Understanding financial ratios and metrics is key to being a more informed investor. After all, reading numbers and lines on a 10-K or 10-Q doesn’t give you much substance, unless you can properly understand, apply, and compare them. This is where the quantitative standpoint of fundamental analysis comes in. Knowing the following financial ratios will give you a more fair and accurate assessment of the financial health of a business.
Price-Earnings Ratio (P/E Ratio)
Price-Earnings Ratio (P/E Ratio) = Price Per Share / Earnings per Share
This ratio reflects how much you, as an investor, pay for $1 of a company’s earnings. The smaller the ratio, the better! After all, you want to be paying less! High P/E ratios do not necessarily mean that a company is overvalued, however. If investors are expecting high year-to-year growth for a company, especially if the company is in a growth sector like technology, then this may explain a high number.
Forward P/E Ratio In the same vein as a standard P/E ratio, a forward P/E ratio considers forecasted future earnings, which is generally more relevant to an investment decision but not necessarily accurate.
Return on Equity = Net Income / Shareholder’s Equity
This reflects how much profit a company generates with the money shareholders have invested.
Current Ratio = Current Assets / Current Liabilities
This ratio reflects the liquidity of a company. It measures whether or not the company has the means to cover all of its short-term obligations. A ratio higher than 1 indicates more liquidity.
Market Capitalization or Market Value = Company’s Shares Outstanding * Share Price
This metric can be thought of as an investor-determined measurement of the company’s size. In theory, a company with a higher market value might have more assets, stronger revenue, and more capital, but still, a large-cap company doesn’t necessarily indicate a better one.
Enterprise Value (EV) = Market Value of Common Stock + Market Value of Preferred Equity + Market Value of Debt + Minority Interest - Cash - Investments
This is more of a comprehensive metric to a company’s total value, also considering short-term and long-term debts, as well as cash. It is often used to value a company for a potential “takeover,” if it were to be bought.
EV / EBITDA = Enterprise Value / Earnings before Interest, Taxes, Depreciation and Amortization
This ratio compares the value of the company to the cash’s earnings less non-cash expenses. This is a more accurate portrayal of a company’s profitability, as it takes into account the company’s size, with EV as the numerator. The higher the ratio, the better.
Extracting financial data from corporate financial statements seems daunting, but you don’t necessarily need to do all the work yourself! Websites like Yahoo Finance have these metrics and ratios all summarized and laid-out cleanly on their pages — just search up the company!
Some numbers could have drastically different meanings, once put under certain contexts. Be sure to check for significant accounting policies or practices. Companies must disclose accounting policies used to portray their financial condition and health, but these are often the results of subjective and complex decision-making by management.
Standing for Management’s Discussion & Analysis of Financial Condition and Results of Operations, this is an opportunity to contextualize the financial performance of the company. It is a place for management to show what the numbers don’t and to acknowledge the trends and risks that have shaped the company in the past and will shape the company in the future.