How to Apply Financial Ratios When Buying or Selling Stock

Buying shares of stocks for your financial security is a good start to suffice your future needs. However, doing so without ensuring the reliability of a particular corporation you want to capitalize on will only jeopardize your investment. It is true that there will be numerous risks to be encountered in investing in stocks. Though, we can still manage to minimize these risks to occur. 

Before venturing your money on stocks, it is absolutely necessary for investors to evaluate the financial performance of every possible corporation they have on their list.  To aid you with that, there are significant and beneficial details that must be considered for you to determine if a corporation is worth investing in. Here are the most helpful financial ratios in evaluating stocks: 

Return on Equity

ROE determines the profitability of exploiting the invested capital. It also verifies the efficiency of the company using the owner’s equity. The return on equity is computed as: 

ROE= Net Income less Preferred Stock Dividend Requirement / Issued and Subscribed Ordinary Shares plus Retained Earnings

This formula indicates how much of the net income will each dollar of shareholder’s equity can gain. To explain it further, let’s assume the following:

 

Ordinary shares, $20 par, 10,000 issued                  $ 200,000

6% Preference Shares, $10 par, 5,000 issued                 50,000

Subscribed Ordinary Shares, 3,275                                  131,000

Net Income – yearend                                                            72,000

Retained Earnings, Unrestricted                                        30,000

Preferred Stock Dividend Requirement                              3,000

 

In order to indicate the profitability using these data, return on equity has to be calculated this way:

ROE= $72,000-$3,000 / $200,000+$131,000+$30,000+ $72,000-$3,000

         =16%

 Take note that retained earnings include net income less preferred stock dividend requirement. From the example, we can say that the company is spending the invested capital successfully as 15-20% ROE is deemed excellent.  Longstanding low ROE denotes the failure of an enterprise to maximize profit. Exceedingly high ROE can be good sometimes since it reflects a successful performance. On the other hand, a high ROE may imply a large amount of debts. Additionally, comparing the ROE of a company to the average ROE of the industry is also a helpful way of evaluating its profitability. 

Earnings Per Share (EPS)

Out of all the information concerned with stocks assessment, this is the most vital profitability ratio that all investors should be focusing on as EPS determines the amount of profit which every single ordinary share can obtain. It is computed as:

EPS= Net Income less Preferred Stock Dividend Requirement / Number of Common Shares Outstanding

Using the foregoing example, here is an illustration on how to apply this formula:

EPS= $72,000-$3,000 / 10,000 shares

        =$6.9 per share

Some companies don’t have preferred shares. If a company has only one class of share capital, a different formula has to be used in order to get its EPS:

EPS= Net Income / Number of Shares Outstanding

A high EPS implies that a company is able to return more than the previous investment of its shareholders. Especially if it’s on a steady upward inclination, potential investors will surely be attracted to availing its shares. Usually, the EPS of a company is weighed against the other companies within the same industry. This would indicate if the company is performing well in comparison to its peers. However, some corporations have a low EPS not because its financial performance is terrible. Its profit might be allocated for reinvestments in order to keep the company progress. Therefore, EPS must not be the only basis in measuring profitability since there are a lot of related factors to be considered. 

Dividend Payout Ratio

Aside from determining the profitability of a company, shareholders are interested in knowing how much dividend they obtained from the earnings. Using this ratio, the percentage of earnings that have been distributed as dividend and the percentage of reinvestment will be revealed. If you are going to rely on the amount per share, it will be calculated as: 

Dividend Payout Ratio= Dividend per Share / Earnings per Share

On the other hand, apply this formula if the only given data is the retention ratio which indicates the portion of the earnings to be plowed back to the company:

Dividend Payout Ratio=1-Retention Ratio

The average S&P 500 dividend payout ratio is approximately 35%. An extremely high dividend payout ratio is considered good as the company is willing to pay out high-priced dividends. But some risks are linked with a high percentage because the company might not be thinking about expanding its operations or not even allocating its profit for future needs. A dividend payout ratio with more than 100% means that the company is distributing more dividends than it is earning. This will possibly result in the postponement of paying out dividends in the upcoming years. These factors have to be considered if investors are planning to acquire a long-term investment.

Small-scale companies that are still starting out normally have a low or 0% dividend payout ratio since their earnings are directly appropriated to a specific purpose such as strengthening financial growth and supporting expansion.

Price-Earnings Ratio (PE Ratio)

Potential investors must not only be interested in how much the company earns. They must also be aware of how willing investors are in obtaining shares. P/E ratio measures the association between the market price and the earnings per share. At times, the P/E ratio is called price multiple because it reveals the extent of how much investors are expected to pay for every dollar of earnings. It must be computed as:

Price-Earnings Ratio= Market Price per Share / Earnings per Share

Even though a high P/E ratio shows how attracted investors are in acquiring shares just because price escalation is anticipated to occur in the future, it could also mean that the market price is overvalued. Companies that acquired losses will result in having a negative P/E ratio and will be expressed as N/A. 

Financial ratios are calculations using numerical figures that originated from financial statements. Being equipped with these fundamental tools is an advantage in indicating if a company performs well. If these are interpreted and utilized correctly, you will be able to derive decisions in avoiding investment risks.