Financial Ratios or Accounting Ratios

Help to find the best stock to invest in!

Financial ratios help you to assess the value of particular companies and hence enable you to achieve the best stock pick.

I obtain these measures from an online broker’s site that is free.

Value investing relies on the use of these ratios together with other ways of measuring the intrinsic value of companies.

As your portfolio increases in value, you may consider paying for additional information - as I do.

The most important financial ratios that I use to assess value and to choose the best stocks are discussed briefly below in terms of their major usefulness.

I do not rely on any one of these measures in isolation. I use them in conjunction with other measures.

Company Size

A measure of the size of a company is market capitalization (stock cap). Smaller companies are generally considered to be more risky as they are less able to recover from potential shocks.

On the other hand, some smaller companies may generate spectacular gains. Peter Lynch describes these companies as 'multibaggers' in his book 'One Up on Wall Street' and discusses how to recognize them.

Relative Valuation Measures

The most common of financial ratios to provide a valuation of a company is the price to earnings ratio (P/E ratio). This is a 'relative' measure as it uses the market price of the company and allows comparison to other companies in the same sector, and to a lesser extent, to the market as a whole.

A P/E ratio higher than its sector suggests overvaluation and a lower value suggests undervaluation.

Price to book value is another relative measure of the value of a company popularized by Benjamin Graham. It measures the value of the shareholders ownership in the company.

Earnings Measures

A common measure of profitability which is often mis-represented is earnings per share (EPS). While it is nice to see earnings per share increase over time (EPS growth), it does not necessarily mean the the company is more profitable.

Earnings per share growth can be measured using the CAGR formula.

A decreasing earnings per share requires further investigation as to the cause.

Another earnings measure of the ongoing performance of a company is the earnings stability. This measures how consistently the company grows its earnings over time.

If the increase in EPS growth is 'stable' (that is, the EPS is increasing at a constant rate), then I can be more confident about any forecasts of the company's future earnings.

A relative measure that takes into account the P/E ratio and the EPS growth is the PEG ratio.

The PEG ratio is a financial ratio that is widely employed as an indicator of a stock's possible true value. Similar to the P/E ratio, a lower PEG means that the stock is more undervalued. Because it also accounts for growth, the PEG ratio is seen to be a more useful measure by some.

Absolute Valuation Measures

Measures used in the estimation of a company's value includes the return on equity (ROE) and shareholders equity. 'Absolute' because the share price is not used when using these measures to determine value.

Return on equity is calculated as the ratio of the net profit to the shareholders' equity held in the company and is my preferred measure of the performance or profitability of a company, and the measure I look for first.

Otherwise referred to as book value or equity per share, shareholders equity is the basis for determining stock fair value by taking into account the percentage of profit that is reinvested as well as the return required of the investor.

Measures of Financial Health

The commonly used financial ratio of a company's debt management is the debt to equity ratio. I prefer companies that have low debt or zero debt compared to its equity.

A related measure is interest coverage ratio which measures the ability of the company to meet its fixed interest obligations.

Liquidity Measures

Liquidity ratios measure to what extent a company can meet its short-term debt obligations. Common measures include the current ratio and the quick ratio (more conservative), that compare assets with liabilities.

A third ratio is the operating cash flow ratio that compares the operating free cash flow to the company's liabilities.

To Conclude

The above measures are quantitative measures as they all use numerical data for their calculation. However, qualitative information may be as important or more important in some instances to judge the future performance of a company.

This is information that can't be expressed in numbers but relates to the nature of the company itself and to the quality of its management.

Financial ratios analysis is important for value investing in order to choose the best stock to buy at the right price.

The related articles below examine the importance of each of the measures in more detail.

Related Articles

Market capitalization (stock cap) - Provides me with a measure of company size - and how survivable it might be!

Earnings per share (EPS) - allows me to check for how the company's earnings are growing over time!

Price to earnings ratio (P/E ratio) helps me to decide to buy when a company's P/E is low - and to sell when it's high!

Price to book value (P/B ratio) - An easy to use guide to fair value if the price to book is less than one!

Return on equity (ROE) - is the measure I like best to identify well managed companies!

Earnings stability - helps me to have confidence in forecasts of a company's future earnings!

PEG ratio - allows the investor to check whether higher P/E ratios are justified by providing a comparison with EPS growth.

Debt management - is important to keep my eye on using the key measures of the debt to equity ratio and the interest coverage ratio.

Qualitative information - is essential for me to take into account as it relates to the quality of the management and the competitiveness of the company.

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