A fundamental part of stock trading is learning how to calculate ratios and using that data to perform lucrative trades. You might have heard about the P/E ratio before and maybe even the PS ratio, but what exactly are they and how do you calculate them?
Before we can talk about ratios and how to use them you need to understand the two most popular ways one can analyze a company stock. The first method is called a technical analysis and it’s based on the idea that one can predict how a stock price will develop by studying the market and the stock price. When performing a technical stock analysis you assume that prices always move in trends and that history tends to repeat itself. This basically means that you look at how a company’s stock price has developed in the past and base your predictions on the concept that the stock will continue to develop the same way in the future.
This type of analysis is highly effective and used by many stock traders and the idea can be applied to other markets and securities too. However, it doesn’t require any ratios to be performed since it’s based on the actual market itself.
The second type of analysis is called a fundamental analysis and unlike the technical analysis, this method is based on information obtained from the company itself. By using different key numbers and ratios, you can calculate how much the market would pay for a company or its stock and also get an idea of whether a stock is under or overpriced. This data is then used to predict the future of the company shares and you’ll decide if you want to invest or look for another stock to buy.
To calculate stock ratios you first need to understand what the following terms mean.
- Earnings per share (EPS) – This is one of the most important numbers for any shareholder and it entails how profitable a stock has been. You get the EPS by dividing a company’s profit by the number of outstanding stocks. Essentially, it shows you how much profit the company has made on a per stock level. Note that there are two kinds of EPS, either a basic EPS based on the average from the past 12 months or an estimated EPS which is a 12-month projection.
- Stock Price – The price per stock is exactly what it sounds like, it’s a number that shows how much one stock in a company costs at any given time. Naturally, this number is constantly changing, and you can find the latest one for any company in our stock price graph.
- Market Value – How much is the company worth? The market value tells you the total value of a company based on the stock price, and you get this data by multiplying the number of outstanding stocks with the stock price.
PE Ratio is short for Price/Earnings ratio, and this is the most commonly used financial ratio there is today. It’s easy to understand, quick to calculate, and it provides a good idea of how a company is doing.
To calculate the P/E of a company’s stock you need access to two variables, the stock price and the earnings per share, and by dividing these two you get the P/E ratio as follows.
Let’s say a company stock sells for $1,000 (stock price) and the company’s EPS is 20, that means the P/E is 50. (1000/20 = 50).
You can find the current stock price in any stock price graph and the calculation is always based on the current price. However, it’s up to you to decide whether you want to use a basic EPS or an estimated EPS to either get a trailing P/E or an estimated P/E. Generally speaking, the estimated EPS is better when planning an investment since it’s based on predictions of what will happen to the company and not what has happened to it.
A high P/E ratio tells the investor that they are paying more for a stock than it’s projected to provide. A low P/E tells the investor that the stock might be undervalued and that it has potential to grow, i.e. be a good investment.
What’s a PEG Ratio?
The PE ratio might be the most popular financial ratio there is but it doesn’t mean it’s not flawed. In fact, there are several issues with the PE ratio that makes it limiting and a bit inaccurate. Because of this, an updated version of the PE ratio has been developed and it’s referred to as PEG ratio or price/earnings to growth ratio.
The difference between the PE ratio and the PEG ratio is that the PEG also focuses on a company’s growth. By calculating the PEG, you answer the question of how much a stock is worth in comparison to how fast the company is growing.
To calculate the PEG you take the P/E ratio (see above) and divide it with the company’s estimated growth (Forecast Earnings Growth).
Compared with the PE ratio, a PEG ratio provides a more comprehensive prediction for how the company and stock price will develop.
A P/S ratio is an indicator that measures the stock price in comparison to a company’s annual sales. The idea behind the PS ratio is to figure out how many times an investor has to pay for every dollar that the company sells for.
To calculate the P/S ratio you divide the company’s sales with the price per share based on an average of outstanding shares throughout the past 12 months.
Other Important Financial Ratios
In addition to the above-mentioned ratios which are the three most commonly used stock ratios, there are other ratios you should know about. For example, the Debt to Equity Ratio that compares a company’s liabilities with shareholder equity, and the Price to Book Ratio that compares the per share price with a company’s book value. Then there is the Current Ratio that’s used to determine if a company’s short-term assets can be used to pay off its short-term liabilities.
The last ratio we’ll mention is the Payout Ratio which focuses on dividends and more importantly on the status of a company’s dividend. This ratio is only used by investors who base their investments on available dividends and it’s used to predict whether there is a risk that the dividend will be cut. A high Payout Ratio means the dividend is at risk and a low ratio indicates that the dividend will be kept as it is or even increased.
Some Last Few Tips on How to Best Use Stock Ratios
Understand that all the information needed for these calculations can either be found on most stock pricing tools or they are provided at the discretion of the company as a part of their quarterly and annual reports. Also, some of the more advanced stock price graphs even provide investors with the ratios already calculated, this is especially true for the P/E ratio.
If you’re going to use any of the above ratios to compare two companies, there is one thing you need to remember. You should never use a ratio like the P/E or P/S to compare companies in different industries since it will diffuse the results. For example, a high P/E ratio in the construction industry isn’t necessarily a high number in the tech industry or vice versa. Always use stock ratios to compare companies in the same industry.
Finally, note that non of the stock ratios mentioned in this post are accurate enough to base an investment on alone. Instead, the best strategy is to use several of them and combine the data from more than one ratio to take your final decision. For example, a stock might have a great P/E ratio but not a good P/S ratio, meaning it could be better to invest in another stock that has a decent P/E and P/S ratio. Generally, you want to avoid investing in over valued or priced stock and focus your attention on undervalued stocks with great potential to grow.