Check These Ratios Before Investing in a Stock

If you are planning to invest in a stock over the long term, it is crucial to perform extensive fundamental analysis and check if the stock is overvalued or undervalued. The valuation of a stock is one of the most important aspects to consider for long-term investments.

An undervalued stock is generally considered to be more lucrative in the long run because its price is expected to increase when a market correction occurs and investors realise the true value of the stock. Conversely, an overvalued stock may depreciate in the long run when the market corrects itself. 

This is why it is crucial to analyse the valuation of a stock before you purchase it. Financial ratio analysis can help you with this.

What is Financial Ratio Analysis?

Financial ratios compare different financial metrics of a company to draw inferences about its financial strength, leverage position, capital usage, revenue, profitability and valuation.

Financial ratio analysis involves computing and interpreting these ratios, so you can better understand the valuation and financial position of a company before investing in it. To effectively understand if a company makes for a good investment, there are various ratios for stock analysis, as you'll see in the following section.

Key Financial Ratios to Analyse Before Investing in a Stock

It helps to have a checklist of different metrics you need to evaluate Check out the top ratios for stock analysis below.

P/E Ratio

This ratio compares the current price of a stock to the company's Earnings Per Share (EPS). The formula for the P/E ratio is:

Price-to-Earnings Ratio = Current Price per Share ÷ Earnings per Share

If you are looking for valuation ratios in stock analysis, this is one of the best metrics to look into. By comparing the current price of a stock to its EPS, you can gauge if the market values the stock higher or lower than its true worth.

Return on Equity (ROE)

This financial ratio compares the net income earned by a company with its total shareholders’ equity. The formula for ROE is as follows:

Return on Equity = Net Income ÷ Shareholders' Equity 

This ratio essentially tells you how a company is utilising its equity capital. A high ROE means that the entity is efficiently using its equity to generate income. Conversely, a low ROE may be a sign of poor financial management as the company's equity is not sufficient to generate high revenue. 

Return on Capital Employed (ROCE)

Like the ROE, the ROCE is also a profitability ratio used in stock analysis. Here, you compare the EBIT of a company with its total capital. The formula is:

Return on Capital Employed = Earnings Before Interest and Taxes ÷ Capital Employed 

This financial ratio can help you gauge how well a company is using its capital to generate profits. Naturally, a high ROCE is preferred as it means a company is efficiently using its capital to carry on its business gainfully.

Debt-to-Equity (D/E) Ratio

As the name indicates, this metric is used to assess how much debt a company has in comparison to its equity. The formula for this ratio in stock analysis is as follows:

Debt-to-Equity Ratio = Total Debts ÷ Shareholders’ Equity

A D/E ratio of 1 means that a company's debts equal its equity. Any D/E ratio more than 1 means that a company does not have enough equity to cover its debts. Conversely, a ratio of over 1 means that a company's equity exceeds its debts. This is why D/E ratios of 1.5 or more are preferred by investors.

Current Ratio

The current ratio helps you check how a company's current assets compare to its current liabilities. This gives us the following formula:

Current Ratio = Current Assets ÷ Current Liabilities 

It is essentially a liquidity ratio that measures whether a company has enough current assets (like cash, inventory and accounts receivable) to repay its current liabilities (like wages and salaries due, accounts payable, tax liabilities and the like). A high current ratio (generally 2 or more) is preferred because it indicates sufficient liquidity.

Quick Ratio 

The quick ratio is another measure of a company's short-term liquidity. It is similar to the current ratio, except that it does not consider inventory and prepaid expenses in the current assets. So, the formula for the quick ratio in stock analysis is:

Quick Ratio = (Total Current Assets — Prepaid Expenses — Inventory) ÷ Current Liabilities 

A high quick ratio is a sign of high immediate liquidity because the company has enough immediate liquid assets that can be converted into cash to pay off its current debts and liabilities.

Dividend Yield Ratio 

This financial ratio is useful in the assessment of any company that pays out dividends — which is a portion of its profit that is distributed to its shareholders. The formula for this metric is as follows:

Dividend Yield Ratio = Dividend per Share ÷ Market Price per Share

A high dividend yield ratio means the company pays out substantial dividends. This may be useful if you are looking for a stable source of passive income. 

Conclusion 

These are some of the most common metrics usually evaluated in ratio analysis. You can check these ratios for the stock you are interested in or even compare the financial ratios of two or more stocks to understand which of those stocks may be a better addition to your portfolio.

The Motilal Oswal Research 360 platform can help you with this. All you need to do is search for the stock you want to analyse, and this all-in-one platform shows you the comprehensive financial ratio profile for that security — including valuation, liquidity, profitability and return ratios for stock analysis.

Sign up on the Motilal Oswal Research 360 platform today to make fundamental analysis of stocks easier and more efficient