Three Financial Ratios That You Should Consider Before Buying a Stock
Now that you’ve learned all about EPS, P/E and Debt to Equity Ratio from Lesson #3 at Wealthlift.com, it’s time to beef up your analysis with these additional financial ratios. As a review, financial ratios help us in quickly determining a business’s financial strength and position. The ratios I’ll discuss here will make sure that you are investing in a company that is growing, efficient, and has good value.
The Price Earnings to Growth Ratio (PEG)
This is a valuation tool that was popularized by Peter Lynch in his book One Up On Wall Street : How To Use What You Already Know To Make Money In The Market. The assumption with this ratio is that “the P/E ratio of any company that’s fairly priced will equal its growth rate”.
PEG = Price to Earnings Ratio / Annual EPS Growth
And for a fairly priced company, P/E = G. In other words, this implies that a fairly priced company will have a PEG ratio of 1.
P/E is the stock’s Price to Earnings Ratio and G stands for the annual earnings growth rate.
Let’s try to figure out Apple Inc.’s (AAPL) “valuation relative to growth” if for example its annual growth rate is 20%, and its current P/E ratio is 8.
PEG = PE / Annual EPS Growth Rate
= 8 / 20
Since the PEG value that we got here is less than 1, we can assume that it is undervalued relative to its growth and is a promising candidate for a buy, but only upon further evaluation of other fundamental factors.
This ratio is a quick tool for checking a company’s “value relative to growth”. If the PEG ratio is below 1, then the price is considered “cheap” relative to its growth and if it is above 1, you are paying “extra” for that growth. Keep in mind though, that this is just a rule of thumb. You should check for the consistency and reliability of the company’s earnings growth over the past few years before making any buy or sell decisions.
Return on Equity (ROE)
This ratio measures a corporation’s profitability by showing how much profit is generated by the money shareholders have invested. It shows how efficient a company is in managing shareholder money to turn out profits. The higher the Return on Equity, the better a company is being managed. And believe me, you’d want to buy only well-managed companies.
Return on Equity = Net Income/Shareholder’s Equity
Apple Inc. has reported Net Income of $25.9 Billion for 2011 and total Stockholder’s Equity is at $76.6Billion. The return on equity is computed as:
Return on Equity = Net Income / Stockholder’s Equity
= $25,900,000,000 / $76,600,000,000
What this means is that Apple Inc.’s management can earn 33.81 cents for every shareholder dollar invested. It is wise to compare a company’s ROE to others in the same sector because the company with higher ROE means it is more profitable, and that is where we want to put our money on. It would also be wise to compare a company’s ROE to the returns offered by US government Treasury bonds. If a company’s ROE is less than that offered by the Treasury bonds, then investing in that company may not be worth the risk at all.
Price to Book Ratio (P/B)
The price to book ratio is used to compare a company’s current stock price to its book value. It shows how much people are paying for its book value per share. It is calculated by dividing the current price of the stock by the latest quarter’s book value per share.
P/B Ratio = Stock Price / Book Value per Share
Book Value per Share = (Total Stockholder’s Equity – Preferred Equity) / Total Outstanding Shares
If for example Apple Inc.’s book value per share is at $96.6 and the current stock price is at $600. The Price to Book Ratio would be computed as:
P/B Ratio = $600 / $96.6
This means that the market is paying 6.21 times the book value per share at the current price of $600. A P/B ratio of 1 could mean that the stock price is reflecting just the book value and this could be a real discount. However, it could also mean that something is fundamentally wrong with the company and that is why people are selling it down. Always make sure to check other fundamentals instead of relying on just a single ratio alone. This ratio also gives some idea of how much you’re paying for what would be left if the company went bankrupt immediately.
Use these ratios to improve your chances of investment success. They are pretty easy to calculate and using them in your analysis will tilt the odds of getting a winner in your favour.