5 Financial Ratios Every Investor Needs to Understand

By Markets Fool.com

Financial ratios are powerful tools when it comes to investing. Terms like "P/E" and "PEG" get thrown around a lot, but many investors don't know what they mean or how they're used. While they may seem like mere numbers on the surface, they have a way of telling a unique story about a company's health and position relative to the overall market. I'll use two stocks as examples when examining these ratios: Netflix (NASDAQ: NFLX) and Pfizer (NYSE: PFE).

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Earnings per share
One of the most important factors used in determining a company's stock price, the earnings-per-share (EPS) ratio, will tell you how much of a company's earnings, or net income, can be allocated to each outstanding common share. Preferred shares are eliminated from this calculation. This particular metric can show how profitable a company may be from the individual shareholder's perspective.

So the formula is:

Earnings per share = (net income - dividends from preferred stock) / average outstanding shares

Company

EPS

Netflix (as of 2/9/16)

$0.28

Pfizer (as of 2/9/16)

$1.24

Based on these EPS figures, each common share of Netflix can account for $0.28 of Netflix's net income, and each common share of Pfizer can account for $1.24 for Pfizer's net income. From the perspective of the investor, and the company as a whole, it's better to have a higher EPS reading, because higher EPS means the company is generating greater profits, which can eventually be distributed to shareholders.

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We'll need this ratio to calculate the price-to-earnings ratio.

P/E ratio
The price-to-earnings (P/E) ratio is a good measure for determining how much an investor can expect to pay toward a stock to yield $1 of the company's future earnings. If a stock has a high P/E, that means the company's share price is high compared to the money it's bringing in. A high P/E ratio can often reflect an overpriced stock, while a low P/E ratio can signal an opportunity for value investors, as it signals that the share price is low relative to the earnings per share.

However, a word of caution: The P/E ratio alone does not represent a stock's value, and it can be affected by many different factors. For instance, because high-growth companies' earnings are expected to grow rapidly in the foreseeable future, their P/Es are often high. Further, the average P/E varies across industries, so keep this in mind when making cross-industry comparisons.

The formula is for P/E is simply this:

Price to earnings = stock price / earnings per share

Company

P/E

Netflix (as of 2/9/16)

307.61

Pfizer (as of 2/9/16)

24.43

Netflix is in the business of providing streaming video. As its sky-highP/E ratio of 307.61 indicates, Netflix's stock commands a high valuation compared to the company's earnings. This is mainly due to the hype surrounding Netflix's online streaming business and the earnings growth this service is expected to drive. Meanwhile, Pfizer is a more established company in the pharmaceutical/drug manufacturing industry where investors expect future earnings growth to be more stable. The pharmaceutical industry in general consists of companies with varying P/E ratios. With a P/E ratio of 24.43, Pfizer falls pretty much in line with the industry average of 21.4.

Dividend yield
The dividend yield shows how much a company pays out in dividends to its investors relative to the company's stock price. Dividends are the portion of net income a company decides to pay out to its investors. The dividend yield is useful in that it is universally applicable to any stock, regardless of how large or the small the company may be.

The formula is:

Dividend yield = annual dividends per share / stock price

Company

Yield

Netflix (as of 2/3/16)

N/A

Pfizer (as of 2/3/16)

3.94%

It is up to a company's board of directors, elected by shareholders, whether or not a company will pay out dividends. While dividend payouts are usually left to the discretion of the company, such payouts are often shaped by the stage of the life cycle the company finds itself in. More established companies with reliable earnings would most likely be inclined to offer a dividend to its investors. Newer companies with less reliable earnings projections may feel that company profits should be reinvested into the company's operations as the company is presented with new opportunities for growth. Netflix doesn't report a dividend yield because the company doesn't distribute dividends to its shareholders. The most probable reason is that Netflix uses its profits to invest in what it sees as growth opportunities. Investors who believe in Netflix's growth prospects are willing to invest in the company without receiving dividends.

Price-to-sales ratio
The price-to-sales ratio is something you would use when judging a company's value relative to its industry competitors. This ratio basically measures a company's stock price against the company's annual revenue.

The formula is:

Price-to-sales = stock price / annual net sales per share

Company

P/S Ratio

Netflix (as of 02/3/16)

5.78

Pfizer (as of 2/3/16)

3.84

When using the price-to-sales ratio to value a stock, it's best to use it as a comparison to other stocks within the same industry, as companies within a single industry tend to fall within a narrow range of price-to-sales ratios. For example, consumer-staples companies may ordinarily show a higher revenue stream than companies involved in research and development. Netflix's P/S ratio of 5.78 significantly exceeds the average of 1.8 in the communication services industry. This owes to the market's relatively high valuation of the stock. Pfizer's P/S ratio of 3.84 is in line with the drug manufacturing industry average P/S ratio of 4.

Debt ratio
The debt ratio measures how much debt a company is taking on compared relative to the assets it holds. That's why the debt ratio is also referred to as the debt-to-assets ratio. This is an important measure of debt because a company's total assets are made up of shareholder equity and total liabilities; the debt ratio simply measures how much of a company's assets debt accounts for. Typically, a higher debt ratio can mean that a company is too highly leveraged and is at risk of defaulting on its debt obligations. On the other hand, it can also mean the company is justifiably borrowing money to pursue greater opportunities. These are all things investors must consider when forming a picture of a company's overall financial position.

The formula is:

Debt ratio = total debt / total assets

Company

Debt ratio

Netflix (as of 12/31/15)

0.78

Pfizer (as of 9/27/15)

0.61

Netflix is slightly more leveraged than Pfizer. Netflix's total debt is measured at roughly $5.2 billion, with its total assets totaling $7.06 billion. Pfizer's total debt is estimated at $98 billion, with total assets at $169 billion. Figures such as assets and debt (liabilities) can be found on the company's balance sheet. Because the debt ratio can be characteristic of a company's industry, size, or niche, it is important to take such factors into account when determining a company's debt risk, which can be quite subjective.

The big picture
These ratios are all important for sound investment analysis, and industry professionals regularly use them. But one single ratio on its own should not be interpreted as a complete picture of a company. Rather, each gives a different perspective of a company's financial health and investment viability. Keep in mind, too, that to truly understand a company, you often have to look beyond its ratios. Regardless, ratios are a great place to start. Studying these different metrics will give you a better shot at making the right investment choice.

The article 5 Financial Ratios Every Investor Needs to Understand originally appeared on Fool.com.

Helen Simon owns shares of Pfizer. The Motley Fool owns shares of and recommends Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.