Investors typically seek to profit from a stock by buying low and selling high. To achieve this, an investor must purchase the stock at the right price. Predicting stock prices is not an exact science, but certain financial ratios can help investors decide whether an investment is a good purchase at a given price. Understanding these ratios and how they relate to the price of a stock can help you make informed investment decisions.
Earnings Per Share
Earnings per share is used in conjunction with other financial data to determine a company’s stock price. For example, the price to earnings ratio uses EPS to determine the market value of a stock. You calculate EPS by dividing a company's net income by its total number of outstanding common stock shares. If a company earns $20 million in net income and has 10 million in common shares of stock outstanding, its EPS is $2 per share. This means that $2 of net income is allocated to each share of stock.
The price-to-earnings ratio is likely the ratio most commonly used by investors to predict stock prices. Specifically, investors use the P/E ratio to determine how much the market will pay for a particular stock. The P/E ratio shows how much investors are willing to pay for $1 of a company’s earnings. Several variations of the P/E ratio exist, but a common formula used is P/E ratio = Price per share / Earnings per share. If the price of a stock is $20 and its EPS is $2, then the P/E ratio is 10. Some investors compare a company’s P/E ratio to similar companies in the same industry to determine if the stock is underpriced or overpriced compared to its competitors. When comparing similar companies, the company with the higher P/E ratio is more favorable than the company with the lower P/E ratio.
Price to Earnings Growth Ratio
A major limitation of the P/E ratio is that it fails to account for the growth of a company. Some investors who desire to determine if a stock’s current price makes for a good long-term investment use the price-to-earnings growth ratio. PEG is calculated by taking a company’s P/E ratio and dividing it by the expected growth rate. The growth rate is an estimate that is open to interpretation, so many investors use a five-year growth estimate to help smooth out volatility. The baseline metric for PEG is 1, which means that companies with a PEG lower than 1 are possibly undervalued. A PEG ratio greater than 1 may mean that the company's stock is overvalued or the market expectation for growth is too high.
Benefits of Using Financial Ratios
Ratios can tell an investor more about a stock price than she can learn by simply researching financial statements. Financial ratios can help investors determine the strengths and weaknesses of a company's stock or an entire industry. The ability to perform such analysis is important for knowing the right price at which to buy a stock. Financial ratios also allow you to determine if a company is profitable, if it can pay its bills, how its performance compared to previous years and how it is measuring against its competitors. All of this information is important for making informed investment decisions.