend payments. You’ll be able to know once you take a look at the payout ratio. It shows how well the net income supports your dividend payment. Management is quite discretionary and if the payout ratio is too high then dividends will be cut and the opposite would be if it’s too low then payments will contiute. Now, not all financial websites will show this but you can calculate it of course! The calculation is Dividends per Share (DPS) divided by Earnings per Share (EPS).
#7 Current Ratio
Have you ever heard anyone talk about liquidity or heard a company going into liquidation? Well, that term is quite crucial in the finance world. The current ratio is just that, a liquidity ratio. It’s looking at the company’s ability to pay debt obligations, both short-term and long-term. Again, some financial websites will show this and some will not. The calculation is current assets divided by the current liabilities. Now, how do you know if the value is good or bad?
A healthy current ratio of 1.5 or above demonstrates the company is capable of supporting the company’s share price. Anything above 1 is generally stable and shows that a company shouldn’t struggle to support the company’s share price. However, an unhealthy current ratio of 1 or below leaves uncertainty and stability. It suggests that a company will struggle to pay off debts and liabilities potentially leading to bankruptcy. Therefore, makes a company a risky investment pushing share prices down.
So, investors, next time you look at your company’s profile keep an eye out for these ratios and do your analysis. Yes, it will take a bit of extra time but you’re putting your hard earned dollars in these companies and you probably want to make darn sure you’re receiving some value! If you’re still unsure on any of these ratios or if something else catches your eye and you’re not sure what it means in the whole scheme of things, just drop us line, and we’ll do our best to impart more information to you!