Investing in individual stocks can be a great way to diversify your portfolio, but it requires a solid understanding of the underlying businesses. To help you make informed investment decisions, let's explore eight crucial financial ratios that every investor should know.
EPS is a fundamental metric that shows how much profit a company generates for each outstanding share of stock. It's calculated by dividing net income by the total number of shares outstanding. While EPS is widely used, it's important to understand its limitations, as executives can influence this number through various accounting practices.
The P/E ratio is a valuation metric that divides a company's stock price by its EPS. It helps investors determine the value they're getting relative to the price they're paying for a share. Companies with high growth prospects often have higher P/E ratios, while those with average or below-average growth tend to have lower ratios.
ROE measures how efficiently a company uses shareholders' capital to generate profits. It's calculated by dividing net income by shareholder equity. A higher ROE generally indicates a better-performing business, but it's essential to consider that high returns can attract competition, potentially impacting future performance.
This ratio helps assess a company's financial leverage by dividing its total debt by its total capital.
ICR measures a company's ability to meet its debt obligations by dividing earnings before interest and taxes (EBIT) by interest expense. A higher ratio indicates better coverage for debt payments, but it's crucial to consider how this might change during different economic conditions.
This advanced valuation metric incorporates a company's debt financing, providing a more comprehensive view than the P/E ratio. It's calculated by dividing enterprise value (market cap plus net debt) by EBIT, allowing for easier comparison between companies with different tax rates or debt levels.
Operating margin measures the profitability of a company's core operations by dividing operating profit by total revenues.
Also known as the acid test, the quick ratio assesses a company's ability to meet short-term obligations with easily liquidated assets.