Important Financial Ratios and Interpretations for Stock Valuation

Posted bySandeep KumarPosted inUncategorized

Here is a table summarizing important financial ratios, their formulas, and interpretations:

RatioFormulaInterpretation
Price-to-Earnings (P/E)[ \frac{\text{Market Price per Share}}{\text{Earnings per Share (EPS)}} ]​A low P/E ratio compared to industry average may indicate undervaluation; suggests how much investors are willing to pay per dollar of earnings.
Price-to-Book (P/B)[\frac{\text{Market Price per Share}}{\text{Book Value per Share}}]A P/B ratio less than 1 suggests the stock is trading below its book value, potentially indicating undervaluation.
Price-to-Sales (P/S)[\frac{\text{Market Price per Share}}{\text{Revenue per Share}}]       ​A lower P/S ratio can indicate that the stock is undervalued relative to its sales.
Price/Earnings to Growth (PEG)[\frac{\text{P/E Ratio}}{\text{Earnings Growth Rate}}]                 ​A PEG ratio less than 1 suggests the stock may be undervalued considering its earnings growth potential.
Dividend Yield[\frac{\text{Annual Dividends per Share}}{\text{Market Price per Share}}]A higher dividend yield compared to the industry average can indicate that the stock is undervalued, especially if the company has a stable or growing dividend history.
Free Cash Flow (FCF) Yield[\frac{\text{Free Cash Flow}}{\text{Market Capitalization}}] A high FCF yield indicates that the company generates substantial free cash flow relative to its market value, which can be a sign of undervaluation.
Debt-to-Equity (D/E)[\frac{\text{Total Liabilities}}{\text{Shareholders’ Equity}}]          A lower D/E ratio suggests the company has less leverage, indicating lower financial risk.
Current Ratio[\frac{\text{Current Assets}}{\text{Current Liabilities}}]                A current ratio above 1 indicates the company has enough short-term assets to cover its short-term liabilities, suggesting good liquidity.
Return on Assets (ROA)[\frac{\text{Net Income}}{\text{Total Assets}}]A higher ROA indicates efficient use of the company’s assets to generate profits.
Return on Equity (ROE)[\frac{\text{Net Income}}{\text{Shareholders’ Equity}}]A higher ROE suggests efficient use of shareholders’ equity to generate profits.
Enterprise Value-to-EBITDA (EV/EBITDA)[\frac{\text{Enterprise Value (EV)}}{\text{EBITDA}}]A lower EV/EBITDA ratio compared to industry peers can indicate that the stock is undervalued relative to its earnings before interest, taxes, depreciation, and amortization.
Enterprise Value-to-Sales (EV/Sales)[\frac{\text{Enterprise Value (EV)}}{\text{Sales}}]A lower EV/Sales ratio suggests that the stock is undervalued relative to its sales.

Here are additional important financial ratios, along with their formulas and interpretations:

RatioFormulaInterpretation
Interest Coverage Ratio[\frac{\text{EBIT}}{\text{Interest Expense}}]Measures a company’s ability to meet its interest payments. Higher values indicate better coverage.
Operating Margin[\frac{\text{Operating Income}}{\text{Revenue}}]Indicates the proportion of revenue that remains after covering operating expenses. Higher margins indicate more efficient operations.
Net Profit Margin[\frac{\text{Net Income}}{\text{Revenue}}]​Shows the percentage of revenue that translates into net income. Higher margins indicate greater profitability.
Quick Ratio (Acid-Test Ratio)[\frac{\text{Current Assets} – \text{Inventory}}{\text{Current Liabilities}}]Measures a company’s ability to meet short-term obligations without selling inventory. Higher ratios indicate better liquidity.
Gross Profit Margin[\frac{\text{Gross Profit}}{\text{Revenue}}]Indicates the proportion of revenue that exceeds the cost of goods sold (COGS). Higher margins suggest better control over production costs.
Return on Invested Capital (ROIC)[\frac{\text{NOPAT}}{\text{Invested Capital}}]Measures the return generated on all capital invested in the company. Higher ROIC indicates more efficient use of capital.
Asset Turnover Ratio[\frac{\text{Revenue}}{\text{Total Assets}}]Measures how efficiently a company uses its assets to generate revenue. Higher ratios indicate better efficiency.
Inventory Turnover Ratio[\frac{\text{Cost of Goods Sold (COGS)}}{\text{Average Inventory}}]Indicates how often a company’s inventory is sold and replaced over a period. Higher ratios suggest efficient inventory management.
Accounts Receivable Turnover Ratio[\frac{\text{Net Credit Sales}}{\text{Average Accounts Receivable}}]Measures how efficiently a company collects receivables. Higher ratios indicate quicker collection.
Debt Ratio[\frac{\text{Total Liabilities}}{\text{Total Assets}}]Indicates the proportion of a company’s assets that are financed by debt. Lower ratios suggest less financial risk.
Dividend Payout Ratio[\frac{\text{Dividends per Share}}{\text{Earnings per Share (EPS)}}]Shows the percentage of earnings paid out as dividends. Higher ratios indicate more earnings distributed as dividends.
Cash Ratio[\frac{\text{Cash and Cash Equivalents}}{\text{Current Liabilities}}]Measures a company’s ability to pay off short-term liabilities with cash and cash equivalents. Higher ratios indicate better liquidity.
Price-to-Cash Flow (P/CF) Ratio[\frac{\text{Market Price per Share}}{\text{Cash Flow per Share}}]Compares a company’s market price to its cash flow. Lower ratios may indicate undervaluation.
Price-to-Earnings to Growth (PEG) Ratio[\frac{\text{P/E Ratio}}{\text{Earnings Growth Rate}}]A PEG ratio less than 1 suggests the stock may be undervalued considering its earnings growth potential.
Earnings Yield[\frac{\text{Earnings per Share}}{\text{Market Price per Share}}]​Inverse of the P/E ratio. Higher earnings yield indicates that the stock may be undervalued.

Detailed Interpretation:

  • P/E Ratio:
    • Low P/E: May indicate undervaluation if the company has strong future growth prospects.
    • High P/E: May indicate overvaluation or that investors expect high future growth.
  • P/B Ratio:
    • Low P/B: May indicate the stock is undervalued, especially if the company’s assets are properly valued and can generate returns.
    • High P/B: Could indicate overvaluation or that investors expect high future growth.
  • P/S Ratio:
    • Low P/S: May indicate undervaluation relative to the company’s sales.
    • High P/S: Could indicate overvaluation or that the company has high profit margins and growth potential.
  • PEG Ratio:
    • PEG < 1: Generally considered good, indicating the stock might be undervalued considering its earnings growth.
    • PEG > 1: Might indicate overvaluation or slower expected growth.
  • Dividend Yield:
    • High Yield: Can indicate undervaluation or a strong, stable company if dividends are sustainable.
    • Low Yield: Might indicate overvaluation or that the company is reinvesting earnings into growth.
  • FCF Yield:
    • High FCF Yield: Suggests the company generates substantial cash flow relative to its market value, indicating potential undervaluation.
    • Low FCF Yield: May indicate overvaluation or that the company is not generating enough free cash flow.
  • D/E Ratio:
    • Low D/E: Indicates lower financial risk and potentially strong financial health.
    • High D/E: Suggests higher financial leverage and risk.
  • Current Ratio:
    • Current Ratio > 1: Indicates good short-term financial health.
    • Current Ratio < 1: May indicate potential liquidity issues.
  • ROA:
    • High ROA: Indicates efficient use of assets to generate profits.
    • Low ROA: Suggests less efficient use of assets.
  • ROE:
    • High ROE: Indicates efficient use of equity to generate profits.
    • Low ROE: Suggests inefficient use of equity.
  • EV/EBITDA:
    • Low EV/EBITDA: Suggests undervaluation relative to earnings before interest, taxes, depreciation, and amortization.
    • High EV/EBITDA: May indicate overvaluation.
  • EV/Sales:
    • Low EV/Sales: Suggests undervaluation relative to sales.
    • High EV/Sales: May indicate overvaluation or high profit margins and growth potential.
  • Interest Coverage Ratio:
    • High Ratio: Indicates strong ability to meet interest obligations, suggesting lower financial risk.
    • Low Ratio: Indicates potential difficulty in meeting interest payments, suggesting higher financial risk.
  • Operating Margin:
    • High Margin: Indicates efficient control of operating costs and higher profitability.
    • Low Margin: Suggests higher operating costs relative to revenue, indicating lower profitability.
  • Net Profit Margin:
    • High Margin: Indicates more effective cost control and higher profitability.
    • Low Margin: Suggests lower profitability, possibly due to high expenses or low revenue.
  • Quick Ratio (Acid-Test Ratio):
    • High Ratio: Indicates good short-term liquidity without relying on inventory.
    • Low Ratio: Suggests potential liquidity issues, indicating reliance on inventory sales to meet short-term obligations.
  • Gross Profit Margin:
    • High Margin: Suggests strong pricing power and effective cost control over COGS.
    • Low Margin: Indicates higher COGS relative to revenue, suggesting less control over production costs.
  • Return on Invested Capital (ROIC):
    • High ROIC: Indicates efficient use of capital to generate returns, suggesting strong management performance.
    • Low ROIC: Suggests inefficient use of capital, indicating potential issues in operational efficiency or capital allocation.
  • Asset Turnover Ratio:
    • High Ratio: Indicates efficient use of assets to generate revenue.
    • Low Ratio: Suggests underutilization of assets, indicating potential inefficiencies in operations.
  • Inventory Turnover Ratio:
    • High Ratio: Indicates efficient inventory management and strong sales.
    • Low Ratio: Suggests slow-moving inventory, indicating potential issues in sales or inventory management.
  • Accounts Receivable Turnover Ratio:
    • High Ratio: Indicates efficient collection of receivables.
    • Low Ratio: Suggests potential issues in collecting receivables, indicating higher credit risk.
  • Debt Ratio:
    • Low Ratio: Indicates lower financial risk with less reliance on debt.
    • High Ratio: Suggests higher financial risk with greater reliance on debt to finance assets.
  • Dividend Payout Ratio:
    • High Ratio: Indicates more earnings are being paid out as dividends, which can be attractive to income-focused investors.
    • Low Ratio: Suggests more earnings are being retained for growth or other purposes.
  • Cash Ratio:
    • High Ratio: Indicates strong liquidity, with sufficient cash to cover short-term liabilities.
    • Low Ratio: Suggests potential liquidity issues, indicating less cash available to cover short-term obligations.
  • Price-to-Cash Flow (P/CF) Ratio:
    • Low Ratio: May indicate undervaluation, suggesting the stock is cheap relative to its cash flow.
    • High Ratio: Could indicate overvaluation, suggesting the stock is expensive relative to its cash flow.
  • Earnings Yield:
    • High Yield: Indicates the stock may be undervalued, offering a higher return on investment relative to its market price.
    • Low Yield: Suggests the stock may be overvalued, offering a lower return on investment relative to its market price.

Published by Sandeep Kumar

He is a Salesforce Certified Application Architect having 11+ years of experience in Salesforce.

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