Aspiring investors with no background in Finance may experience difficulty in embracing the technical aspects of investing. It can be pretty intimidating at the start when everything seems foreign and unfamiliar. To ease the learning curve, we introduce 4 essential ratios for aspiring investors which we believe will provide investors a good flavor of the stock in question.
Essential Ratios #1 Price to Earnings Ratio
Price to Earnings (PE) ratio is one of the most basic metric of valuation for a fundamental analyst. It is simply a ratio of a company’s current share price compared to its per-share earnings. Alternatively, it can also be calculated by dividing the company’s total market capitalization with its net income.
By comparing the current share price to the annual earnings per share, the PE ratio indicates how cheap or expensive a stock is. The higher the value, the more expensive the stock and vice versa. Stocks trading at high PE ratios are often regarded as growth/glamour stocks. By paying a higher multiple of current earnings, the belief is that earnings will grow significantly and today’s premium price will actually correspond to a low PE ratio in the near future. Conversely, stocks with low PE ratios are considered value stocks which are often perceived to be unexciting.
Advanced variations: Price to recurring earnings, Price/Earnings to growth, PE over time, Shiller PE (these have been covered previously)
Essential Ratios #2 Price to Book Ratio
The Price to Book (PB) ratio is an alternative metric of valuation for investors that is equally simple to the PE ratio. Unlike the PE ratio which relates price to the income statement, the PB ratio compares price to balance sheet figures. A company typically possesses assets such as inventory and equipment which are necessary for its operations. Besides assets, a company also owes creditors in the form of borrowings or payables; these are called liabilities. The residual amount after deducting liabilities from assets belongs to investors. This amount is called the net asset value. It is also called net book value or equity value.
The PB ratio is calculated by dividing either a company’s current share price with its net asset value per share, or by dividing a company’s market capitalization with its net asset value.
By pegging to the amount of assets, the PB ratio is often used as a proxy for liquidation value. Once again, the higher the ratio, the more expensive valuations are for the company. Most profitable companies trade at a premium to book value (more than 1.0x PB).
Advanced variations: Net current asset value, Revalued net asset value
Essential Ratios #3 Debt to Equity Ratio
The Debt to Equity (DE) ratio measures the solvency risk of a company. When a company needs to raise cash, it can choose between debt and equity financing. Debt financing is borrowing from corporations or investors with an agreed time of repayment. The borrower also pays interest prior to the full repayment of the principle. Equity financing, on the other hand, is the sale of ownership in an enterprise. Investors are not promised any returns, but are accrued to the residual value after a company pays off its creditors. The DE ratio is calculated by dividing total debt over net asset value.
The higher the DE ratio, the more risky a stock is perceived to be. Companies with too much debt and which are unable to pay off their creditors go into bankruptcy. This usually means huge losses for equity owners. Certain industries, such as the Finance and Oil & Gas sector, are more leveraged than others. Additionally, one has to consider off-balance sheet liabilities such as operating lease obligations, which is too considered a form of debt depending on the location and duration of the lease.
Advanced variations: Net debt to equity, Long term debt to equity
Essential Ratios #4 Current Ratio
The current ratio measures the liquidity risk of a company. A company may be profitable in the long term, but it will still run into trouble if it is unable to pay off their suppliers in the short run. A company with good cash collection processes is termed as more ‘liquid’ and is less likely to experience such issues.
‘Current’ is used to describe items on the balance sheet with duration of less than 1 year. Benjamin Graham advocates a current ratio of at least 2 times. On the flip side, an excessively high current ratio is also sometimes perceived as a sign of poor capital efficiency.