4 Financial Ratios Investors Need To Understand

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As an investor, we often see complicated financial terms like P/B ratio, P/S ratio, and P/E ratio being thrown around when people talk about valuing a stock or fundamental analysis. But have you ever wondered what they actually mean? And why are they even important?

For savvy investors, it’s important to know how these ratios are calculated and what they mean.

It’s also important to understand that these metrics apply differently across various industries, what seems like a good Price-to-Earnings ratio in one industry may not be an ideal Price-to-Earnings ratio in another industry.

By understanding these financial ratios, we can compare different companies in the same industry with each other. Lastly, we can use these metrics as a measuring stick to assess whether we are overpaying or underpaying for a certain stock.

Earnings-Per-Share (EPS)

Earning-Per-Share is an important metric which allows an investor to understand how much profit a company makes for each share of it’s stock if the investor were to hold it.

Simply put, Earning-Per-Share is is a company’s net profit divided by the number of common shares it has outstanding. Earning-Per-Share is also used to calculate a company’s Price-To-Earnings ratio.

An example would be if company A generates a net profit of $4000 for the whole year of 2020. If the company has a total of 2000 outstanding shares, it would mean that the company’s EPS would be $4000 divided by 2000 shares, or $2 net profit (earnings) per share.

If the company’s share price is currently $8, this would mean that if a investor were to buy the stock, he or she would be paying $8 for every $2 the company was able to make in profit.

Price-To-Earnings Ratio

Price-To-Earnings Ratio is the measure of a company’s current share price to it’s Earning-Per-Share. A company’s Price-To-Earnings Ratio (P/E Ratio) is determined by dividing a company’s current share price by it’s Earnings-Per-Share.

Generally, Price-To-Earnings Ratios are used to compare companies in both similar and different industries to see which one has a higher price tag on it’s share price. A higher P/E ratio normally means higher growth expectations of the company.

Using the previous example of company A, with a EPS of $2 and a share price of $8, we would calculate the stock’s P/E ratio by using the share price ($8) to divide by the EPS ($2). This would give us a P/E ratio of 4x.

Do note that Price-To-Earnings ratios differ between different industries, due to their business models. Some stocks also do not have P/E ratios as they have yet to turn a profit in their business operations, since P/E ratios are a measure of the company’s profitability, which do not apply if the company has yet to make a profit.

Price-To-Sales Ratio

The Price-To-Sales Ratio is a commonly used financial metric which compares a company’s stock price to it’s total revenue.

The Price-To-Sales Ratio is calculated by first determining the sales per share which is the total revenue of a company for a year divided by the number of common shares it has outstanding, similar to the Earning-Per-Share formula.

The stock price of the company is then divided by the sales per share to get the Price-To-Sales Ratio.

If company A with it’s 2000 outstanding shares, has a full-year total revenue of $8000, we would then find out the sales per share by dividing it’s total revenue ($8000) by it’s number of shares outstanding (2000 shares). This would give us a sales per share of $4.

With a current share price of $8, we can find out the Price-To-Sales Ratio by dividing the company’s share price of $8 by the sales per share of $4, giving us a Price-To-Sales Ratio of 2x for the stock.

The Price-To-Sales Ratio can also be measured by taking the annual total revenue of the company and dividing it by the market capitalization of it’s shares on the stock market.

The market capitalization is basically the total market value of all the outstanding shares of the company. For company A, it’s market capitalization would be 2000 shares x each share’s price of $8 which would give us a total of $16000.

If we divide the company’s market capitalization of $16000 by it’s total sales of $8000, we would get a Price-To-Sales multiple of 2x as well.

Net Profit Margin

The last metric which we’ll talk about is the Net Profit Margin. A company’s Net Profit Margin is the percentage of its total revenue which it keeps after paying off all its expenses of running the business.

Net Profit Margin can be calculated by dividing the company’s Net Profit by the total revenue for the year, and then multiplying it by 100.

For company A, we would divide its full year Net Profit of $4000 by its total revenue of $8000. We would then multiply it by 100 to get a number of 50.

Since Net Profit Margin is always shown in percentages, the Net Profit Margin of the company would therefore be 50%.

The Net Profit margin of a company should be used in comparison with its peers in similar industries in order to see which company is better at generating profits for its shareholders.

We can also use the Net Profit Margin to deduce how profitable it’s business model is, as a higher Net Profit Margin generally means the business is able to offer it’s goods or services at higher prices due to various factors such as better branding or a more competitive business moat.

Conclusion

For the well-informed, by learning what these ratios mean and how to calculate them, they will be able to understand the company’s valuations and financials better, and also interpret how the company and their business models compare with other companies as well.

With all these knowledge, the investor would then be better able to form his investment thesis and also have greater conviction in the stock if it’s share price did not perform well initially.

Although these ratios do not make or break a great investment, it is still better to do your due diligence and go into an investment with your eyes open, fully knowing what the company’s valuations and financials are, instead of relying on hearsay or other people’s advice.

Ultimately, you are the best person to look after your own money.

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