All of the ratios for investing are important when you apply proper fundamental analysis. But some are more significant than others.
It’s important to know which those are, especially if you are only starting out on investing in stocks. So, having a few of the most important metrics to begin your analysis without overthinking it is invaluable.
In this article, we will be looking at the 9 most essential ratios for investing you need to equip yourself while screening for stocks.
Let’s start right away!
1. Return on Equity (ROE)
The return on equity (ROE) is the net income of a company relative to its equity. It is calculated by dividing the net income by the equity and it’s expressed as a percentage.
First of all, the net income is the final earnings figure after you subtract all the expenses and taxes from the revenue.
Second, the equity is what remains after you subtract all the liabilities of a company from its assets (a.k.a book value).
Now, let me give you an example. Suppose the equity of a company is $100 million and it generated $10 million in net income last year. The return on equity would be 10% ($10 million / $100 million).
The return on equity is a particularly useful metric when you want to see how much earnings a company generates by taking into account its equity base.
2. Return on Capital Employed (ROCE)
The return on capital employed (ROCE) measures the net income relative to the capital employed. Expressed as a percentage, it is calculated by dividing net income with capital employed.
Capital employed is considered the assets that a company needs to generate its income. It’s generally calculated as assets minus current liabilities.
This is one of the most important ratios for investing when it comes to assessing a company’s profitability. It shows you how well the managers use the assets they have at their disposal to generate income.
Knowing how to interpret it will also help you remember how to calculate it since the current liabilities are what goes out of the company in the short-term and thus cannot contribute to the generation of income.
3. Profit Margin
The profit margin is yet another profitability metric that shows how much of the revenue has ended up as net income (as a percentage figure). It is calculated by dividing the net income by the revenue.
For example, if the revenue of a company has been $2 billion and its net income $100 million, the profit margin would be 5% ($100 million / $2 billion).
The profit margin is an excellent figure to compare against other companies in the same industry as it can reveal if the company you analyze ends up having above-average profitability.
4. Price to Earning Ratio (P/E)
The Price to Earnings Ratio (P/E) is a valuation metric measuring how high the price per share of a company is relative to its earnings. It’s calculated as the price per share divided by the earnings per share (EPS).
For example, if the share price of a company is $50 and its EPS in the last year was $2.50, then the P/E ratio would be 20 ($50 / $2.5.)
Do not be confused by the use of the EPS figure here. The EPS is basically the net income divided by the number of shares outstanding.
The advantage is that by looking at the relation between the price and earnings of a company on a per-share basis, you can have a better view of how much you will be paying for the earnings of a company. That’s because you will be buying “shares” of a company, not the whole company.
5. Price to Book Ratio (P/B)
The price to book ratio (P/B) shows the relation between the price per share and the book value. It’s calculated as price per share divided by book value per share.
A while ago, we explained that equity is the total assets of a company minus all the liabilities. Well, book value basically means the same thing, but it’s on a per-share basis to be consistent with the price for the stock of the company which is also on a per-share basis.
Similar to the P/E ratio, the P/B ratio shows how much you will be paying for the equity of a company.
6. PEG Ratio
The PEG ratio (Price Earnings Growth) shows the relation between the price of the stock, the EPS, and the EPS growth rate. You can calculate it by dividing the P/E ratio by the forecast EPS growth rate.
This is like the P/E ratio but it also factors in growth. For example, let’s assume that the average P/E of the market is 30 and a stock you’re analyzing has one of 40. You may be inclined to say that the stock is overvalued.
However, the PEG ratio could have a different story to tell if the growth rate could justify the higher than average P/E ratio. If the growth rate that we can expect is 30% for the stock but 15% for the market, then the stock’s PEG ratio will be lower than the one of the market; the stock’s PEG would actually be 1.33 (40 / 30), while the market’s would be 2 (30 / 15).
As you can imagine, it works the same way as the P/E ratio; the lower the better.
7. Debt to Equity Ratio (D/E)
The debt to equity ratio (D/E) shows how much debt and how much equity a company consists of. It’s calculated as total liabilities divided by total equity.
For example, if a company has a debt of $5 billion while equity of only $2 billion, then the D/E ratio will be 2.5 ($5 billion / $2 billion), showing that the company’s debt is 2.5 times its equity.
Of course, the lower the better, but make sure that you don’t dismiss a company with a high D/E ratio if it generally shrinks over time. What matters is that a company’s assets aren’t financed through debt for too long so that it can raise more money by going into further debt if the conditions demand it.
8. Current Ratio
The current ratio measures how well a company can pay for its short-term obligations considering its current assets. It’s calculated as current assets divided by current liabilities.
If for example, a company has current assets of $4 billion and current liabilities of $1 billion, then the current ratio will be 4 ($4 billion / $1 billion), indicating that it has current assets 4 times the current liabilities; a great margin of safety for paying them.
9. Interest Coverage
The interest coverage ratio shows how many times over (or under) the interest expense a company’s earnings before earnings and taxes (EBIT) are.
As with the current ratio, this is too a financial health ratio measuring how well a company can cover its interest expense. The numerator that is used here is EBIT because that’s the earnings figure just before accounting for the interest payments on a balance sheet.
Don’t Use Ratios that Don’t Apply to your Situation
The above investing ratios are all pretty common among financial analysts and fundamental investors.
But they don’t necessarily have to apply to your situation and be consistent with your investment approach.
Everyone’s different and before you use any ratio, make sure that you first understand it completely and that it tells you something that you should know; otherwise, you will be wasting your time.
Thank you for reading this article of the 9 most essential investing ratios and I hope you good luck with learning how to apply them in your analysis!
Please share this article if you found it useful and let me know if you need help with anything down in the comments.
Disclaimer: This information should not be viewed as financial advice. You should consult a financial advisor or do your own due diligence before you invest. The owner of this website and author of this article are not to be held liable for any undesired result by anyone who uses this information that is provided here in any way.
