Financial ratios are the key to understand how a company performs. The share price of a company is also affected based on the company’s performance. Today, we will be discussing five valuable financial ratios that every investor must know of. You may have probably heard about some of them, but let’s see what these ratios really means.
The first and most important ratio is EPS. What is EPS?
EPS is the short form of earnings per share. Let’s explain it through an example. Imagine a company, ABC, has a total of 1000 shares and they have made a profit of $50000 this year. What is the EPS of ABC? It’s $50000 in profits or net income divided by 1000 shares. So, its $50 per share. Easy isn’t it? In much simpler terms, EPS is a portion of profit that belongs to one share.
What is a PE ratio?
PE ratio is the short form of price to earnings ratio. Let’s look at an example to understand this. Imagine that ABC’s share is selling at 500$. From the previous section, we know that the EPS of ABC is 50$. PE ratio is just the price, which is $500 here, divided by the EPS, which is $50. So the PE ratio of ABC is 10.
What does this really mean?
It just means that you are paying 10$ to get back 1$ yearly from the company. In other words, if you invest $10 in ABC, you will get back all your money from earnings after 10 years. Investors usually consider a stock with PE of 10 to 15 as fairly priced. A stock with low PE ratio is considered as cheap but also remember that it doesn’t mean you should buy it. Do your research on other factors before making any investment decisions.
Debt To Equity Ratio:
Our third ratio will be debt to equity ratio. Debt is an important factor to consider while investing in a company. A high debt company will often be in trouble during hard times and may file bankruptcy. Debt to equity ratio gives us an idea of the company’s debt compared to the total value of its stock.
Let’s explain this through an example. ABC has a total debt of $1 million dollars. The total value of its stock will be 1000 x 500$ = 500,000$.
So debt to equity ratio will be $1 million/$500,000 = 2. In other word company has leveraged twice the amount of money that it has on stocks.
Now let’s look at the fourth ratio – ROE. It is the short form for return on equity. ROE is extremely useful while analyzing companies. It shows the return we get from profits in terms of percentage.
Let’s explain this for the case of ABC. We know that ABC has a net income of 50000 dollars and a total of 1000 shares.
ROE can be calculated by dividing net income, 50000, by total number of shares, 1000, times 100%.
=> (50,000/1000) x 100%= 5000%
Here the ROE would be 5000%. 5000% ROE is very unrealistic. We just took the numbers as an example. A higher ROE means the company is performing well. Usually, investors will aim for ROE greater than 15 percent.
Price to Book Value:
Finally, let’s look at our last ratio. Price to book value. Before going further into the ratio, we need to understand what a book value is.
A book value is the value of a company according to its books or balance sheet. What does that mean? Well, it is the net worth of a company. It is the difference between the assets and liabilities of a company.
Let’s try to understand this through an example. Company ABC has 2 million dollars in assets. Assets can be property, cash etc. From our debt to equity ratio example, we know that ABC has 1 million dollars in debt or liability.
So the book value of ABC will be assets ($2 million) – liability ($1 million) = $1 million.
Great! Now you know what a book value is. ABC company has 1000 shares, so book value per share will be $1 million divided by thousand which equals 1000 dollars. Now let’s go to price to book value. To get price to book value, you simply divide the price, which is 500$ by book value per share, which is 1000$. It will be equal to 0.5. In other words, ABC is selling at half the price of its net worth.