If you’ve done any amount of reading about stock picking, you’re likely to have come across the phrase “do your homework,” but you might be a little fuzzy on what that entails.
Part of it is understanding a company’s business model and the market in which it operates. Another aspect is analyzing a company’s management and what they’ve said about where they want to take the company.
But to really dig down into the valuation of a stock you’ll want to understand some key financial ratios to compare the health of a company with its peers, its industry and itself over time.
None of this guarantees a stock will perform the way you want it to in the future, but these eight investment ratios can provide a helpful guide in identifying names you might want to buy and hold:
— Risk-to-reward ratio.
— Price-to-earnings ratio.
— Price-to-book ratio.
— Dividend yield.
— Dividend payout ratio.
— Price-to-free-cash-flow ratio.
— Debt-to-equity ratio.
— Price-to-sales ratio.
[Sign up for stock news with our Invested newsletter.]
Risk-to-Reward Ratio
“It is not necessarily necessary for retail investors to get very detailed when picking stocks, but understanding key ratios can be helpful in making informed investment decisions,” says Mina Tadrus, CEO of investment management firm Tadrus Capital.
According to Tadrus, the only necessary ratio is one comparing potential return on an investment relative to the risk taken to achieve that return.
To calculate it, divide expected reward by the risk associated with it. That’s not as fuzzy as it may sound at first.
For the risk portion of the ratio, investors can use standard deviation of returns, the probability of loss and the volatility of an asset, Tadrus says. Reward can be measured by the expected return on a stock or interest rate on a bond.
The time horizon can also affect the ratio.
“A high risk-to-reward ratio indicates that the potential return is high relative to the risk taken, while a low risk-to-reward ratio indicates that the potential return is low relative to the risk taken,” Tadrus says.
Price-to-Earnings Ratio
The P/E ratio can be especially useful when trying to determine whether a stock is cheap or expensive compared with its peers or the wider market.
To calculate it, divide a company’s share price by its annual earnings per share — either looking backward for actual earnings or forward with expected earnings.
“A key ratio for investors going into 2023 is the price-to-earnings ratio,” says Jonathan Elliott, managing partner with wealth management firm Optima Capital Management.
As of Dec. 29, the S&P 500’s forward P/E ratio was 16.5, he says.
“Therefore, investors should review their stocks and consider selling stocks with high P/E ratios,” he says, giving the example of Tesla Inc. (ticker: TSLA), with a P/E ratio that he says has fallen to 34 from 190 at the beginning of 2022.
“If this ratio is 8 or lower, then it is a bargain, and if it is 6 or lower, then it is a very good bargain,” says Steven Jon Kaplan, CEO at True Contrarian Investments. “A ratio of 10 to 15 is typical. If the ratio is above 15, then the company is probably overpriced.”
“One sign that the U.S. stock market was too high a year ago is that the price-earnings ratios for most U.S. companies were above 20 and many of them were above 30,” Kaplan says. “Unfortunately, many of these ratios remain relatively overpriced today.”
Price-to-Book Ratio
One of the most important ratios, according to Kaplan, is this one that compares the current total market capitalization of a company with its book value. You can also calculate it by dividing a stock’s price by its book value per share, Tadrus notes.
Book value is calculated by subtracting a company’s liabilities from its assets, Tadrus says.
Investors can think about book value as how much a company would be worth it declared bankruptcy and the total value of its real estate, patents, goodwill and other intellectual property were added up, Kaplan says.
“If a company is trading for less than its book value, then it is probably a very good bargain,” he says. “If it is trading for several times book value, then it is probably overpriced and should be avoided until its price is lower.”
Dividend Yield
To calculate this ratio, divide a company’s annual dividend per share by the stock’s price, says Tadrus.
“The dividend yield is a measure of the amount of cash dividends paid by a company relative to its stock price,” Tadrus says. “A high dividend yield may indicate that a stock is a good income investment, while a low dividend yield may indicate that it is not.”
[SEE: 9 Highest Dividend-Paying Stocks in the S&P 500]
Dividend Payout Ratio
Don’t confuse the dividend yield with the dividend payout ratio.
The latter compares the dividend to a company’s earnings per share, instead of the share price.
The dividend payout ratio tells investors how much earnings are paid out in dividends versus how much is reinvested back into the company.
The higher the percentage, the less money remains to reinvest back into growing the company.
One area where this has been particularly important to investors is in the energy sector, where shareholders have been wanting companies to prioritize dividends and share buybacks over exploring for more oil and gas.
That’s one reason why energy prices have risen and contributed to inflation while at the same time helping boost oil and gas company earnings.
Price-to-Free-Cash-Flow Ratio
For those energy sector investors, seeing free cash flow returned to them has been more important because, in the past, oil and gas companies spent too much on exploration and production only to see oil and natural gas prices tank.
Free cash flow is the amount of money left over after subtracting a company’s operating expenses and expenses used to buy or upgrade its buildings and equipment.
To determine the price-to-free-cash-flow ratio, divide the company’s market capitalization by its free cash flow, or divide its share price by its free cash flow per share.
A lower ratio indicates a company may be undervalued, while a higher ratio may signal overvaluation.
[See: Best Investing Books for Beginners.]
Debt-to-Equity Ratio
The debt-to-equity, or D/E, ratio compares the amount of the company owned by creditors versus the amount owned by stockholders.
To calculate it, divide the company’s total liabilities by its shareholder equity, says Tadrus.
It’s an important ratio to consider because a greater proportion of debt constrains a company’s flexibility to grow as more revenue is directed to pay debt costs.
“A high D/E ratio may indicate that a company is heavily reliant on debt, which can be risky if the company is unable to meet its debt obligations,” Tadrus says.
Like most ratios, compare the debt-to-equity ratio to those of other industry members, as some sectors, such as utilities, have higher typical debt ratios compared with other sectors.
Price-to-Sales Ratio
Those who want to eliminate some of the variables that can come with earnings — such as one-time charges — can use this ratio.
You can calculate it by dividing a company’s market capitalization by its total sales. Or divide a stock’s price by sales per share.
A lower price-to-sales ratio suggests you’ve found a bargain, or a value stock. Industry consensus says lower-P/S stocks have better value because investors are paying less for every dollar of a company’s revenue.
“It is important for retail investors to do their own research and due diligence when considering an investment, and understanding key ratios can be a useful part of that process,” Tadrus says.
“However, it is also important for investors to consider other factors, such as the company’s growth prospects, competitive advantage, management team and industry trends, in addition to financial ratios.”
More from U.S. News
10 Long-Term Investing Strategies That Work
7 Best International Stock Funds to Buy in 2022
8 Key Investment Ratios for Stock Picking originally appeared on usnews.com
Update 01/03/23: This story was published at an earlier date and has been updated with new information.
