7 most important financial ratios traders need to know to build wealth
Financial ratios are one of the essential tools for an investor to succeed in creating wealth by investing in the stock market. Ratio analysis can help decipher bits of financial data, which is a prerequisite for most traders.
A good market reader knowing financial ratios will always be on the right side of the coin in most situations. These ratios can signify operational efficiency, profitability, debt repayment capacity and other factors of a business.
Since a complete assessment of the health of a company and its offered securities is a tedious process, financial ratios can help with careful scrutiny of stocks.
Anish Singh Thakur, CEO, Booming Bulls Academy helped us decode the seven most notable financial ratios that can help investing without the stressor.
● Price / earnings ratio (PE ratio)
The name itself is self-explanatory. The P / E ratio is the current price of the stock relative to the profit the company can get per share. This ratio is significant in terms of indicating whether a company is overvalued or undervalued.
P / E = share price / earnings per share
The higher the value of the ratio, the more likely the company has to hope for higher profits. A lower value would indicate that the company is undervalued. Lower PE ratios are generally preferred when looking for a valuable stock. As these ratios have different comparison criteria in various industries, absolute values cannot be compared directly.
● Earnings per share (EPS)
Earnings per share or EPS is the most basic financial ratio that can be evaluated. The value of EPS is often used to determine other financial ratios. It is defined as the net profit of a company over a given period divided by the number of countable shares outstanding. It can be calculated on an annual or quarterly basis.
There are generally two ways to calculate EPS.
Earnings per share: net income after tax / total number of shares outstanding.
Weighted earnings per share: (Net income after tax – Total dividends) / Total number of shares outstanding.
When deciding to invest, one should consider looking at the company’s past EPS. If it grows over the years, it is safe to invest; otherwise, stagnant EPS means the business is not the place to invest your money.
● Price / book ratio (PBV)
The price-to-book ratio represents the relationship between a company’s current value and its book value. The ratio represents the portion of the present value of the investment that will be received by the investor if the company declares bankruptcy and all of its assets are liquidated. Here, book value can be defined as the value of all assets owned by a business.
Formula for P / B ratio = Market capitalization / book value.
A PBV of less than three is generally considered a good rate when looking to invest. When the PBV is less than 1, it results in an undervalued business, and it can also mean that there are underlying issues in the business.
● Debt ratio
The debt ratio is defined as the total of debt and liabilities to shareholders’ equity. It is also called the risk ratio. If a company has this ratio less than one, then it is safe. A company with a lower equity position would have a high debt ratio. The rule of thumb here is that any business with more than 1 is risky to invest.
● Return on equity (ROE)
Return on equity is essential for the profitability of a business. It is defined as net income divided by shareholders’ equity. In simpler terms, ROE can indicate how well a company can reward its shareholders for their investment.
Return on equity = (Net income) / (Average equity)
Year after year, ROE is a good indicator of growth. The trick here is to avoid companies with less than 15% ROE.
● Dividend yield
The stock dividend yield can be defined as the company’s annual cash dividend per share divided by the current share price and is expressed as an annual percentage.
Dividend yield = (Dividend per share) / (Price per share) * 100
Many companies on the brink of growth do not pay dividends but try to invest their income in their growth. An investor can play the judge here, and you can invest in a company with low or high dividends.
● Current ratio
The current ratio helps in the assessment of a company’s liquidity. It tells us how easily a business can meet its short-term debts or payments. It is generally used when short term investments are considered. It is mathematically defined as
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Current ratio = (Current assets) / (Current liabilities)
If the company’s current ratio is less than 1, then that company is vulnerable to investment. If the value is greater than one, it means the business has more short-term assets than short-term liabilities and can be seen as a way to build wealth.
(Disclaimer: The opinions / suggestions / advice expressed here in this article are solely by investment experts. Zee Business suggests that its readers consult their investment advisers before making a financial decision.)