Investing in stocks is not something most people are comfortable to engage in, mostly because of knowledge to avoid losses. Below are some financial ratios to consider when planning to invest in a company.
Return on equity ratio (ROE)
As an investor you will always want to put your money in a company that is profitable and efficient in generating profit from its owners’ investments called equity. Knowing how companies are able to generate profit with owners’ funds is an important aspect you must check out for when making decisions on where to put your money. The return to equity ratio has been developed by financial analysts to help you as an investor determine if a company is efficient in generating income from its owners’ funds or not. It is always good to compare the return on equity ratio of two or more companies in the same industry and benchmark all to the industry ROE so as to know which one is more efficient and which one is not.
Return on Asset ratio (ROA)
Money invested into a business is used to buy assets to run the business activities so as to generate profit. If a business is able to generate more profit with this asset, it means the business is efficient, thus making it a good place to invest your money. The return on asset ratio is a ratio that tells you at a glance how efficient a company is in generating profit from its assets. It is always good when making an investment decision to compare this ratio among firms in the same industry as different firms in different industries have different asset bases. A higher ROA shows that a company is efficient in turning its assets into profit and vice versa.
Earnings per share (EPS)
Before investing your money in a company, it is essential you find out what the earnings (profit made) per outstanding shares of the company is. As this tells you how profitable the company is and how much earnings the shareholders’ investment per share is producing. If the EPS of a company is high then you should be thinking of putting your money into such a company as it means the company is creating more value for its investors by being profitable and vice versa. This metric can be found in most companies’ annual reports. For better usage of EPS, it should be compared with the company’s share price which gives us what is known as price to earnings ratio.
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Price to earnings ratio (P/E)
This is a key financial ratio every investor must check out for when planning to invest in a company. It is a ratio that measures a company stock price (i.e. the amount a company’s shares are sold in the stock market) with its earnings per share (the amount the company earns per share invested). The P/E ratio tells the amount it will cost you to own a company’s share compared with the earnings generated from that shares. As an investor it is important you review a company’s P/E ratio to determine if the share price accurately represents the projected earnings per share before taking a stand, because a higher P/E ratio can sometimes mean that a company’s share price is overvalued. If you are planning to use P/E ratio in picking up stock for investment, then know that companies with higher P/E ratios have greater expectation of future growth while companies with low P/E have less expectations of future growth. This may be good for you if the company is seen to perform well in the future because the higher the P/E ratio, the more expensive a stock is relative to its earnings and the lower the ratio, the less expensive the stock is relative to its earnings.
Dividend coverage ratio
Investors always like to invest in a company that pays dividends regularly from its earnings, whether low or high. Dividend is the reward you get from investing in a company. The dividend coverage ratio helps you to determine the number of times a company could pay dividends to its shareholders (ordinary) from its earnings for the financial year. The ratio enables investors to measure the level of risk involved in getting dividend payment on their investment. A company with a higher dividend coverage ratio is preferable to a company with less dividend coverage. However, as an investor you still need to be careful as companies that do not pay dividends from earnings may be planning to reinvest them for future growth.
Dividend Yield
When considering which company’s shares to buy or sell in the capital market, it is a good idea for you to check out for dividend yield as it tells you the percentage of the company’s share price paid annually as dividend. If a company is seen to pay out dividends at a higher percentage of its share price, it means the company is offering a greater return for its shareholders investments and you may consider buying. However, it is advisable when making this decision to track the company’s dividend paying record if it has been consistent in dividend payment or not as this will make you know the company’s financial strength to continue paying dividends well in the future.
Profit margin
This is a key ratio used in checking the financial health of a business. It shows how profitable a company is in converting money earned from sales of products (called revenue) into profit. For companies to make revenue, it has to incur some cost. First, is the cost of sales which refers to the cost of buying the goods sold or cost of producing the goods sold (in the case of manufacturing companies). The difference between revenue and cost of sales is called the gross profit.
The second is expenses which includes operating expenses (which refers to cost incurred when carrying out the activities that generate revenue), interest expenses, tax expenses, etc. The difference between the revenue, cost of sales and all the above expenses is termed as Net profit. For better insight, it is good for you to consider all the three common profit margins which include gross profit margin, operating profit margin and net profit margin to determine the financial health of a company. The result should be compared with other companies in the same industry for better decision making.
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