What ratios to use when searching the market for stocks to buy?
If you want to buy stocks, the wrong way is to follow your intuition and expect everything will work spontaneously.
Ratios important to make a profit in stocks is something we will explain to you why that is and how to calculate and examine them. The truth is, you have to favor investing and trading strategies to eliminate emotions. These ratios will give you insight into a company’s fundamentals and let you evaluate a company’s health.
Stock investing demands a rigorous analysis of financial data if you want to find out the company’s real worth. Investors commonly estimate profit, losses, check business accounts, cash flow, balance sheets. You might think it is too much work and give up or, what is really dangerous, you might buy a stock without any estimation, like you are buying a lottery ticket. Yes, sometimes evaluating the right stock can be hard and eat your time. The question is why should you do that? Instead, you can find a lot of these data free on the internet.
Understand ratios before buying
Much more before you buy stocks, it is very valuable to know how to calculate, understand, and read ratios when you see them. It doesn’t matter if you get them from your broker or you find them on the internet. Ratios are important to make a profit in stocks because they will tell you everything about the company you want to invest in. If you don’t estimate the ratios, the possibility of making the wrong investment decision will increase. Just ask yourself, do you really want to invest in a company with debt, that hasn’t enough cash to maintain it or support the operations, and moreover, has low profitability? To be honest, estimating ratios or calculating them isn’t a foolproof method but it is a way for fast checking of the company’s health.
What ratios are important to make a profit in stocks?
The most common categories are related to earnings and the balance sheet since they are crucial indicators of a company’s health. The crucial ratios show the company’s income and its ability to persist solvent. But you can use a lot more ratios important to make a profit in stocks and we would like to show you how to put them to work to help you make a proper investment decision.
So, let’s start!
P/E Ratios Important To Make Profit In Stocks
It is the most usually mentioned ratio. The price-to-earnings ratio is sometimes called P/E or just pE ratio. This ratio measures the share price correlated with the earnings per share. The P/E ratio is helpful when you want to compare the stock of one company with the stock of some other from the same industry. By using it you’ll be able to unveil if some stock is underpriced, overpriced, or in harmony with other companies in the same industry. This ratio is a very popular metric and the calculation is quite simple. All you have to do is to divide the value per share by earnings per share for one company. Calculate this ratio for the last four quarters (of course you can do this for several years) and if all of them were equal remember, the lower the P/E ratio is better.
Use forward earnings
Also, use forward earnings, which is the average of Wall Street’s projections for the current fiscal year. According to Benjamin Graham, it is proposed the stocks should trade for a P/E multiple equal to 8.5 times earnings plus doubling the growth rate of earnings. If you want to estimate some cheap stock, well, the P/E ratio maybe isn’t an adequate metric.
For example, the S&P 500 trades for 19,47 times during the past four quarters of earnings reports. The average P/E for the last 80 years is 15.86, which means the market is a little pricey. This is just an example and figures can be inaccurate at this moment.
So, if the P/E ratio is lower than average, it’s a sign that you’ve found a potential bargain. Well, you don’t have all the relevant data to decide whether to buy a stock or not. A lot depends on growth, so the next ratio to watch is the PEG ratio.
The PEG ratio is a pick of growth investors. To calculate it just divide the P/E by the company’s growth rate earnings expected in the next five years (this is the most accurate). Again, Graham, of course, and efforts to gauge the size of a discount or premium you will pay for growth. If the PEG ratio is less than 1 (which is low PEG), it implies the stock can be undervalued. Contrary, if the PEG ratio is higher than 1 or more, it is an indicator that the stock is overvalued. But the PEG ratio isn’t ideal, it has some downsides. By using the PEG ratio you are not able to predict future growth rates.
Use Price-to-Sales Ratios important to make a profit in stocks
P/S ratio is similar to the P/E ratio and to calculate it just divide the market capitalization by the company’s total sales for the last 12 months. So, put aside the earnings. This ratio will tell you how much you will pay for every single dollar in yearly sales. To make clear why we have to put aside the earnings. Well, there are periods when the company doesn’t have earnings so the total sales can tell better about the company’s value than the P/E ratio can. Maybe even more, because no one can manipulate the sales, earnings are something that can be manipulated. If the P/S ratio is low in comparison to other companies, that means a company could be a winning investment.
But be careful, sometimes a low P/S ratio can be spoiled if the company has a huge debt and permanent lack of profitability.
Price-To-Book or P/B
Use this ratio to compare the stock price to the company’s book value. A P/B is expressed as a difference between assets and liabilities, meaning assets minus liabilities. If P/B is low it may indicate a good buying opportunity. When the book value per share is higher than the stock price, it is an indicator that the stock is undervalued. The idea behind is to understand how much money you’ll have in case you sell all of it.
This is price multiple metrics. The P/B is used when comparing current multiples to historical averages. This ratio is useful for comparing the companies that provide some kind of services, for example, meaning they don’t have a real property. For instance, the equipment company has little book value but trade at very high P/B value multiples, sometimes 25 times over book value.
Price/Cash Flow or shorter P/CF ratio
It measures the value of a stock’s price related to its operating cash flow per share. It is particularly helpful for evaluating stocks that have positive cash flow but have non-cash charges and are not profitable.
The formula is
P/CF = share price / operating cash flow per share
You have to count the operating cash flow for the previous 12 months. Further, have a focus on cash generated by the company, forget depreciation from earnings, or amortization. This measure is better than the P/E ratio to compare the valuations of companies from different countries. You know that different countries have different depreciation charges and that may influence earnings. Lower P/CF is better, but remember, almost all companies have extra cash flow, not all is coming from the operations.
For example, free cash flow. It is the amount that the company owns after paying debts, dividends, buying back stock. If cash flow is negative it shouldn’t be a red alarm until it becomes a constant problem. If that is the case, the company can easily meet the solvency problem.
Why ratios are important to make profit in stocks?
Ratios important to make a profit in stocks are also dividend yield, dividend payout ratio, return on assets (ROA), return on equity (ROE), profit margin, a current ratio, etc.
There are so many tools, websites, reports that are useful. You have to analyze a stock before you buy it. Also, you have to know the time frame of your investment. We always say stock trading is different, it isn’t the same as investing. Researching stock will take some time, you can’t finish it in a few minutes. But it is completely irresponsible to buy any stock without researching and evaluating by using ratios mentioned above.
If you are a trader maybe this can help you. Test it with our preferred trading platform virtual trading system. In investing, permanent study and examination are crucial.