17 Key Financial Ratios

How you can understand key attributes of any

business and quickly evaluate its investment
potential

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 Key Valuation – Is the Profitability – Does
stock an attractive the business make
attributes investment? money?

of any
business Liquidity – Can the
company meet its
Business Activity –
Are the operations
short term
and stock obligations?
efficient?

fall into 5
Leverage – Does the
main company make
proper use of debt
and equity financing?
categories
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 The proper due diligence
requires careful study of
You need every part of the business
to
An investor also concerns
investigate himself with the valuation
each metrics
group of Operations affect the
attributes stock values

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 Investors want to
know if the stock is THE VALUATION
an attractive
investment METRICS

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 These 6 key valuation metrics help you
Should look at the stock from various angles
1. Price to Earnings (P/E) Ratio
You Buy 2. Price to Book (P/B) Ratio
this Stock 3. Dividend Yield
4. Dividend Payout Ratio
Today or 5. Enterprise Value/EBIT (EV/EBIT)
6. PEG Ratio
Not
 Price to Earnings
(P/E) Ratio
One of the primary earnings valuation metric
P/E Ratio = ( Price / Earnings per share ), or,
P/E Ratio = ( Market Value / Net Income
attributable to common stock )

It considers if you are paying a proper multiple to the

earnings of the company. You are implicitly assuming
that the company derives its market value from its
earnings power. P/E ratio should be used directionally
at best as there are many reasons why it is not a
reliable indicator of value

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 Price to Book (P/B)
Ratio
One of the primary asset valuation metric
P/B Ratio = ( Price / Book Value per Share), or,
P/B Ratio = ( Market Value / Book Value)

It considers if you are paying a proper multiple to the

book value of the company. Book value tends to be a
more tangible and sustainable indicator of value than
the earnings power. Keep in mind that various
industries will naturally have different levels of
average or typical P/B ratios

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 Dividend Yield
Favorite of income investors
Dividend Yield = (Annual Dividend per Share /
Current Stock Price)
Dividends provide a regular income stream to the
investors in lieu of holding the stock. This is important
to an income investor, and to investors who are
looking for an alternative to bonds

Higher dividend yields are generally better, but too

high yields may indicate a company that may not be
able to afford the dividend in the future. The next
metric helps sort out these kind of situations

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 Dividend Payout
Ratio
Tests to see if the dividend yield is sustainable
Dividend Payout Ratio
= [ Dividends Paid / Net Income ] , or,
= [ Dividends per share / Earnings per share ]

A high dividend payout ratio indicates the company is

getting overstretched by trying to keep the dividend
going. I recommend a payout ratio of under 50%

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Enterprise Value/EBIT
Similar to the Price/Earnings Ratio
EV/EBIT = Enterprise Value (EV) / Earnings Before
Interest and Tax (EBIT)

You may want to use EV/EBIT if you wish a valuation

metric that is neutral to the capital structure of the
business. This is important to an acquirer as they may be
looking to re-capitalize the business, and want to get a
metric that is not distorted by the amount of debt or tax
structure, or even large amounts of cash on the books

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 P/E/G or PEG Ratio
Tends to be some value investor’s favorite
PEG Ratio
= PE Ratio/Expected Earnings Growth Rate

Popularized by Peter Lynch, the PEG ratio tries to take

the expected earnings growth into account. The main
argument is that higher growth rates deserve a bigger
P/E multiple. A PEG ratio under 1 is considered a good
value.

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How profitable are
the company’s
THE PROFITABILITY
operations?
METRICS

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 Is the These 4 key profitability metrics help you
company start looking at the business operations
1. Return on Equity
running its 2. Return on Assets
operations 3. Earnings per Share (EPS)
4. Profit Margin
profitably?
 Return on Equity
(ROE)
How good is the company leveraging the
shareholder’s equity to make additional income
Return on Equity = Net Income/Shareholder’s
Equity

High ROE indicates that the company is able to

shepherd shareholder’s equity and generate above
average wealth for the shareholders.

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 Return on Assets
(ROA)
How good is the company leveraging the assets it
owns?
ROA = Net Income / Total Average Assets

High ROA indicates that the company is able to make

very good use of its assets such as machinery,
property, etc.

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 Earnings per Share
(EPS)
What are the shareholders earning per share?
Earnings Per Share (EPS) Ratio = Net
Income Attributable to the Common
Stockholders / Number of Common Shares
Outstanding

It is important to see if the EPS value trends up over

time. This implies the company is growing and
creating more income as time goes by

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 Profit Margin
The key profitability metric
Profit Margin = Profit / Sales

This can be calculated on the gross level or on the net

level

Gross Profit Margin = (Sales – Cost of Sales)/Sales

Net Profit Margin = Net Income/Sales

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Can company run its
operations with the
THE LIQUIDITY
liquidity it has?
METRICS

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 Does the
These 3 key liquidity metrics help you
company understand if the company can take care
of its short term obligations
have 1. Current ratio
2. Quick ratio or Acid test ratio
sufficient 3. Interest coverage

liquidity?
 Current Ratio
The key liquidity metric
Current Ratio = (Current Assets / Current
Liabilities)

This is used to see if the company has sufficient

current assets (assets that are quickly converted to
cash) to cover its current liabilities.

Any current ratio above 1.5 should be safe. Higher the

better.

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 Quick Ratio or Acid
Test Ratio
Similar to Current Ratio but more stringent
Quick Ratio = (Current Assets - Inventory) /
Current Liabilities

This is used to see if the company has sufficient near

cash assets to cover its current liabilities.

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 Interest Coverage
Ratio
Can the company pay its debt comfortably
Interest Coverage Ratio = Earnings Before Interest
and Tax / Interest Expense

You want to see an interest coverage ratio above 2.5.

An interest coverage ratio below 1 indicates
insufficient earnings to support debt payments and is
a red flag

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How efficiently does
the company run its
THE BUSINESS
operations?
ACTIVITY METRICS

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 Are the These 2 key operations metrics help you
understand if the company is running its
operations business efficiently
1. Inventory turnover
humming? 2. Average collection period
 Inventory Turnover
How fast are company’s goods selling?
Inventory Turnover = Cost of Goods Sold /
Average Inventory

Fast inventory turnover implies the company is able to

sell off its inventory quickly

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 Average Collection
Period
Is the company able to collect payment from its
buyers quickly?
Average Collection Period = (Days x Average
AR/Net Credit Sales)
Quicker collection means cash comes in faster and
can be reinvested in the business faster. This has
major impact on growth rates.

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Is the company using THE LEVERAGE
debt prudently?
METRICS

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 Is Debt These 2 key leverage metrics help you
understand if the company prudently
Supporting or using debt to fund its business
Hindering the 1. Debt ratio
operations? 2. Debt to Equity ratio
 Debt Ratio
How leveraged is the company?
Debt Ratio = Total Debt / Total Assets

There is a optimal amount of debt for every company.

Debt is important as debt is a cheaper way to fund the
business than equity. However, too much debt can
compromise the financial flexibility of the company.

Think of Debt Ratio as a measure of whether the

company is using adequate amounts of debt

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Debt to Equity Ratio
Similar to the Debt Ratio and used for similar reasons
Debt to Equity Ratio = Total Liability /
Shareholder’s Equity

Debt to Equity ratio can stand as a proxy for risk in the

business. A high Debt to Equity ratio means the
business is highly levered and therefore inherently
risky

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How you can use the
Value Stock Guide
expertise to guide
and grow your own
NEXT STEPS
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