Financial Ratio

Important Financial Ratio



EARNINGS PER SHARE (EPS)

This ratio is perhaps the most widely used by analysts because it reveals how much profit was gained on a per share basis. On its own, EPS is not particularly useful. When sizing up the value of a company’s stock using the EPS ratio, you must compare the current figure to that from the previous quarter or year. When doing so, you can properly determine the rate of growth for a company’s earnings.

P/E RATIO

P/E is short for the ratio of a company's share price to its per-share earnings. As the name implies, to calculate the P/E, you simply take the current stock price of a company and divide by its earnings per share (EPS)

Although the EPS figure in the P/E is usually based on earnings from the last four quarters, the P/E is more than a measure of a company's past performance. It also takes into account market expectations for a company's growth. Remember, stock prices reflect what investors think a company will be worth. Future growth is already accounted for in the stock price. As a result, a better way of interpreting the P/E ratio is as a reflection of the market's optimism concerning a company's growth prospects.

If a company has a P/E higher than the market or industry average, this means that the market is expecting big things over the next few months or years. A company with a high P/E ratio will eventually have to live up to the high rating by substantially increasing its earnings, or the stock price will need to drop.

S&P 500 P/E

Is This Company P/E Cheap or Expensive ?

The P/E ratio is a much better indicator of the value of a stock than the market price alone. For example, all things being equal, a $10 stock with a P/E of 75 is much more "expensive" than a $100 stock with a P/E of 20. That being said, there are limits to this form of analysis - you can't just compare the P/Es of two different companies to determine which is a better value.

It's difficult to determine whether a particular P/E is high or low without taking into account two main factors:

1. Company growth rates - How fast has the company been growing in the past, and are these rates expected to increase, or at least continue, in the future? Something isn't right if a company has only grown at 5% in the past and still has a stratospheric P/E. If projected growth rates don't justify the P/E, then a stock might be overpriced. In this situation, all you have to do is calculate the P/E using projected EPS.
2. Industry - It is only useful to compare companies if they are in the same industry. For example, utilities typically have low multiples because they are low growth, stable industries. In contrast, the technology industry is characterized by phenomenal growth rates and constant change. Comparing a tech company to a utility is useless. You should only compare high-growth companies to others in the same industry, or to the industry average. You can find P/E ratios by industry on Yahoo! Finance.

For the Market, An increasing P/E ratio between 15 and 30 is considered bullish, while a P/E ratio above 30 or a declining P/E ratio is considered bearish.

PEG RATIO

The calculation: price/earnings (P/E) ratio divided by expected per-share earnings growth over the next year. More than likely, a result that is less than one tells us that we may have a good investment that is undervalued for the time being. On the other hand, a result of more than one is usually a sign that the position is valued higher than it should be.

This ratio represents a hybrid application of the P/E ratio (the price to earnings ratio) and a company’s annual growth rate. If a stock’s PEG falls below a value of one, it is typically considered underpriced. If it jumps much higher than one, it is considered overpriced. It should be noted that when applied on its own, the accuracy of this formula has been questioned by many reputable economists.

Small- to mid-cap stocks are well suited to utilize the PEG Ratio as the initial screening tool since they usually pay little or no dividends. In effect, it is a good tool for some stocks that are usually more difficult to value using traditional methods. Just as it is true that the ratio is beneficial for smaller stocks, larger stocks should have an additional requirement to help create a more useable and appropriate valuation tool. By simply adding an overlay of dividend yield along with the earnings a much better outcome can be crafted for large-cap stocks.

PEG ratios are considered less useful in assessing cyclical stocks and those in the banking, oil, or real estate industries, where assets are more accurate indicators of relative value. With these stocks, the growth rates are low and the company’s assets are a much better indicator of stock value.

SHORT RATIO (SHORT INTEREST RATIO)

Number of shares of a security that investors have sold short divided by average daily volume of the security (measured over 30 days or 90 days). There are various interpretations of this ratio. When people short, it is usually (but not always) because they are pessimistic about the security's future performance. Shorting involves buying at at some point however. Hence, some would interpret a high short ratio as an indicator that there will be some buying pressure on the security that would increase its price.

SHARPE RATIO

A portfolio performance measure used to evaluate the return of a fund with respect to risk. The calculation is the return of the fund minus the “risk-free” rate divided by the fund’s standard deviation. The Sharpe Ratio provides you with a return for unit of risk measure.

For example, assume Equity Fund 1 returned 20 percent over the past five years with a standard deviation of 2 percent. The risk-free rate is generally the interest rate on a government security. Further assume that the average return of a risk-free government bond fund over this period was 6 percent.

The Sharpe Ratio would be:

(Return of the Portfolio minus Risk-Free Rate)/Standard Deviation of the Portfolio

In the case of Equity Fund 1, the Sharpe Ratio is (20% minus 6%) ÷ 2%, which equals 7%. Therefore, for each unit of risk, the fund returned 7% over the risk-free rate.