6 Key Financial Ratios for Investors

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  • A financial ratio is a tool to help investors understand a company’s health.
  • Financial ratios are best used to compare companies within the same industry.
  • Every ratio has its own weakness and should be used in concert with other metrics to make an investing decision.

When you’re looking to invest your money, it’s important to do your due diligence. Once you start the research process, however, you will quickly find there are dozens of details to consider — from external factors like the economy and interest rates to internal factors like a company’s management and financial statements.

With so much to think about, deciding between two or more stocks can seem overwhelming. That’s where financial ratios come in.

“A financial ratio is a valuation metric that scales a company’s financials, making it easier for investors to compare to other companies,” says Ryan Graves, CFA and vice president of Bemiston Asset Management.

We spoke with several financial professionals to compile a list of the key financial ratios investors should know.

1. Price/earnings-to-growth

The price/earnings-to-growth, or PEG ratio, uses a company’s P/E ratio and divides it by the growth rate of the company’s earnings.

The P/E ratio is a popular metric to determine which stocks may be overvalued or undervalued relative to others, but it has its weaknesses.

“The main limit of the P/E ratio is that it fails to capture growth in earnings, by only viewing how much someone is willing to pay per $1 of current earnings,” says Ryan Flanders, CFA and investment advisor at The Flanders Group. “Companies are intended to grow over time,” Flanders says. “When determining if an investment is a reasonably priced addition to a portfolio, it is important to not look at relative value at the moment, but over time.”

By using the PEG ratio, an investor can get a more accurate picture of a company’s relative value. A PEG ratio below 1.0 can be an indicator of a stock that is undervalued and a PEG ratio above 1.0 can be an indicator that a stock is overvalued.

2. Price-to-sales

The price-to-sales ratio is calculated by dividing the company’s stock price by total revenue. The price-to-sales ratio tells an investor how much the market values ​​$1 of the company’s sales.

“This can be a good ratio to look at if a company is growing rapidly but is not generating profits yet,” says Brian Feroldi, author of “Why Does The Stock Market Go Up?” The ability to evaluate a stock before it has generated a profit is one reason why this ratio became popular in the 1990s, prior to the dot-com bubble.

3. Gross profit

Gross profit is perhaps one of the easiest financial metrics to find and calculate. “Net sales minus cost of goods sold equals gross profit,” says Will Gogolak, a finance professor at Carnegie Mellon University.

Gross profit tells an investor if a business is viable. Gross profit does not consider overhead costs, only the cost to directly produce goods. Overhead costs like rent are calculated when looking at net profit.

“If you can’t make a gross profit, don’t expect to make a net profit,” Gogolak says. Keep in mind, though, that gross profit is just a snapshot in time. Some companies may not have positive gross profit in the early years but start to become profitable later.

4. Price-to-cash flow

The price-to-cash flow (P/CF) ratio compares a company’s stock price to its operating cash flow. Operating cash flow is the amount of money earned by the company through its normal business activities. P/CF can be calculated by taking the company’s share price and dividing it by the operating cash flow per share.

This ratio tells an investor how much cash a company earns in relation to its stock price. Generally, a low P/CF ratio indicates that a company is undervalued, while higher ratios could indicate that it’s overvalued.

“The price to cash flow ratio is excellent because it is less subject to earnings manipulation by management than the popular price-to-earnings ratio,” Graves says. “Research also suggests that differences in price-to-cash flow ratios are related to differences in long-run average returns,” he adds.

The P/CF ratio is also important because in an uncertain economic environment, having a positive cash flow can give a company the ability to navigate through challenges.

5. Free cash flow yield

Free cash flow is calculated by taking cash from operations minus capital expenditures, then dividing by the company’s market cap.

Free cash flow yield is a measure of profitability that uses a company’s cash-flow statement instead of the income statement. “It removes much of the noise that can obscure or amplify profitability on the income statement as a result of accounting choices,” says David MacDougall, CFA and portfolio manager at Ipswich Investment Management.

“The higher the free flow yield, the more profitability is left over after reinvesting for growth to reward shareholders with dividends, share buybacks, or other investments for further growth,” MacDougall says.

6. Return on invested capital

Return on invested capital (ROIC) is a measure of the profitability of a company’s investment decisions. It’s calculated by dividing net profit by invested capital.

The ROIC ratio essentially asks, “Is the company’s reinvestment in the business achieving a return that is high enough to cover debt payments and reward equity holders?” MacDougall said. “Generally speaking, a return on invested capital over 10% is a good hurdle rate.”

the bottom line

Avoid the mistake of relying on just a single ratio to determine your entire portfolio. Financial ratios on their own can only answer narrow questions and may leave out information that could impact a stock’s performance, like pending legal actions or shifts in the industry.

“What is important for investors to know is that every ratio has flaws,” Feroldi says. “Ratios also need additional context.”

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