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How Key Stock Ratios Work





One large component of fundamental analysis is reviewing key stock ratios to evaluate the companies profitability, liquidity, performance and value.

It should be noted however that any single ratio should not be used to determine whether or not it’s a good company to own.  In my opinion, a combination of ratios should be used along with your own discretion as to whether or not it’s a good opportunity to own the company.

Price to Earnings (P/E)

The P/E or Price to Earnings ratio is perhaps the most common valuation tool used.  It displays the ratio of the stock price relative to its earnings.  The lower the ratio, the cheaper the stock.  The one issue with the P/E ratio is that “earnings” can be manipulated by accounting tricks, so it shouldn’t be used as the end all be all of determining value.  As well, the P/E ratio range varies between sectors/indexes.  For example,  the small cap index will likely have a higher P/E ratio than the large cap index as the expected growth rate is higher.

Price to Earnings to Growth (PEG)

To improve the P/E ratio, Peter Lynch came up with the Price to Earnings to Growth ratio, or the PEG ratio.  This ratio is simply the P/E ratio divided by the expected earnings growth of the stock.  The lower the number, the more appealing the stock (according to Mr. Lynch).  Growth rate can be taken from company forecasts (which I don’t like), or simply taking the earnings per share (EPS) growth over the past 5.

Price to Book Value (P/B)

Book value is the net worth of the company.  In other words, it’s the Assets minus the Liabilities.  Book value is often compared to the price of the current stock which is simply the price per share divided by the book value per share.  Value investors often look at book value gauge how much the company would be worth if they had to liquidate their assets.  Companies with a P/B ratio of 1 means that the company’s net worth or shareholder’s equity is equal to the current asking price of the stock – in other words, possibly cheap!

Current Ratio

The current ratio is a solvency ratio and indicates the companies ability to cover liabilities due in the near future (12 months).    The higher the ratio, the better off the company is able to pay their upcoming liabilities.  However, too high of a current ratio could mean that the company is holding too much cash which is not being used to generate more profit.  A ratio of 1 means that they have $1 of current assets for $1 of current liability.  A common threshold for evaluation of a minimum current ratio of 2.

The formula is:  current ratio = current assets/current liabilities.

Generally speaking, current assets are assets that are relatively liquid which means they can be converted to cash in a relatively short period of time.  This can include cash, inventory, accounts receiveable.

Current liabilities is cash that is due to the paid back within a 6-12 month time frame.  This can include, payroll, accounts payable, portions of long term debt and short term debt.

Like the other ratios, chances are you don’t need to dig into the balance sheet to pull current assets/current liabilities, there are a lot of websites out there, like stockhouse.ca or msn money that display current ratio already calculated.

Quick ratio

There are some sectors that have huge inventory costs, but inventory on the balance sheet can be slow to move.  The issue with this is that inventory is often counted as a “current asset” but can skew the current ratio if the inventory value relatively large.

To adjust for this, you can use the quick ratio which is simply:  (Current Assets – Inventory)/Current Liabilities.   Many investors like to see the quick ratio to be 1 or greater.

Conclusions

What to take away from all this?  Value investor guru Benjamin Graham would typically look for companies with a current ratio of 2.0 or greater, a Price/Earnings of 15 or less, Price/Book of 1.5 or less (among other criteria).  Here is my article on Canadian Stock Screeners that can help you identify stocks with these ratios.

Do you use stock ratios when evaluating your investments?





13 Comments, Comment or Ping

  1. 1. Passerby

    While these ratios are very helpful, relying onl just these ratios can be risky akin to looking at the tree and missing the forest. For example, the P/E ratio and stock price relative to book value could be lower for valid reason such as low expeted future income due to erosion of monopoly advantage /comptitive edge.

  2. 2. DanP

    Passerby brings up a good point. I’ve definitly seen people fall into value traps by relying on the ratios too much. Yellow pages was a good example of this, and some expect RIM to be of this. But like everything else, these ratios area great tool, but one of many taht people should look at. But great info!

  3. 3. Echo

    I look at P/E ratios before doing further analysis on a stock. I also like to look at the Graham numbers to get a better picture of value. As Passerby mentioned, you can’t rely solely on these ratios to make your decisions.

    That being said, there was an interesting quote on Tom Connolly’s website recently about selecting a stock with a P/E over 20:

    “If you buy a stock with a p/e over 20, your returns will most likely be poor, like very poor: how about one point one percent per year (median return for stocks with p/e over 20 for S&P 500 from 1926 to 1998).”

  4. 4. Tyler B

    Good to see some fundamentals here :-) Love this site BTW and all the great contributions people make. It’s one of my favorites in my RSS feeds.

    A great book for this is the Intelligent Investor. I didn’t click on the link, but I guess it would bring me to it eventually :-). There is a lot of technical details in the beginning of the book, but at the end of the book it get’s into deeper comparisons of common stocks. Many versions of the book have more recently listed stocks too. Enjoyable read. Took me a very long time to read. Much of it was very abstract to me in the beginning, but eventually it all makes sense.

  5. 5. OneRedFlag

    What’s a good website to find all these stock ratios in one place?
    I noticed most of them will show you P/E and PB, but PEG and current ratio seem to be hard to come by. Or they require subscription, etc.

  6. 6. Mike

    Great breakdown here of the different ratios. I remember learning how to utilise a lot of these effectively in college, but it’s important to remember that the ratios are there as just a guide.

    Don’t read too much into them and if you’re unsure of the results after a calculation, then ask for some advice from someone who can dive deeper into your finances.

    Thanks for the post.

  7. @OneRedFlag, try stockhouse.ca, pick a stock, then click on “financials”. You’ll see a tab there for “key ratios”.

  8. 8. TSM

    This is great… its one thing they never really explain on most of the financial portfolios, other then just stating the number itself.

  9. 9. Sarlock

    All of the ratios are important in their own right, though for my uses the P/E ratio is the most frequently used. I don’t use it to evaluate whether any individual stock is “good” or “bad” to buy by itself. I need to understand the company first, pour over its financial statements, news releases, track record and growth prospects, then I can use the P/E to make a rough determination as to whether the stock is at a good point to buy or not. A high P/E ratio on a company that has good growth prospects isn’t necessarily a bad thing… if they can sustain or even improve their growth rate, even a 40-50 P/E ratio can be a good buy on the right stock/company. Likewise, a P/E ratio of 8 can still be overpriced if the company is heading in the wrong direction. RIM is at 4.5 right now… good buy? Maybe… if you think they can turn things around!
    Return on equity is an important factor for me as well.

  10. 10. Ryan

    How are the earnings calculated for the PE ratio?

  11. @Sarlock, good point, I do refer to ROE and ROI at times, but the ones mentions are my staple ratios.

    @Ryan, check out a companies income statement and you’ll see earnings calculated at the bottom. It’s basically income minus all expenses.

  12. 12. Ryan

    For what time period are the earnings calculated?

  13. Ryan, public companies are required to report their earnings quarterly. When P/E quotes are published on websites, they are likely 12 month trailing (afaik).

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