Make a smart investment using three simple financial ratios

If you are looking to determine what companies to invest with, do not just depend on the analysis of financial experts. While they can offer a great baseline, doing some of your own analysis can lead to helpful insights.

All publicly traded companies are required by the Securities and Exchange Commission (SEC) to report their financial information. Since that information is in pure form it may be difficult to compare one company against another. Companies have different share prices and earnings, and just because a stock costs more (or less) does not mean that it is a better investment opportunity.

Financial ratios are calculations you can perform to compare investing in one company over another in an objective manner.

The math behind these financial ratios is not complicated but the insights help you make a more informed investment decision.

Price-to-Earnings Ratio (P/E Ratio)

The Price-to-Earnings ratio allows you to compare the relative value of one company’s shares with another’s. This ratio is great for standardizing the value of earnings across companies. You can also use this ratio to determine historical company trends. To calculate this ratio, divide the current stock price by the earnings per share to find the Price-to-Earnings ratio.

Price-to-Earnings Ratio = Market Value Per Share/Earnings Per Share

This ratio will help you determine the market value of a stock compared to the company’s earnings. A high Price-to-Earnings ratio could tell you that a stock is overvalued, while a low ratio could tell you that a stock is undervalued. Generally, a high Price-to-Earnings ratio means that investors are expecting higher future growth.

When analyzing this information, be aware that the current average Price-to-Earnings ratio across companies is about 20 to 25 times earnings. If companies do not have a Price-to-Earnings ratio it usually means that they may be losing money.  As always, you should do additional analysis before deciding to invest with a company. One ratio alone is commonly not sufficient to guide an investment strategy.

Dividends

While dividends are not technically a ratio, they are still important to consider. You may want to invest in a company that will reward you as a shareholder or you may want a company that is reinvesting profits into growing the company and thus not paying high dividends at the moment. Your dividend strategy is one component of your overall investment strategy.

Current Ratio

This ratio is helpful in determining if a company is in the position to pay its short-term debt. if a company cannot pay its debt, regardless of impressive sales numbers, it may be an indicator that it could fail.

Current Ratio = Current Assets/Current Liabilities

A company with a current ratio of less than one does not have capital on hand to meet short-term debts. While this can be bad for many companies, it is also only a snapshot. Just because a company cannot pay all of its debts at a given moment, does not necessarily mean that the company will have issues when comes time to pay back its debt.

This ratio is most helpful when you calculate it at multiple points in time. This will ensure you are not only viewing an outlier or is it a positive or negative overall trend. 

Usually, you want to look for a company with a current ratio of between 1.5 and 2 which typically means that the company is both able to pay its debts and making smart long-term investments.

Financial ratios do not need to be complicated to offer insights into good investment opportunities. While there are many options for analysis, in combination, these three ratios offer a good starting point. Take the time to do your research before investing and ensure that you understand your portfolio. You may learn more about investing at www.investor.gov.

Disclaimer: This blog is a general overview of principles you may want to consider. Only you can decide what is best for you. The information is educational in nature and is not intended to be, and should not be construed as, tax, legal or investment advice. You should always consult a certified advisor for advice on those topics. The examples are for illustrative purposes only.