Basic Ratio of Stocks

A financial ratio measures the relative magnitude of a relationship between two selected indicators taken from a company's financial statements. Why do we need it?

For example, suppose company A and company B are competitors:

• Company A has annual sales of $10 million and a profit of $1 million.
• Company B has annual sales of $2 million and a profit of $0.5 million.

So, which of the two companies is more profitable?

In absolute terms, company A has a higher profit than company B. However, it is incorrect to conclude that company A is more profitable, overlooking the sales difference.

Since financial ratios exclude the influence of scale, they are more helpful in comparing different underlying companies at a relative level, known as cross-sectional or horizontal analysis. Moreover, when looking at a company's financial ratios in time sequence, we can see whether the data improves or deteriorates, known as trend analysis.

Before we approach the ratios, let's start with two important stock concepts: earnings per share and market capitalization.

Earnings Per Share

Earnings per share (EPS) refers to the net profit earned by a company during one period divided by the number of outstanding common shares. It tells us the amount shareholders will receive per share if the company distributes all its profits earned in one period. It is an important indicator of a company's profitability.

Specifically, there are two forms of EPS: basic and diluted. We won't elaborate on their calculation here, but their difference should be noticed.

• Basic EPS: This only includes current outstanding common shares.
• Diluted EPS: Assuming all potentially dilutive financial instruments (e.g., stock options, convertible bonds, etc.) are converted into common shares, there would be more common shares outstanding than before.

Therefore, the diluted EPS is equal to or less than basic EPS.

Market Capitalization

Simply put, market capitalization refers to the market value of a company. It is calculated by multiplying the current stock price of the company by the number of total outstanding shares:

Market Capitalization = Stock Price×Shares Outstanding

For example, company C has 100 million common shares outstanding, trading at $10 per share. Its market capitalization is $1 billion.

Profit Margins

When looking at an income statement from any listed company, you can usually find three types of profit: gross profit, operating profit, and net income. The three types of profit margins are calculated below, generally in percentage.

• Gross Margin = Gross Profits/Revenues
• Operating Margin = Operating Profits/Revenues
• Net Margin = Net Income/Revenues

Profit margins measure a company's profitability, used in both horizontal and trend analysis. Now we can answer the question posed at the beginning of the article: which company is more profitable? Even though company A has a higher net income, its net margin is 10% (=1÷10), lower than company B's net margin of 25% (=0.5÷2). We can conclude that Company B is more profitable than A due to its higher net margin ratio.

Price Multiples

Price multiples compare the stock price with specific fundamental data, e.g., earnings per share. It is often used to evaluate the relative worth of a company's stock.

Let's look at four price multiples.

Price/Earnings Ratio (P/E)

The P/E ratio measures the value of a company's stock price to its earnings per share.

P/E Ratio= Share Price/Earnings per Share

Suppose company ABC has a P/E ratio of 30. It indicates that investors are willing to pay 30 times company ABC's earnings to purchase one share.

When you buy stocks, you, in a sense, buy the rights to receive the firm's future earnings. Suppose stock A has higher current earnings than stock B. In that case, you are generally willing to pay a higher price to buy stock A, assuming the two companies' profitability stays the same.

Other price multiples

• The Price/Book ratio (P/B) measures a company's stock price to its book value per share.

P/B Ratio = Share Price/Book Value per Share

• The Price/Sales ratio (P/S) measures a company's stock price to its sales per share.

P/S Ratio = Share Price/Sales per Share

• The Price/Cash Flow ratio (P/CF) measures a company's stock price to the cash flow per share, which includes free cash flow (FCF) and operating cash flow (OCF).

P/CF Ratio = Share Price/Free Cash Flow per Share

Or
P/CF Ratio = Share Price/Operating Cash Flow per Share

Dividend Yield

The dividend yield is the ratio of a stock's annual dividends to its current price, measuring how much cash dividends a company pays out relative to its share price.

Dividend Yield = Annual Dividends per Share/Share Price

For example, suppose a company pays $3.00 per share to common stock investors as annual dividends. If the stock trades at $90, its dividend yield is 3.33% (=3÷90).

There are two types of profits in stock investing: capital gain and dividend payments. Thus, the dividend yield is also an important consideration for investors when making investment decisions.

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Reference:

Introduction to Financial Statement Analysis. (2022) CFA® Program Curriculum Level I (Vol. 2).

Financial Analysis Techniques. (2022) CFA® Program Curriculum Level I (Vol. 3).