10 Key Ratios in Stock Trading and Investing

Publicly traded companies and their shareholders use many financial ratios to judge the overall health of a business and the soundness of stock investments. If you read stock trading journals and business literature, you will often encounter the terms below. Both company heads and investors must understand how these ratios are computed and applied so that they can make good decisions about financial operations, and about buying and selling stocks.

Price Earnings Ratio, P/E Ratio

In its most general form, the P/E ratio is equal to the market price of a share divided by the earnings per share (EPS). Earnings are taken over a period of four quarters, usually the previous four. The Forward P/E Ratio takes the share price divided by the projected EPS over the next four quarters.

Example: A company's stock price is $22.50 per share and the earnings over the last year were $3.75 per share. The P/E ratio is 22.5/3.75 = 6, which means that investors are willing to pay $6 for $1 of annual earnings.

Price/Cashflow Ratio

The price-to-cashflow ratio is the share price divided by the cashflow per share. It is sometimes used in place of the P/E ratio since different jurisdictions have different accounting rules as to how depreciation is factored into earnings. The P/C ratio only considers cash factors, which are not subject to varying accounting laws.

Example: A company's stock is valued at $9.60 per share and the company has cashflows of $4.75 per share. The P/C ratio is then 9.60/4.75 = 2.021.

Price/Earnings to Growth Ratio, PEG Ratio

The PEG ratio is not as mathematically rigorous as most investment ratios, but it is useful when comparing companies that have high P/E ratios and high growth rates. The PEG ratio is simply calculated by dividing the P/E ratio by an earnings growth factor, which somewhat "normalizes" the P/E ratio.

Example: Company A has a P/E ratio of 29.6 and its earnings are estimated to grow by 35%. Company Y has a P/E ratio of 23.2 and an estimated annual growth rate of 24%. The PEG ratio for Company X is 29.6/35 = 0.846, and the PEG ratio for Company Y is 23.2/24 = 0.967. Both of these ratios are low enough to indicate that the stocks' high P/E ratios are not due to over-valuation, but due to expected growth.

Debt Equity Ratio, D/E Ratio

The D/E ratio equals the total liabilities of a company divided by the total shareholder equity. It affords a simple way to compare the shareholders' stake in the company versus the creditors' stake. The lower the ratio the better, though large well-established companies can get away with higher D/E ratios.

Example: A company has a total liability of $35,700 and total shareholder equity of $42,600. The D/E ratio is 35700/42600 = 0.838. The D/E ratio is often read as a percent, so this is equivalent to 83.8%. Most analysts consider the D/E ratio in conjunction with the debt ratio, explained next.

Total Debt Ratio

The debt ratio of a company equals the total liabilities divided by the total assets. A debt ratio less than 1 means a company can cover its debts with its current assets.

Example: A company has liabilities totaling $35,700 and assets totaling $100,900. The debt ratio is 35700/100900 = 0.354, or 35.4%.

Dividends Per Share, DPS Ratio

To compute the dividends per share, take the total dollar amount of dividends issued in the past year (not including any special dividend payments) and divide by the total number of issued shares. A high DPS is favorable to investors.

Example: A company paid out $45,000 in dividends last year, including a one-time special payment of $8,500. The company has 29,100 outstanding shares. The DPS is thus (45000-8500)/29100 = 1.254, or $1.25 worth of dividends per share.

Dividend Payout Ratio

The dividend payout ratio is calculated by dividing the DPS by the EPS. This ratio indicates how much of the dividends are covered by the earnings.

Example: You hold stock in a company for which the dividends per share is $1.05 and the earnings per share is $1.97. The dividend payout ratio is 1.05/1.97 = 0.533

Price-to-Book Ratio, P/B Ratio

To compute the price-to-book ratio, you divide the current closing price of a share by the book value per share. When the market price of a stock is higher than the book value, the ratio will be greater than 1. The P/B ratio can indicate if a company's stock is over-valued compared to other firms in the same sector.

Example: The current closing price of a Company X's stock is $14 per share, and the book value is $5.80 per share. The P/B ratio is then 2.414 for Company X. Company Y, which is very similar to company X, has P/B ratio of 4.7, possibly indicating that Company Y is over-valued.

EBITDA to Sales Ratio, EBITDA Margin

The EBITDA margin is defined as a company's earnings before interest, taxes, depreciation, and amortization divided by revenue. It is a measure of how much certain cash expenses eat up the revenue. In general, a higher margin is better because it indicates that a company can efficiently control some of its costs.

Example: A Company reports an EBITDA of $2 million for the four quarters and a total revenues of $5.6 million. Its EBITDA margin is 2/5.6 = 0.357 or 35.7%.

Times Interest Earned Ratio, Interest Coverage Ratio, TIE Ratio

The TIE ratio is the EBITDA divided by the interest payable. The TIE ratio indicates how well a company can pay interest on its outstanding debts. This is helpful to compare alongside the debt ratio.

Example: A company's EBITDA is $897,000 and it owes $103,00 in interest. The TIE ratio is then 897000/103000 = 8.709. This company is in excellent shape because it is more than able to cover its interest obligations.

© Had2Know 2010