When it comes to starting your investing journey, financial ratios play the most important role. This is because you just can’t invest randomly. You have to make sure that the company you have chosen to invest your precious money in, is capable enough to help you get higher returns.
Here is where the role of financial ratios comes. It not only helps investors to analyze the performance of any company but also helps companies to estimate their performance and compare with other such companies in the industry. Elaborated here are some of the most important financial ratios that assist you to begin with your trading journey:
Price Earnings Ratio (P/E Ratio)
The Price Earnings ratio, also known as Price Multiple or Earnings Multiple is the one that measures the current share price of a company relative to its Earning Per Share (EPS). This ratio is used by analysts to determine a relative value of shares by comparing it fundamentally or to compare its present earnings with its historical records.
This ratio can be determined on a trailing, i.e., backward-looking and forward, i.e., projected basis. The companies with zero earnings or the companies that are losing money continuously tend to have no price-earnings ratio. This is because they have nothing to put in the denominator
P/E Ratio= Share Price / Earnings per share
Earnings Per Share (EPS)
Earnings Per Share is ascertained as a company’s profits divided by the company’s remaining (leftover) shares of its regular stock. It reflects the value of money which a company makes for each share of its stock. This is one of the widely used metric ratios that analysts take into consideration for estimating corporate value. The higher EPS seems to be more profitable. A high P/E ratio reflects the overvaluation of the company’s stock. Also, it signifies higher value because if investors feel that the company will earn higher profits relative to its share price then they will always be ready to invest more and more money.
EPS = Net Income After Tax / Total Number of Outstanding Shares
Debt – Equity Ratio (D/E)
The Debt-Equity Ratio is the one that is determined by apportioning a company’s total liabilities by shareholder equity. In other words, it is a measure that determines up to which aspect a company is financing its operations by debts as compared to financing them with wholly owned funds.
However, it is somewhat difficult to compare in the case of industry groups where amounts of debts differ. This ratio is estimated to discover a company’s financial leverage. It is one of the most important metrics for financial growth estimation because it signifies how shareholder equity will be able to cover all outstanding debts in the down periods of a business. A higher leverage ratio reflects a company’s stock with higher risk to shareholders.
D/E = Total Liabilities/Total Shareholder’s Equity
Return on Equity Ratio (ROE)
Return on Equity Ratio is the one that measures a company’s profitability about stockholder’s equity. It is estimated by apportioning net income by Shareholder’s Equity. It is generally expressed in percentage and can be calculated easily for any organization if net income and equity, both are positive.
Net income refers to income, net expenses, and taxes generated by the company.
The satisfactory position of ROE depends upon what the normal measures are for company peers and industry. A ROE that increases over time can mean a company is good at generating shareholder value because it knows how to reinvest its earnings wisely and increase productivity and profits. On the other hand, a declining ROE can mean that management is making poor decisions on reinvesting capital in unproductive assets.
ROE = Net Income / Shareholder’s Equity
Price to Book Ratio (P/B Ratio)
The Price Book Ratio is calculated by dividing the current closing price of the stock by the latest quarter’s book value P/B is equal to share price divided by book value per share. Market value is the share price of a company multiplied by its outstanding number of shares and book value means a value of the net assets of the company. It is used to compare a company’s market capitalization with its book value. This ratio helps the investors to identify the potential investments of a company.
In other words, it gives a reality check to the investors who are looking for growth at a reasonable price. For a company, it reflects if they are paying too much in comparison to what if a company goes bankrupt immediately. As it helps the company and the people interested in it so much, it is favoured by value investors and is also preferred by analysts widely.
P/B Ratio = Market Price per Share / Book Value per Share
Once you have estimated these financial ratios, you will be able to compare different companies’ potential. Equipped with this information, you can easily take a step towards the trading as you would now be clear about which company and which sector can take you to greater heights.
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