Financial Valuation Ratios Explained

5/7/09 - Update - we have decided to stop including financial valuation ratios in our picks for the time being. The main reason for this is that we don't update the ratios, and by the time you read the article pick, the ratios will have changed. We will continue to focus on changes in ratios or valuation figures that change over time and directly impact a company's financial health. For example, if a company is loaded with cash but has an increasing amount of AR (Account Receivables), and an inventory that is out of control, we'll make sure to take this into account. Please always note the date of the article - as our evaluation stems from that date, and the financial figures that were applicable at that time. If we update an article, we will post an update date similar to the one above.

Financial valuation ratios explained

These fundamental ratios are comparisons of a company's financial health relative to its industry. We explain growth, pricing, profit margin, and debt to equity ratios. Please note that green numbers are positive, or represent an increase in value, whereas red numbers (in parenthesis) are negative, or represent a decrease in value. Please note that the numbers below are made up and don't apply to any particular company or data source.

Quarterly Growth (compared to year ago quarter)

Quarterly growth shows the increase in sales and net income from the most recent quarter, compared to the same quarter one year ago. Because seasonal variations can impact sales, and some companies operate in cyclical industries, a comparison to the same quarter (same time of year) is essential to prevent seasonal and cyclical variations from being factored in.

We arrive at our result by subtracting the industry growth statistic from the company one and rounding off. A higher percentage is better.

• Growth: Company % - Industry % = Difference %
• Sales : 12.90 - 7.70 = 5%
• Net Income : 110.20 - 45.40 = 65%

Annual (5 years) Average Growth

Annual growth over a period of 5 years is a good way to gauge the long term health of a company. If a company has been outperforming its industry for 5 years or more, the odds of the company's financial performance stemming from sound business practice, as opposed to the upshot of one or two successful quarters, increases.

We arrive at our result by subtracting the industry growth statistic from the company one and rounding off. A higher percentage is better.

• Sales : 23.31 - 15.33 = 8%
• Net Income : 35.50 - 29.89 = 6%

Price Ratios (Earnings, Sales, Book, and Cash Flow)

Price ratios are used to gauge a company's present value compared to the industry it operates in. The P/E ratio (price to earnings), one of the most commonly used indicators of a company's financial valuation, takes the company's earnings into account relative to its price. Taken by itself, the P/E ratio doesn't mean much, but when compared to its industry, it provides a meaningful indicator of valuation according to earnings. The P/S ratio (price to sales) is used by some analysts in lieu of the P/E ratio, especially in industries where sales are more indicative of a company's valuation than earnings (which can be manipulated) are. The P/B ratio (price to book) gives us an idea of the company's valuation relative to its book value. A company's book value is derived by dividing its net worth by the number of shares outstanding. Finally, the P/CF ratio (price to cash flow) gives us an idea of the company's health in terms of its cash flow. A cash rich company, relative to its competitors, will have a better chance of surviving a downturn in the economy.

We arrive at our results by dividing the company ratio by the industry ratio. A lower ratio is better.

• Price Ratio = Company / Industry = Ratio
• P/E = 11.30 / 9.10 = 1.24
• P/E (5 yr Low | Current | 5 yr High) : 10.50 | 11.30 | 23.70
• P/S = 0.25 / 0.65 = 0.38
• P/B = 1.26 / 1.05 = 1.20
• P/CF = 5.50 / 4.20 = 1.31

Net Profit Margin and Debt to Equity Ratios

Net profit margin is a key indicator of a company's financial health. After expenses, how much money is the company making? We compare this ratio to the margins of a company's competitors to gauge its performance relative to its industry. The D/E ratio (debt to equity) gives us an idea of how much debt a company has piled on its balance sheet. In an economic downturn, a high debt load can prove fatal to a company.

For the net profit margin, we arrive at our result by calculating the difference (ie. subtracting) between the company ratio and the industry ratio. A higher result is better.

For the debt to equity ratio, we arrive at our result by dividing the company ratio by the industry ratio. A lower ratio is better.

• Ratio = Company - Industry = Total Ratio
• NM = 1.40 - (-0.80) = 2.20
• D/E = 1.09 / 1.22 = 0.89

How to evaluate financial ratios

The above financial ratios are not necessarily indicative of a company's overall financial health, and the numbers mean less in some industries than in others. Biotechnology companies, for example, won't turn a profit for years, and therefore will have negative profit margins. Once they do, however, the value is usually long factored into the stock price, as investors try and get in on a run in the stock price prior to the news. Furthermore, important statistics such as inventories and AR (accounts receivable) are not necessarily reflected in these ratios, nor are particular growth trends that can be derived from financial statements. However, these financial ratios do provide a good starting point for evaluating a company, and therefore we take them into careful consideration when evaluating a company.