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8 Key Investment Ratios for Stock Picking Success

Analyze investments quickly with ratios.

Stock analysis can seem like a dark cave, but fundamental analysis and ratio study can improve investment success. Ratio analysis isn’t only for individual stock pickers, this type of study also benefits fund investors. Financial ratios are used to compare stocks with peers and within an industry; some of the stats based on historical performance can yield a deeper understanding of asset value. Research can lead to stock picks that are reasonably valued with room to grow. Here are eight key investment ratios that will open the door to superior stock and fund analysis.

Price-earnings ratio

Divide a company’s share price by its annual earnings per share, using either the last 12 months or forward 12 months earnings estimate, to uncover the P/E ratio. A $20 stock with $1 earnings per share has a P/E of 20. “It is probably the best way of comparing assets in different sectors and of finding true bargains,” says Steven Jon Kaplan, CEO at True Contrarian Investments.This ratio tells how much investors are willing to pay for $1 of a company’s earnings. Higher P/E ratios suggest more richly valued companies. While the number itself doesn’t mean much, investors should use this ratio to compare it with other industry members and the overall stock market.

Price-sales ratio

Robert Johnson, professor of finance at Creighton University and co-author of “Strategic Value Investing: Techniques from the World’s Leading Value Investors of All Time” touts the benefits of share price divided by sales per share, commonly referred to as the price-to-sales ratio. “The price-to-sales ratio is used by analysts who want to eliminate some of the distortions that can result in company earnings,” Johnson says. It’s a useful ratio whether a company has earnings, cash flow or even positive book value since sales is always a positive number. This ratio is commonly used when valuing a service business for a merger or acquisition, he says. A lower ratio suggests a bargain or a value stock.

Profit-margin ratio

This is the amount of profit a company makes for every unit of sales. Profit margins are unique to an industry, with grocery chains known for low profit margins, while software companies claim double-digit ratios. But this information doesn’t necessarily mean that it’s better to buy a software company than a grocery store stock. Any stock could be a winner with a growing revenue stream and steady profit margins. When analyzing a company to buy, consider several financial ratios, growth prospects, sales, debt levels along with relative profit margins.

Dividend-payout ratio

Companies with rising dividend payments are favored by John Robinson, owner of Financial Planning Hawaii. The dividend-payout ratio is the percentage of net income paid to investors in the form of dividends. The higher the percentage, the less money remains to reinvest back into growing the company. “Companies that pay out less than 60 percent of their earnings as dividends tend to have room for further dividend increases and the ability to withstand temporary earnings downturns without having to reduce or eliminate dividend payments,” he says.

Price-free cash flow ratio

Tim Parker, a partner at Regency Wealth Management in New York, reveres free cash flow because that is the amount of money left over after a company reinvests in the business to pay dividends, buy back shares or make acquisitions.To determine price-free cash flow, divide the company’s share price by the operating free cash flow per share. The ratio measures how much cash a company earns for each share of stock. Parker favors this ratio, since free cash flow is harder to manipulate than earnings. A lower ratio indicates a company may be undervalued and selling at a bargain price.

Debt-equity ratio

Valuation ratios are important, but so are quality measures, such as debt and liquidity metrics. Divide a company’s total liabilities by its shareholder equity to compute the debt-equity ratio. This ratio explains a company’s financial leverage, the comparison between borrowed funds and equity or ownership. Think of this ratio like a homeowner’s mortgage value versus principal on the home. A greater proportion of debt constrains a company’s flexibility to grow as more revenue is directed to pay debt costs. Like most ratios, compare debt-equity ratios to those of other industry members, as some sectors, such as utilities, have higher typical debt ratios than others.

Quick and current ratios

Sameer Samana, a global equity and technical strategist at Wells Fargo Investment Institute recommends examining the quick ratio and current ratio to find out if the company has enough working capital to handle potential downturns and financial setbacks.The current ratio divides current assets by current liabilities to measure how much cash a company has on hand to pay short-term obligations within a year. The quick ratio sums cash, marketable securities and accounts receivables and divides this sum by current liabilities. Higher numbers for these ratios suggest greater liquidity.

Mutual fund ratios

Adam Dechtman, a certified financial planner at Dechtman Wealth Management evaluates mutual funds using three ratios. The net expense ratio or fund management fee divided by total investment is used to find low-fee mutual funds. Lower fees allow investors to put more capital into the markets rather than to a fund manager. The Sharpe ratio measures the risk-adjusted return of a financial portfolio. “We love this ratio because it can be used to compare risk-adjusted returns across all fund categories,” Dechtman says. The third fund ratio, downside capture ratio, shows how a fund has performed against its benchmark, or market index comparison during a down market. This ratio shows how well managers can manage risk.

Investors should understand financial ratios for stock picks.

A thorough stock analyst will explore other valuation, profitability and liquidity ratios. The overriding strategy in valuation analysis is to compare the ratios to industry averages and individual company averages. The ratios can be found online or in a company’s annual report or brokerage firm’s website. Analysts use these ratios to seek out trends to ensure strong future growth and profitability. To review, here are eight key financial ratios to understand when making an investment:

— Price-earnings ratio.

— Price-sales ratio.

— Profit-margin ratio.

— Dividend-payout ratio.

— Price-free cash flow ratio.

— Debt-equity ratio.

— Quick and current ratios.

— Mutual fund ratios.

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