Important Ratios You Must Know Before Investing

Posted by finomyonline on December 25th, 2020

Investing in stocks is a great way to create long term wealth but a challenging task too, as it calls for a scrupu0lous analysis of a company’s financial data to know its true worth. Before investing in any company, it is imperative to check the company’s background like the products/services it offers, its recent growth etc. and analysing its financial statements like balance sheet, profit and loss account etc. to refrain from buying into a company with high debts or paying a high amount for stocks having less earning potential.

An easier way to evaluate the stock is through its financial ratios. Here are 5 financial ratios that investors must know before investing in a company.

Earnings Per Share (EPS):

EPS is a crucial ratio and is computed by dividing the net profit that a company has made in a given time by the total outstanding shares of the company. Before investing in any company, it is recommended to check past EPS for the last five years. You will be able to check if the company is generating profits if the EPS is growing for these years.

Price to Earnings Ratio (P/E):

P/E ratio shows the relation between the current share price to the earning of the company per share. This ratio lets you know if the company is undervalued or overvalued. Usually, when a P/E ratio is high, it indicates that the investor is paying more price for the share. While buying a stock; a low P/E ratio is preferred, but it varies from industries to industries.

Price to Book Ratio (P/B):

P/B Ratio is calculated by dividing the current price of the stock by the book value per share. It implies how much shareholders are paying for the net assets of a company. Generally, a company with a lower P/B ratio is considered undervalued as compared to one with a higher P/B ratio. However, this ratio differs among various industries.

Debt to Equity Ratio:

Used as a standard to ascertain a company’s financial standing, the debt-to-equity ratio measures the relationship between the amount of capital that has been borrowed (debt) and the amount of capital contributed by shareholders (equity). It helps to determine whether the company has high debt or not. A company with a high D/E ratio is considered a higher risk to investors because it shows that the company is financing a significant amount through debt. Customarily, if a company’s debt-to-equity ratio is more than 1, it is treated as risky and should be considered carefully before investing.

Return on Equity(ROE):

Return is the ultimate motive behind any investment. ROE assess the rate of return that shareholders get on the stock of a company from the business and its earnings. It holds importance for investors because it determines the company’s capability to generate profits on stock investments. ROE is estimated by the net income to shareholder equity.

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