The following are the most know financial ratios among investors and analysts. They are used to help in evaluating the fair values of the shares of listed companies:
Price – to – Earnings Ratio (P/E)
To examine the company’s profits attributable to its share price, investors should view the so-called Price – to – earnings ratio (P/E). It is sometimes called the multiplier. To calculate the multiplier, the share’s market value is divided by the earnings per share.
The P/E refers to the price level that investors want to pay for each real profits of the company. It also refers to the time required to cover the amount paid by the investor to buy the stock on the assumption that the company would deliver the same returns in the coming years. The higher the company’s Price-to-Earnings ratio the more indication there is for the share’s market value inflation. But if the company has a high P/E value and at the same time has great opportunities for achieving high profits or high growth in the future, its stock will remain attractive for investors despite the high price.
And contrary to the previous, the decline in price to earnings ratio for the company below the sector’s average indicates the reduction in the assessment by investors of the company’s share price in the sense that investors in the company price its stock for less than the potential or expected price. The investor should pay attention to the possibility that a company with low price to earnings per share suffers from poor management or that there are substantial reasons for its failure to attract investors to invest in its stock.
Price – to – Book Ratio (P/B)
It is used to compare a company’s book value to its current market price P/B. An investor could calculate the price-to-book ratio per share by dividing the shareholders’ equity ( Assets – Liabilities) on the number of the company’s issued shares. For example, if a company shows in its balance sheet that it has assets worth 200 Million Riyals and liabilities worth 125 Million Riyals then the company’s book value would be 75 Million Riyals. If there was 25 Million outstanding shares, the book value per share would be 3 riyals.
According to the above, and assuming that the share’s market value is 27 Riyals then the P/B equals 9. It is better if the value, the investor pays to buy shares, is close to the book value per-share. That is because the outstanding share value is covered and guaranteed by the company's available liabilities. The rise in this percentage might reflect, in a way, the investors’ high evaluation of the company’s performance.
Return on Shareholders’ Equity Ratio (ROE)
The ROE measures the percentage of the company’s profit to shareholders’ equity in it. It is calculated by dividing the company’s net income on shareholders’ equity.
For example, if the company’s net income for the past year is 400 million Riyals and the total of its shareholders’ equity is 800 million Riyals, then the ROE is 0.5 or (400million ÷ 800million = 0.5).
In general, whenever there is a rise in the rate of return on shareholders’ equity (ROE), that shows a strength in the company’s performance. It is considered a clear indication on the good management where the company’s (ROE) would be with time ahead of the companies’ average in the same sector (ROE). This average increase might sometimes reflect the company’s tendency to finance its activities in debt even with a weak rate of return on assets It is useful for this indicator not be considered separately from other indicators.
Return on Total Assets Ratio
The rate of return on assets could give the investor an idea on how a company manages and invests its assets. It could be calculated as:
In general, whenever the rate of return on assets is increased it indicates efficiency in the company’s management and assets investment.
Current Ratio
It measures the company’s available cash at the current period. It could be calculated by dividing the company’s current assets on its current liabilities. For example, if the company’s current assets is worth 50 million Riyals and current liabilities worth 33 million Riyals then the current ratio is 1,5.
In general, if the company’s current ratio is greater than 1 and less than 2 then that mean that the company is ready to cover its obligations and short term operating expenses. But if the current ratio exceeds this, it might indicate the management’s failure in reinvesting the assets in order to develop its work and that could negatively reflect on the company’s long term revenue. As previously noted in talking about financial accounting ratios, it is important to compare the current ratio of the company in question with other competitors operating in the same sector as well as with the companies operating in the entire sector’s average current ratio.
Quick Ratio
It is calculated by dividing the current assets subtracted by the inventory on current liabilities. By subtracting the inventory from the current assets we can know the company’s ability to cover its current obligations without liquidating the inventory which could be considered a great loss since it is the least current assets that are able to be liquefied.
If we used the previous example, if the company’s inventory are 10 million Riyals then its quick ratio would be ( 50 million – 10 million = 40 million ÷ 33 million = 1.21). 1.0 or more quick ratio is considered a good indicator that the company could cover any immediate expenses and that it is running smoothly in its area.
Liquidity Ratio (Cash Ratio)
It is considered the least used indicator but it is useful when the investor wants to know the liquidity size of a company compared to others. It could be calculated by dividing the company’s cash plus its marketable securities on the company’s current liabilities. A liquidity ratio could be beneficial when comparing two small emerging companies that have high growth potential and are extremely competitive. If these two companies are equal in everything, the company that has a higher liquidity ratio would be prepared to win over its competitors.
Price – to – Sales Ratio (PSR)
Even if the company didn’t profit from managing its business, it gets revenue every time a service is offered or a product is sold. The price to sales ratio is a way to evaluate the company’s value based on its revenue. This ratio is presented as a multiplier and is calculated by dividing the company’s current capital value by the per-share revenue in the past year.
For example, if the company’s capital value in the current market price is 100 million Riyals (20 million shares x 5 Riyals per share) and its last twelve months sales is 300 million Riyals, then the PSR equals (100 million ÷ 300 million = 0.33).
Whenever the PSR is decreased, the investment value in the company is better. Most analysts think that an investor should search for a PSR below 1.0 when choosing between a group of companies to invest in one of them.
