The best Investment Ratios and how to use them?

Investment ratios are essential for assessing financial health, growth prospects, and intrinsic value of a business. They can provide simple, fast, and effective snapshots of a business' performance. Ratios help to look at the relationship between multiple areas of financial statements and can give valuable insights into profitability, liquidity, and drivers of the enterprise. It's best to use them with other ratios and formulas when conducting quantitative analysis. Here is a list of key investment ratios with simple explanations and examples. There are a lot of ratios out there, the below is what I have found to be the most useful.
*A quick snapshot of some of the ratios.

Investment ratios are essential for assessing the financial health, growth prospects, and intrinsic value of a business. They can provide simple, fast, and effective snapshots of a business’ performance. Ratios help to look at the relationship between multiple areas of financial statements and can give valuable insights into profitability, liquidity, and drivers of the enterprise.

It’s best to use them alongside other ratios and formulas when conducting quantitative analysis.

Here is a list of key investment ratios with simple explanations and examples. There are a lot of ratios out there, the below is what I have found to be the most useful.

INVESTMENT RATIO CONTENTS:

Click the Title or Chalk Board to see the ratio.

Return on Equity (ROE)

The Return on Equity (ROE) is a “profitability ratio” used to measure the profitability of a business in relation to its equity deployed. The ratio shows how efficient (or deficient) the company is at taking the equity investments of its shareholders and deploying that equity and generating income from it.

Return on Assets (ROA)

The Return on Assets (ROA) is a “profitability ratio” used to measure how much profit it can generate from its assets. It shows how efficient a company is at earning profits from utilising its economic resources or assets on the balance sheet.

Return on Capital (ROC)

The Return on Capital (ROC) is a “profitability ratio” used to measure the efficiency in which a business allocates its capital to generate profits. Return on capital is one of the best ratio’s that investors can use to determine whether a business will make a viable investment opportunity. The capital return ratio shows how much operating income (EBIT) is generated for every dollar invested in capital.There are two types of capital return ratios: ROCE (Return on Capital Employed) and ROIC (Return on Invested Capital). Both are used when valuing the capital returns on a business and each have a place which we will explore further below.

Gross Margin (GM)

The Gross Margin (also known as Gross Profit Margin) is a “profitability ratio” that measures gross profit to sales revenue. It reflects the profits of a business after paying off its costs to produce its goods and services (COGS). The ratio is reflected as a percentage showing each dollar of revenue that is retained as gross profit. Whatever money is left over after a company subtracts all the costs to deliver its product or service gives us the Gross Profit Margin.

Operating Leverage (DOL)

The Operating Leverage is a financial efficiency ratio not specifically a “profitability ratio”. The OL is a ratio used to measure how operating income is affected by how fixed & variable costs intertwine with sales volume. Operating leverage and profitability are positively related as profits are determined by the fixed and variable costs associated with generating that revenue.

Operating Margin (OM)

The operating margin is a “profitability ratio” also known as the EBIT Margin or Return on Sales. The ratio measures the revenue after deducting the operating expenses associated with generating that sale to show how much profit a business makes on a dollar of sales. It excludes Interest and tax expenses.

Earnings Yield (E/P)

The Earnings Yield is a financial metric used to measure the indicative rate of return on a stock. It is calculated by dividing the company’s earnings per share by the stock price, which forms the Earnings Yield (E/P). This ratio is not commonly used for valuation, but it is an effective way to look at what sort of returns one can expect.

Earnings Per Share (EPS)

Earnings Per Share (EPS) is an important financial metric that determines how much of a company’s accounting profit is allocated to each common share outstanding. The earnings of a company is one of the most significant variables in shaping a stock price. The EPS in used in other key financial and valuation ratios.

Debt-to-Equity (D/E)

The Debt-to-Equity ratio (D/E) is a “leverage ratio” that measures the weight of total debt and liabilities against total shareholder equity. A company’s financial leverage is an important metric to monitor as debt can make or sink companies. It is an indirect way to assess the degree to which a company finances its operations rather than funding from profits or dilution.

Current Ratio (CR)

The Current Ratio (CR) is a “liquidity ratio” that measures a company’s ability to meet its short-term obligations. It is calculated by comparing the current assets to current liabilities. This ratio is used alongside the Quick Ratio to see the short-term obligations coming due within one year.

Operating Cash Flow Ratio

The Operating Cash Flow Ratio explained. The OCF Ratio (coverage ratio) is a liquidity ratio that measures whether a business generates enough cash from its core operations to pay off its short-term obligations (Current Liabilities). As an investor, assessing a company’s short-term liquidity can provide valuable insights into its financial viability.

Inventory Turnover Ratio (ITR)

The Inventory Turnover Ratio (ITR) is a metric that measures a company's efficiency in managing inventory. The ratio shows how many times a company has sold or replaced its inventory within a year. In simpler terms, a higher inventory turnover ratio means a company is effectively converting inventory into revenue. On the other hand, a low ratio indicates that stock is not moving as quickly and may be sitting on shelves or in storage for too long.

Price-to-Sales (P/S)

The price-to-sales ratio is a “valuation metric” used to measure the value of a company compared to its annual sales (revenue). It can be measured using market capitalisation against total revenue or on a per-share basis against sales per share. The price-to-sales ratio indicates what investors are willing to pay for every dollar of sales generated by the business.

Price-to-Earnings (P/E)

The price-to-earnings ratio is a “valuation metric” used to value a company’s share price relative to its earnings per share (EPS). It is one of the most used valuation ratios by investors to determine if a stock is undervalued or overvalued.

P/E-to-Growth (PEG)

The price/earnings-to-growth (PEG) ratio is a “valuation metric” that compares a company’s price-to-earnings to its EGR (expected growth rate). The metric can help investors value a stock by comparing the company’s market price, earnings, and future growth prospects.

Price-to-Cash Flow (P/CF)

The price-to-cash flow ratio is a “valuation metric” that measures a company’s stock price value relative to its per-share operating cash flow (the amount of cash it produces). The P/CF is a handy tool as it considers a company’s ability to generate cash flow from its operations while removing the impact of non-cash expenses such as depreciation and amortisation. This helps the ratio be more reliable as it minimises the exposure to manipulated accounting practices from earnings reported.

Price-to-Book (P/B)

The price-to-book ratio is a “valuation metric” that measures the current market value of a company relative to its book value (also known as shareholders equity). The book value represents all the physical capital a company invests in, such as warehouses, computers, machinery, property, and inventory. The price-to-book (P/B) ratio is important because it helps investors understand whether a company’s market price seems reasonable compared to its balance sheet.

Enterprise Value (EV)

The Enterprise Value is a metric used to determine the total value of a company if it were to be purchased entirely. It is different from market capitalisation, which considers only the common equity of all shares. The EV provides a more accurate representation of a company’s actual value in terms of its total purchase price.

EV-to-EBITDA (EV/EBITDA)

The EV-to-EBITDA Multiple is a “valuation metric” used to measure the fair market value of a company. I value the EV/EBITDA ratio above the Price-to-Earnings ratio as the Enterprise Value and the EBITDA component tend to be a lot more in-depth than the price and the earnings alone. Using the total EV against the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) allows us to value similar companies side by side from the perspective of an acquirer.

Dividend Yield (DY)

The dividend yield (DY) is a financial ratio that measures the amount of cash that is paid out as a distribution to shareholders relative to the market value per share. A company earns profits, as shareholders we are entitled to a share of profits, and the dividend is our slice of that profit.

Dividend Payout (DP)

The Dividend Payout Ratio (DPR) is a measure of the percentage of a company’s net income that is paid out to shareholders as dividends. When a company earns profits, it can either retain them to fund operations or distribute them among shareholders as dividends. The DPR is a crucial indicator of how much money a company pays out to investors, as this reduces the amount of cash it can use for expansion and growth.

Quick Ratio (QR)

The Quick Ratio (QR), also known as the “acid test,” is a liquidity ratio that measures a company’s ability to use short-term liquid assets to meet its short-term obligations. Focusing on assets that can be quickly converted to cash is what makes this ratio different to the Current Ratio.

Free Cash Flow Yield

The Free Cash Flow Yield explained. The Free Cash Flow Yield is a “solvency ratio” that measures how much money a company makes in free cash flow relative to its market capitalisation. Many stakeholders, including myself, believe that free cash flow is a more reliable measure than Earnings Per Share.

➡️ Here is a brief guide to the types of Ratio Multiples I Look For.

Why learn about ratios when there is an abundance of publicly available information about companies and their metrics? Understanding how to use different ratios can help investors improve their analysis and valuation work. There are standard ways of using the ratios but they can be altered to suit individual styles. Learning the purpose behind each one and what they measure is an important aspect of improving your analysis work.

If there is a ratio that you believe should be on this list connect with me and I will add it.

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