Why Are Financial Ratios Important?

Ratios provide insights into a company’s performance by removing the influence of scale. For example, comparing two competitors:

• Company A has annual sales of $10 million and a profit of $1 million.
• Company B has annual sales of $2 million and a profit of $0.5 million.

So, which of the two companies is more profitable?

In absolute terms, Company A appears more profitable. However, when adjusting for sales differences, Company B has a higher net margin (25%) compared to Company A (10%), making it relatively more profitable.

Ratios are also used for:

Cross-Sectional Analysis: Comparing different companies at a relative level.

Trend Analysis: Evaluating changes in a company’s performance over time.

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Concepts for Stock Ratios

Earnings Per Share

Earnings per share (EPS) refers to the net profit earned by a company per outstanding common share, indicating profitability from the shareholder's perspective.

Specifically, there are two forms of EPS: basic and diluted.

• Basic EPS: Includes only current outstanding shares.
• Diluted EPS: Assumes all convertible financial instruments (e.g., stock options, convertible bonds) are converted into shares, resulting in more outstanding shares.

Since diluted EPS accounts for potential share dilution, it is always equal to or lower than basic EPS.

Market Capitalization

Market capitalization refers to the market value of a company. It is calculated by multiplying the current stock price of the company by the number of total outstanding shares:

Market Capitalization = Stock Price × Shares Outstanding

For example, company C has 100 million shares outstanding, trading at $10 per share. Its market capitalization is $1 billion.

Profit Margins

When looking at an income statement from any listed company, you can usually find three types of profit: gross profit, operating profit, and net income. The three types of profit margins are calculated below, generally in percentage.

• Gross Margin = Gross Profits/Revenues
• Operating Margin = Operating Profits/Revenues
• Net Margin = Net Income/Revenues

Profit margins measure a company's profitability, used in both horizontal and trend analysis. Now we can answer the question posed at the beginning of the article: Which company is more profitable? Even though company A has a higher net income, its net margin is 10% (=1÷10), lower than company B's net margin of 25% (=0.5÷2). We can conclude that Company B is more profitable than A due to its higher net margin ratio.

Price Multiples

Price multiples compare the stock price with specific fundamental data, e.g., earnings per share. It is often used to evaluate the relative worth of a company's stock.

Let's look at four price multiples.

Price/Earnings Ratio (P/E)

The P/E ratio measures the value of a company's stock price to its earnings per share.

P/E Ratio= Share Price/Earnings per Share

Suppose ABC Company has a P/E ratio of 30. It indicates that investors are willing to pay 30 times ABC Company’s earnings to purchase one share.

When buying stocks, in a sense you buy the rights to receive the firm's future earnings. Suppose Stock A has higher current earnings than Stock B. In that case, you are generally willing to pay a higher price to buy Stock A, assuming the two companies' profitability stays the same.

The Price/Book ratio (P/B)

Measures a company's stock price to its book value per share.

P/B Ratio = Share Price/Book Value per Share

The Price/Sales ratio (P/S)

Measures a company's stock price to its sales per share.

P/S Ratio = Share Price/Sales per Share

The Price/Cash Flow ratio (P/CF)

Measures a company's stock price to the cash flow per share, which includes free cash flow (FCF) and operating cash flow (OCF).

P/CF Ratio = Share Price/Free Cash Flow per Share

Or
P/CF Ratio = Share Price/Operating Cash Flow per Share

Dividend Yield

The dividend yield is the ratio of a stock's annual dividends to its current price, measuring how much cash dividends a company pays out relative to its share price.

Dividend Yield = Annual Dividends per Share/Share Price

For example, if a company pays $3.00 per share to common stock investors as annual dividends, and the stock currently trades at $90, its dividend yield is 3.33% (=3÷90).

‌Financial ratios offer a framework for analyzing stocks, assessing profitability, and evaluating valuation. Understanding metrics like EPS, market capitalization, profit margins, price multiples, and dividend yield can help you make informed decisions and identify companies that align with investment goals.

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Reference:

Introduction to Financial Statement Analysis. (2022) CFA® Program Curriculum Level I (Vol. 2).

Financial Analysis Techniques. (2022) CFA® Program Curriculum Level I (Vol. 3).