Being able to compare investor ratios can mean the difference between investing in a good company or a bad company. Certain investor ratios are commonly cited and used to determine the health of a company; therefore, knowing how to interpret those numbers is crucial as an investor. Not only will you be able to more aptly compare investments, but you can use the investor ratios to devise trading strategies and weed out under-performing stocks.
Importance of Ratios
As an investor, you want to get a snapshot of a company's health without having to pore over every line of its financial statements. Ratios give you such a snapshot. Comparing specific numbers from financial statements to other numbers provides you with a barometer of the company's financial health. Ratios are important, but a single ratio never tells the whole story. Comparing ratios to past ratios, or to the ratios of a company's competitors, can provide a context for the ratios. This comparison gives you an edge in determining which company's stock is a better investment.
Earnings Per Share
Earnings per share (commonly called EPS) is a measure of profit (earnings) produced for each share that the company has issued. This ratio is an easy way to compare the profitability of different companies. An EPS figure that increases from quarter to quarter shows the company is doing well; if EPS drops, it means the company's growth is slowing. Calculate the ratio for a particular time period by taking net income, subtracting dividends on preferred stock, then dividing the total by average shares outstanding. EPS is usually provided in a company's earnings announcement each quarter.
The price-earnings (P/E) ratio is a gauge of value that tells you how much investors are paying per dollar of earnings. To calculate the P/E ratio, find the current share price and divide it by the EPS. This is usually calculated using EPS for the last 12 months, so add up the last four quarterly EPS numbers to get an annual figure. Compare the P/E ratio of one company to other companies in the same industry to determine which one investors value more. But there's still a lot of room for interpretation, based on each company's health: A lower P/E ratio could mean the stock is a bargain, or that investors are wary of the stock. A high P/E relative to the company's peers could mean the stock is overpriced, or that investors expect the company to do even better in the future.
As an investor, dividends can play a significant role in your portfolio. From 1926 to 2010, the S&P 500 returned 9.9 percent per year on average, and 42 percent of that return came from dividends, according to a Sentry Investments study. Comparing the dividend yield of different companies' stock allows you to see which company is paying the best dividend relative to share price. Compute the dividend yield by dividing the annual dividends per share by the current share price. If the company has a good track record of paying dividends, and a high dividend yield relative to competitors, that means are getting a lot of bang for your investment buck. A low dividend yield, relative to the company's peers, means the stock may be overpriced for the dividend you are getting.
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