Question

No matter how much or how little you follow CNN, C-SPAN, MSNBC, etc. you have heard many of the financial statement ratios discussed in this chapter either in passing, on a TV show, from people quoting a bunch of ratios that have no idea what they mean, etc. After reading and studying this chapter and forming your own opinions on these calculations, let's say you had $1,000 to invest in a blue chip equity type stock with the sole intent of earning decent returns (it is subjective what this means I know) on such investment, short run or long run, what are the first 3 ratios that you might look up or calculate yourself to compare such investments/companies and why? Again, no right or wrong answers here, just good reasoning or not-so-good reasoning.

Answer 1

Suppose we had $1000 to invest in a blue chip equity type stock with sole intent of earning decent returns, the first 3 ratios that we can look up to compare such investments/ companies would be related to return criteria. These 3 ratios can be -

1. Return on equity - Considering the ultimate aim, Return On Equity ratio measures the profit of the company on each dollar of shareholders equity.

Return on equity is calculated as follows =

Net income / shareholders equity

Return on equity is a strong criteria for financial performance, as it is calculated after providing for debt. Investors generally prefer firms with higher ROE 's.

2. Dividend yield - This is the ratio that ultimately gives Investors the information that ultimately how much amount per share they are going to recieve. Out of earnings of the company, some amount is retained back in the company and balance is distributed among shareholders as dividends.

Dividend per share is calculated as =

Dividend declared / Number of outstanding shares

Stability in dividends indicate financial stability in the company.

3. Price to Book Ratio - It is also a very important ratio used to compare a company's market price to its book value. It indicates how much shareholders are paying for the net assets of the company. It is derived as follows =

Price per share / Book value per share .