Looking at a company financial statements and not knowing what to look out for can be a headache for investors, which is why certain investment ratios have been widely used to explain certain important aspects of a company’s financial statement in a more simplified manner. For those who have some investment knowledge would have heard of terms like PE ratio, Debt to Equity ratio etc. These ratios make use of certain elements of the financial statement to give investors an easy understanding of certain strengths or weaknesses of the company. In this post, I shall try to explain some of the key ratios that investors normally use and what it means.
These are the 5 common investment ratios that I will explain below:
- Price to Earnings (PE) ratio
- Price to Book (PB) ratio
- Return on Equity (ROE) ratio
- Quick Ratio
- Debt to Equity Ratio
1) Price to Earnings ratio
Just as the name suggests, PE ratio simply means:
PE ratio is widely use by a lot of value investor to see if the stock is undervalued or not. Generally a low PE ratio of less than 10 is considered to be undervalued. Whereas a high PE stock usually are found in high growth stock. For instance the FANGs stocks, Facebook, Amazon, Netflix, and Google, most of their PE are above average PE ratio in the US. This is because investors believe that these tech stocks will continue to grow their Earnings per share (EPS) rapidly hence at present times they are willing to bid up its present stock price to a high level ==> Thus a high PE ratio.
In other words, it represents the amount one is willing to pay for each dollar worth of earnings of the company.
2) Price to Book ratio
Price to Book ratio (PB) is also another widely used indicator by value investors to determine if the stock is overpriced or not.
In this case the book value of a company is the value of the assets of the company on the balance sheet => since Total Asset – Total Liabilities = Total Equity
Thus, PB ratio is simply at what price are you paying for the value of the underlying assets in the company. A low PB ratio means that you are paying a low price for the value of assets in the company, the opposite is true for high PB stocks.
However one have to understand that PB ratio has it own shortcomings, for instance, it is more accurate for company that are capital intensive or company with a lot of assets.
3) Return on Equity (ROE)
ROE is a measure of how many dollars can a company generate on every dollar of equity.
Many termed the ROE as a measure of efficiency as it measures how well the management deploy the shareholder’s capital. Being able to get more dollars of profit out of lesser dollar of equity is a good thing to look out for (High ROE). Thus, usually company with high ROE is preferred over one with low ROE.
However also note that ROE can be artificially affected if the total equity portion is changed. For instance share buyback decreases total equity and hence boost the ROE.
4) Quick ratio **
Although not used by many, I feel quick ratio is a rather important measure of the company ability to manage their debt obligations.
Quick ratio provides an understanding of whether a company can meet its short term debt obligations. In this case, the short term investment refers to any securities the company hold that can be liquidated in a year.
A high quick ratio of more than 1 would mean that the company are able to pay off their debt in a year and hence the company would not run into any issues with the debtor within the financial year.
A low quick ratio of less than 1 would show that the company may have troubles meeting the near term debt obligations and could run into financing issues which as investors we would not want. This can prompt management to take on more long term debt to finance their short term obligations or raise funds through rights issues which we usually try to avoid.
5) Debt to Equity ratio **
Debt to Equity ratio is another way to understand about the company’s debt status.
Debt to Equity calculates the amount of financial leverage the company has.
High debt to equity ratio (usually more than 1.5x, in my opinion) mean that the company is highly leverage and can be rather risky. If the company cannot generate enough cash to pay off the debt that could spell trouble for the company.
Whereas an extremely low debt to equity ratio can mean that the company are too conservative and may be missing out on the extra growth benefits that taking on some debt can bring.
** For both of the ratios used to determine the debt status of a company. It is important to distinguish the nature of the debt. Is it being use to expand operations, or is it used to pay off loans that are going to expire? Choosing a company that uses debt well to expand operations that lead to higher profits and growth is good. Whereas a company that consistently borrow to pay off bad debts is definitely bad.
Another indicator would be to examine their cash flow to see if they are earning enough from their operations to cover the amount of debt they incur. Hence, one should never fear away from company that takes on debt, but instead study them closely.
no one ratio can tell you the full story of any company. You would need to actively look at a few ratios, compare across the industry, look at their growth prospects before you can derive at a fuller picture. Hopefully, you have learnt more about certain ratios that are widely used by investors. If you are looking to learn more about how to read annual reports you can click here (for part 1) & here (for part 2) which should greatly aid in helping you make better use of the ratios you have learnt here!