“How to invest in stocks” is the first question anyone who wants to build passive income asks, and why not? In the book Rich Dad Poor Dad by Robert Kiyosaki, stocks are defined as “assets”, or something that generates passive income. While stock analysis is a vast subject, one starting point that every new investor should know is financial ratios. Other concepts like “fundamental analysis” can be a lot for a beginner.
This is why knowing these key metrics is the first step to becoming a great stock investor.
What Are Financial Ratios in Stock Investing?
But before we get into “how to invest in stocks” and learn about the key financial ratios, let us first understand what the financial ratios are. Financial ratios are numbers or formulas that compare different parts of a business, such as its share price, revenue, profit, debt, equity, and more. Financial ratios show essential information about a company’s:
- profitability
- valuation
- leverage
- liquidity
- dividend payout structure
and more by comparing these key measures in pairs.
5 Financial Ratios Every Stock Investor Should Know
Now that we know what the financial ratios are, let us understand the types of ratios that every single stock investor should understand.
Price to Earnings (P/E) Ratio
The P/E ratio is the current share price divided by the company’s earnings per share, as the name suggests. It helps investors understand whether a stock is relatively expensive or cheap.
Let’s imagine that a business earns a total of ₹1000 in profit. The market also has 100 shares of it.
So, its “earnings per share” is ₹10. Also, let’s imagine that the company’s shares are selling for ₹100 each. So, we have
P/E Ratio = 100/10 = 10
In the simplest terms, this means that you are paying ₹10 for every ₹1 the company earns. However, a higher P/E ratio does not always mean that a company is overvalued. It may also indicate that investors expect higher growth in the future. What is the best P/E ratio for a stock you can buy? It’s not easy to answer this question because P/E ratios should not be compared as absolute values, since each industry has its own typical range.
Return on Equity (RoE) Ratio
The ROE ratio measures profitability relative to shareholders’ equity. In simple terms, it tells investors how efficiently a company uses shareholders’ money to generate profits. In terms of math,
ROE = Net Income / Total Shareholders’ Equity
This ratio is important because it shows how effectively the company generates profit from the capital invested by its shareholders. If you are the promoter of a firm and have put in ₹100 in equity, the company’s total equity is ₹100.
If the company makes ₹20 with this equity, then the ROE is 20%. If another firm has the same amount of equity but makes ₹40, its ROE ratio will be 40%. Many investors consider companies with higher ROE to be more efficient, although the ratio should always be analysed along with other factors.
Price-to-Book (P/B) Ratio
The price-to-book ratio compares a company’s market price per share with its book value per share.
Let’s first talk about what book value signifies before we talk about the P/B ratio.
The easiest way to understand book value is to imagine what the firm would be worth based on its assets after paying off its liabilities.
Let’s imagine that a business has total assets worth ₹1000 and total liabilities of ₹400. In that case,
The company’s total book value is
1000 – 400 = ₹600.
Let’s imagine there were 100 shares outstanding. So, the book value per share of the company is 600 / 100 = ₹6.
At this point, The P/B ratio is the market price of a share divided by the book value per share.
Let’s imagine that a share of the company costs ₹60 in the market. So, P/B Ratio = 60 / 6 = 10.
Dividend Yield or the Dividend-Price Ratio
Dividend yield is the annual dividend paid by a company divided by the current price of the stock. It tells investors how much income they may receive from a stock relative to its price.
If you bought a stock for ₹100, that would be the market price. The price of the shares is still ₹100 a year later. Is this a smart thing to do with your money? A cursory look at the rise in the share price shows that it isn’t. You earned a zero percent return. But have you thought about the dividend before making this choice?
What is a dividend?
If the company makes ₹1000, it may choose to keep ₹600 for corporate growth and distribute ₹400 to its shareholders. If there were 100 shares in the market, each shareholder would receive a ₹4 dividend. This is the income that shareholders receive from their investment. The shareholder still made money on the investment even if the share price did not increase.
Debt-to-Equity (D/E) Ratio
This ratio shows the relationship between a company’s debt and its equity. To find it, divide the company’s total debt by its total shareholder equity. It helps investors understand how much of the company’s financing comes from borrowed funds compared to its own capital.
There is no perfect D/E ratio because it varies across industries.
Investors generally believe that companies with very high debt levels may face difficulty repaying their obligations. Debt also carries interest costs, which affect the company’s profit and loss statement and can reduce its net income.
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Conclusion
While stock analysis in itself is a vast subject, knowing these financial ratios is a great way of knowing how to invest in stocks. Remember, the stock market requires a lot of studying and analysing, so make sure you invest carefully!
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