Stock Investments and Ratios
Financial ratios play an important role in guiding investors into making investment decisions. Financial ratios provide a quick snapshot into the analysis of financial statements. Ratios will therefore provide a quick guide into understanding information relating Cash flows, income statements and balance sheet.
The main ratios that are relevant in the valuation of stock investments include Price To Earnings Ratio, Price to Book Value and Price to Sales ratio.
Price to Earnings Ratio
This is one of the most commonly used ratios to evaluate the attractiveness of company shares for possible investment. Price to earnings ratio or commonly referred to as P/E ratio is the price that a potential investor will pay for each dollar of earnings the firm has realized and it works well when comparing peer group of companies. Investors will generally prefer a higher P/E ratio as this is an indication that investors will be expecting higher earnings in the future. It should however be noted that P/E ratio varies across industries and as such some industries will always record higher P/E ratio while others will record lower P/E ratio.
P/E ratio=Market Value per Share/Earnings per Share
Price to Sales Ratio
Most companies are also evaluated on their revenue generation abilities and as such the price to Sales ratio provides a perfect measure of the company’s revenue generation abilities from shareholder funds.
Price to Sales ratio is calculated as follows:
Price to sales ratio=Total Market Capitalisation/Total sales (Revenues)
The most perfect ratio is 1 as it shows that the company revenue generation abilities is consistent with the current value but it’s important to check if the ratio makes sense.
Price to book value ratio
This is another measure of looking at how successful in growing the initial assets of the business. A high figure of price to book value would be desirable to investors as this indicates that the business has seen growth and therefore a sign of better future prospects.
Based on the above three ratios an investor with $10,000 would be in a perfect position to decide whether to invest in a company or not but its important to note that ratios will work best when there are a number of options in terms of companies to invest in and they must belong to the same sector to provide a better comparison.
Damodaran,A.(2012). Investment Valuation: Tools and Techniques for Determining
the Value of any Asset, University Edition. John Wiley and Sons.
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