6/11/24
Ratio Analysis
Author: David Sun
Editor(s): Kushagra Sadwal
In evaluating a company, one commonly used step is ratio analysis. As the name implies, ratio analysis is when we compare two values from a company’s financial statements and consider the implications of said comparison. For example, we may evaluate trends in a company’s ratios and compare the ratios between companies. Let’s take a look at a few widely used ratios:
Price-to-Earnings Ratio
Often abbreviated as P/E Ratio, this is a company’s share price divided by its earnings per share (EPS). This comparison is usually made quarterly. A company’s share price is the price it’s trading at (as the name suggests) and its EPS is its net income divided by the number of outstanding shares. However, it is unnecessary to calculate EPS since it is reported by all publicly traded companies in their quarterly reports.
A lower P/E Ratio is viewed as more favorable. Intuitively, this makes sense. This would mean that a company can generate more profit while also being cheaper to invest in. Generally speaking, the average P/E Ratio is between 20 and 25. Anything below this range is usually considered good and anything above this range is usually considered bad. However, it is more useful to compare a company’s P/E Ratio to its industry’s average and competitors.
Return on Equity
Often abbreviated as ROE, this is a company’s net income divided by its shareholder’s equity. This comparison is usually made on an annual basis. A company’s shareholder’s equity is its total assets minus its total liabilities. Both of these values, as well as net income, can be found on a company’s annual reports.
A higher ROE is viewed as more favorable. This would mean that a company can generate more profit per dollar that its shareholders have invested in it. Generally speaking, the average ROE is between 15-20%, so anything above this is usually good and anything below this is usually bad. However, it is more useful to compare a company’s ROE to its industry’s average and competitors.
Dividend Yield
A company’s dividend yield is its annual dividends per share divided by its share price. This comparison is made every year. A company’s annual dividends per share are divided by the number of outstanding shares. These values can be found on a company’s annual reports.
Unlike the two previously discussed ratios, there isn’t a definite way to say whether or not a company’s dividend yield is a good sign. This is because higher dividend payouts often come at the expense of spending on research and development. Thus, it is important to consider the context of a company’s dividend yield when determining whether or not it is a strength or a weakness.
Conclusion
By analyzing a company’s ratios, we may get a better idea of its financial health and cost structure. This allows us to make comparisons between competitors and more informed decisions as investors.