5 Financial Ratios Every Stock Investor Should Know

• Financial ratios compare different important aspects of a company like its profits, revenue, market price per share, equity, debt and book value.
• The important financial ratios include the price-to-earnings ratio, return on equity, price-to-book ratio, price-to-sales ratio and debt-to-equity ratio.
• Low P/E, P/B and P/S values are signs of undervaluation, while high values of these ratios may be indicative of overvaluation.
• Low D/E values are preferred as they signal manageable debt levels, while high ROE values are suitable for investors as they indicate efficient usage of shareholders’ funds.

Fundamental analysis is crucial for long-term investing. If you want to invest in a company and potentially benefit from its value appreciation over several months or years, you need to perform the required fundamental analysis to make a smart decision. Financial ratios are central to fundamental analysis. These ratios compare various financial metrics of a company to give you insights into its valuation, liquidity, debt structure and more.

In this article, we take a closer look at 5 important financial ratios, how to calculate them and what they each indicate.

Financial ratios are mathematical or numerical metrics that compare various aspects of a company, like its share price, revenue, profitability, debt levels, equity, sales value and more. By comparing these key metrics in pairs, financial ratios reveal important information about a company's profitability, valuation, leverage, liquidity, dividend payout structure and more.

These insights are valuable for investors with a long-term outlook because they help assess if a company could potentially appreciate or depreciate in value over time. Important financial ratios can also offer insights into any problems that a company may be facing, like liquidity issues or unmanageable levels of debt. These red flags are signs that the company may not be a suitable investment over the long term. If you are planning to invest in a stock with a long-term outlook, you need to factor in the important financial ratios before making a decision.

The price-to-earnings ratio or P/E ratio compares the current market price of a company’s shares to its earnings per share (EPS). So, it tells you how the market values a company’s shares for each rupee of its earnings. This is the formula for the P/E ratio:

Price-to-earnings ratio = Market value per share ÷ Earnings per share

This financial ratio can help you assess if a company is overvalued or undervalued. A high P/E ratio means that the company’s market value is several times its earnings, which may point to overvaluation. Conversely, a low P/E ratio may indicate undervaluation.

The price-to-book ratio or P/B ratio measures the current market price of a company’s shares with the entity’s book value. The book value is simply the net asset value of the company, which is the difference between its total assets and liabilities. To find this financial ratio, you can use the following formula:

Price-to-book ratio = Market value per share ÷ Book value per share

A high P/B ratio means that the market values the company higher than its book value warrants — which is a sign that the stock could be overvalued. On the other hand, a low P/B ratio may be a sign of undervaluation.

The return on equity (ROE) ratio evaluates a company’s financial performance by comparing its net income with the shareholders’ equity. This means it tells you how much net income the company is generating per rupee of shareholders’ equity available. The formula for this financial ratio is as follows:

Return on equity = Net income ÷ Shareholders’ equity

A high ROE is a positive sign because it means that the company is utilising the shareholders’ funds effectively to generate high net income. Conversely, a low ROE may be a red flag for equity investors.

The price-to-sales or P/S ratio is another important financial ratio that measures how the market values a company’s shares for each rupee of sales that the company generates. This gives you more clarity about the company’s current valuation. The P/S ratio formula is given below:

Price-to-sales ratio = Market price per share ÷ Sales per share

A low P/S ratio means that the market does not value the company highly despite its high sales. This may be a sign of potential undervaluation. However, a high P/S ratio could mean that the company’s stock is overvalued.

The debt-to-equity ratio is a leverage-focused financial ratio that measures a company’s debt level with its equity level. The formula for the D/E ratio is easily derived from its meaning. Check out this formula below:

Debt-to-equity ratio = Total liabilities ÷ Total shareholders’ equity

A high D/E ratio means that the company’s total debts and liabilities far exceed its equity. This may increase the risk for investors. However, a low D/E ratio is generally a positive sign because it means that the company’s liabilities are within manageable levels.