If you have just started to invest in the financial markets and want to judge a stock’s growth potential without having to rely on a professional wealth advisor, then you need to get your hands dirty and do some basic number crunching.
For that, it is important to understand some of the key financial ratios to judge the growth potential of a stock and to gauge its current valuation, among other things.
These are the five key ratios investors should be aware of before they place a huge bet on stock(s):
Key financial ratios:
Price-to-earnings (P/E) ratio: Price/ earnings ratio is calculated by dividing the market value per share to earnings per share. A high P/E ratio means the stock is overpriced and a low P/E ratio means the stock is under-priced.
PEG (P/E to growth) ratio: It is a price/earnings ratio divided by the growth rate of its earnings for a specified period. It is considered to be a better indicator than P/E ratio by adding expected earnings growth into the calculation. A PEG lower than 1 is best, which suggests that the company is undervalued.
Price-to-sales ratio: The price to sales ratio is calculated by taking a company’s market capitalization and dividing the same by the company's total sales or revenue over the past one year. Lower the P/S ratio, the more attractive the investment and higher the ratio, the less attractive is the stock.
Price-to-book (P/B) ratio: This ratio evaluates the company’s valuation relative to its book value. It is calculated by dividing the company’s stock price per share by its book value per share. This ratio is used to find undervalued companies. P/B ratios under 1.0 are considered good investments by value investors.
5.Debt-to-equity (D/E) ratio: This ratio gives an indication of the size of the loan relative to equity held by the corporate entity. It is calculated by dividing the company’s total liabilities by its shareholder equity.
To sum up, as a lay investor you want to invest in a stock market without mis evaluating the stock’s growth potential then it is vital to examine the stock’s value – on the basis of what it appears in its books – in relation to its earnings, sales, book value and its loan book.
It’s only after understanding the stock value holistically that one should take a decision whether to make an investment or not.
