Financial Ratios Explained: Analysis, Formulas, and Types

In our earlier posts, we covered the key ratios for company valuation. However, there are additional financial valuation ratios that can be highly useful in comparing companies and determining their relative attractiveness. 

While they may not be as well-known, some of these ratios include Free Cash Flow Yield, Book Value Ratio, and Earnings to Growth Ratio.

Don't let their lack of fame fool you—they pack a punch!

chart showing financial ratios

What are Financial ratios?

Generally, ratios are usually used to compare companies in the same sector and of a similar size or to compare them with the historical average of the company itself.

We must know that ratios can be calculated using two magnitudes: either aggregated values (market capitalization, profits…) or per-share values.

We can compare the market capitalization with another aggregated magnitude (profits, sales, book value, etc.) or compare the price per share with earnings per share (sales per share).

Key Financial Ratios

  • Price/Book Value Ratio \ Price/Book Value
  • Price/Earnings To Growth Ratio \ PEG Price/Earnings Growth
  • Price/Sales Ratio \ Price/Sales
  • Dividend Yield \ Dividend Yield
  • Enterprise Value Multiple \ EV/EBITDA: Enterprise Value/EBITDA
  • Free Cash Flow Yield \ Free Cash Flow/Market Capitalization

Price to Book Value Ratio | Formula and Interpretation

This financial ratio tells us the relationship between market capitalization and book value. We could also divide the share price by the book value per share.

price book ratio

To calculate book value, you subtract liabilities and intangible assets from assets.   This relationship tells us how much we would be paying for the company if it were declared bankrupt immediately. And generally:

  • A low ratio indicates that the company is undervalued, although it could also be due to something bad happening in the company, and therefore it would help in the comparison of other companies in the sector as well as other valuation ratios.
  • And conversely, an excessively high ratio means that the company is overvalued or that its growth expectations are incredibly high, although this is usually the first option.

Book value would be the “minimum value” of the company, since it does not take into account future profits.

PEG (Price-Earnings-Growth) ratio: Formula and interpretation

This ratio takes into account not only the company’s profits, as does the PER (price-earnings ratio), but also the relationship of the price to the growth of profits.

At first, this ratio would give us more complete information about the behavior of the benefits in relation to the stock quotation than the PER. 

We must take into account that while a high PER could lead us to think that the company is expensive, the PEG could be telling us something else and that is why we are going to see the formula of how the PEG is calculated

peg ratio

The PEG tells us if a stock is overvalued or undervalued, although it is not a precise indicator for companies with low or high-profit growth. Growing companies usually use it.

The interpretation of the PEG is:

  • A low ratio indicates that the stock is undervalued
  • A high ratio would indicate that the stock is overvalued.

Price/Sales Ratio | Formula and Interpretation

It tells us the relationship between the quotation price and the sales per share, or analogously, the relationship between the market capitalization and the sales. This relationship tells us what value the company gets for each dollar earned. It is a ratio used to compare companies in the same sector.

Next, the formula for the price-to-sales ratio is expressed, along with an example:

Image showing the relationship between the quotation price and the sales per share
 Image showing the relationship between the quotation price and the sales per share

In this example, whose share price is 10 units, we would calculate the market capitalization by multiplying by the number of shares outstanding.

Then we see how it can be calculated in two ways:

  • Using aggregated data (market capitalization/sales).
  • Calculating per share data. For this, sales should be divided by the number of shares outstanding.

Regarding the interpretation of the price/sales ratio:

  • If the result of the division between the market capitalization and sales is low, the company may be undervalued,
  • And as always, if the ratio is high, the company may be overvalued.

Dividend Yield | Formula and Interpretation

The dividend yield tells us the percentage we will receive in dividends paid by the company on our investment.

We must take into account whether the dividend is paid from the company’s cash flow if it is paid using debt, or if it is done through successive capital increases.

It is calculated from the percentage of profits that the company distributes among the shares, which gives us a dividend per share, and that dividend per share will represent a percentage of the quotation price or the price at which we acquire the shares.

In fact, the dividend is so widely quoted, that there are even strategies that focus solely on dividend investment.

So, the formula for calculating dividend yield is

Image showing the formula for calculating dividend

And regarding its interpretation, in this case, it is simple: the greater the percentage given by the result obtained, the greater the dividends will provide for the investment, so perhaps it would be convenient to invest a larger amount.

Finally, regarding the ratios EV/Ebitda and Free Cash Flow Yield, I will not extend myself in this post since you can consult what they are, how they are calculated, and how you should interpret them to know how to value a company in the link that I have left you in this same paragraph.

In short, there are many ratios to evaluate through fundamental analysis, that is, analysis of the value of companies as reflected through their financial statements, or how much a company is worth. From more classic ratios such as PER or EV/ Ebitda to other company valuation ratios such as dividend yield or price/book value.

FAQs

What does the PEG ratio reveal about a company's growth prospects?

The PEG ratio combines a company's price-to-earnings ratio and its projected earnings growth rate. A lower PEG ratio may indicate an undervalued stock with strong growth potential.

How can financial ratios be used to compare a company against its competitors and industry peers?

Comparing financial ratios against competitors and industry peers helps gauge a company's relative performance and identify areas of strength or weakness. Benchmarking provides context and aids in decision-making.

What are the key differences between profitability ratios and liquidity ratios?

Profitability ratios measure a company's ability to generate profits, while liquidity ratios assess its short-term liquidity and ability to meet obligations. Both ratios provide distinct perspectives on a company's financial health.

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