Evaluating stocks to buy and sell can be a tricky business, even with all of the data available at your fingertips. There are dozens of ratios and metrics that give clues to the financial health of a company. How do you know which ones matter?
Here are ten financial ratios that can tell you most of what you need to know when you’re scouring the market for good stocks to buy.
- PE Ratio
- PEG Ratio
- PS Ratio
- PCF Ratio
- PBV Ratio
- Debt-to-equity
- Return on equity
- Return on assets
- Profit margin
- Dividend payout ratio
Let’s get to it.
1. Price-Earnings Ratio (PE)
This number tells you how many years worth of profits you’re paying for a stock. To calculate PE, divide the stock price by earnings per share (EPS)EPS.
Note that the most frequently used earnings number in the calculation is total EPS over the past four reported quarters. You could also use “forward” earnings, which is the average of Wall Street’s forecasts for the current fiscal year.
All things equal, the lower the PE, the better.
Benjamin Graham, the legendary investor and Warren Buffett’s teacher at Columbia University, postulated that stocks should trade for a PE multiple equal to 8.5 times earnings plus two times the growth rate of earnings.
PE is Relative
A good PE ratio varies by industry and by the investing climate. It is a comparative measure, and you need context to determine if a PE is good or bad.
Here’s an example. For the market as a whole, the S&P 500 currently trades for about 23 times the past 12 months of reported earnings. The index’s average PE since 1935 is lower at 16. Compare those two numbers and the implication is that today’s market is a bit pricey.
Industries characterized by volatile earnings tend to trade at low PE multiples. Why? Because investors are cautious when earnings can tumble in a hurry. Homebuilders and commodity producers fall into this bucket.
Rapidly growing companies often have high PE ratios, for the opposite reason. Investors are more willing to pay a premium when they expect strong future profits. Tesla and Paypal are two examples, with PE multiples of 50 and 36, respectively.
Comparing PE Ratios
To evaluate an individual stock’s PE ratio, compare it to competitors. You should also compare a stock’s current PE with its average multiple over the past three, five or 10 years. If the current ratio is lower than the average, you may have spotted a bargain, assuming the company has growth potential.
This leads us to the next metric you should know, the PEG ratio.
2. Price/Earnings Growth (PEG) Ratio
The PEG ratio, another Benjamin Graham invention, attempts to measure the discount or premium you’re paying for growth.
To calculate PEG, divide the PE ratio by the expected annualized earnings growth rate. You can use different timeframes for the expected growth rate, but longer is better. If you have a good estimated growth rate for the next five years, use that.
A PEG ratio of less than 1 suggests the company is undervalued.
The downside of the PEG ratio is that future growth rates are notoriously hard to predict. Companies’ growth profiles can change, sometimes drastically.
Apple
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3. Price-to-Sales (PS)
The price-sales ratio divides a stock’s market capitalization by total sales over the past 12 months. This metric was popularized by investment manager and longtime Forbes columnist, Ken Fisher. It tells you how much you are paying for every dollar in annual sales.
The price-sales multiple can be a better indicator of a company’s relative value than the PE for two reasons. One, there are times when cyclical companies have no earnings. And two, sales are more difficult to manipulate than earnings.
Like other ratios, you should compare the PS of a stock with competitors and with historical sales multiples. Know that a low PS ratio can be spoiled by an ongoing lack of profitability and/or big debt balances.
4. Price/Cash Flow FLOW (PCF)
To calculate PCF, divide the stock’s share price by its operating cash flow over the prior 12 months.
PCF can provide a more straightforward comparison than PE. This is because cash flow doesn’t include noncash expenses like amortization and depreciation. Excluding these items eliminates any differences in the way companies depreciate their assets.
Lower PCF ratios are preferable.
Note that the PCF ratio uses operating cash flow only, which means it overlooks a company’s cash flow performance from financing and investing activities.
5. Price-To-Book Value (PBV)
PBV describes how much you’re paying for every dollar of assets owned by the company. To calculate PBV, divide the market capitalization by the difference between total assets and total liabilities.
The idea is to approximate the money left if the business shut down and sold everything. As with most price multiple metrics, you should compare a stock’s current price-to-book to its historical averages.
When comparing two different companies, PBV is best suited for asset-heavy companies. The metric is less telling for service businesses or companies without substantial property, plant and equipment. For instance, United States Steel (X) trades for 0.52 times book value, while Apple fetches an astronomical multiple of 45.6 times book value.
6. Debt-to-Equity Ratio
We mentioned the debt-to-equity ratio yesterday in the context of analyzing balance sheets. As a recap, you calculate debt-to-equity by dividing total debt by shareholder’s equity. The resulting number tells you what percentage of a company’s assets are financed with debt.
A lower percentage is better, because high debt loads can become problematic in a downturn. Debt cuts both ways, though. In expansionary times, a company can boost profits by taking on more debt.
Heavy established industries like utilities and industrials generally have higher debt-equity ratios than rapidly growing companies. Caterpillar
7. Return On Equity (ROE)
ROE measures a company’s efficiency at generating profits from money invested in the company. You’d calculate ROE by dividing shareholders’ equity into net income.
ROE is useful for measuring management’s effectiveness. The downside is that it’s not instructive for young companies that aren’t profitable. Uber
A higher ROE is better. A stock with a higher ROE produces more profit from each $1 of equity on its balance sheet.
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8. Return On Assets (ROA)
ROA is another measure of management effectiveness. The formula for ROA is net income divided by total assets.
A higher ROA shows the company can grow profits more efficiently from a given base of assets. On the other hand, companies with a comparatively low ROA will need to borrow or raise equity to achieve the same amount of profit.
ROA is most useful for intra-industry comparisons. The trend over a multiyear period can be more instructive than ROA for a single year or quarter.
9. Profit Margin
Rising sales are great, as long as they’re not at the expense of profit.
Profit margin, introduced in our income statement analysis section, shows how much a company earns from each dollar of sales. To determine profit margin, divide the company’s profits by its sales.
As a reminder, the number you get depends on which profit number you use in the calculation:
- Gross profit, which is sales minus cost of sales, is the simplest measure.
- Operating profit is gross profit less overhead items. This is the best measure of profitability from ongoing business activities.
- Net profit (income) is what’s left after paying taxes.
Margins vary widely by industry. They tend to be highest among manufacturers and decrease down the value chain to wholesalers and retailers.
Declining margins over time mean declining profits, unless the business can offset the margin drop with rising revenues.
10. Dividend Payout Ratio
Dividend payout ratio is the percentage of the company’s earnings that are paid out as dividends to its shareholders.
The ratio indicates how sustainable the company’s dividend is. Payout ratios vary by industry and business model, but you generally want to see this number below 80%. Higher than that, and the company is at risk of having to reduce its dividend in a downturn. And a severe dividend reduction is usually followed by a drop in share price.
Note that REITs, by law, must distribute 90% of their taxable earnings to shareholders. So they routinely have very high payout ratios.
Tools For Analysis To Assess Value
Using these financial ratios gives you an objective way to evaluate individual companies and the broad stock market, as well as a framework to understand value the way that highly successful investors like Warren Buffett view it.
Despite being armed with these weapons of analysis, stock prices are influenced by a variety of factors, but over time, capital tends to flock to true value. As Buffett’s mentor, Benjamin Graham famously quipped: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
The brain trust at Forbes has run the numbers, conducted the research, and done the analysis to come up with some of the best places for you to make money in 2024. Download one of Forbes' most popular and widely anticipated reports, 12 Best Stocks To Buy for 2024.
