Accounting Ratio in the Purchase of Common Stock
Original post by Dana Griffin of Demand Media
Financial ratios show a breakout of a company's performance and profitability. They can help investors determine if a particular stock is a good investment, and how much risk they are taking. Accountants use many important ratios including price, growth, profitability, investment and ratios of financial condition. All these numbers together help determine the fiscal health of a company, so investors should never depend on just one on its own.
Earnings per share (EPS) represents the profit per share the company makes. To find the EPS, first take the net income of the company and subtract any preferred dividend payouts. Now, divide that number by the total number of outstanding common shares.
Price to Earnings Ratio
The price to earnings (P/E) ratio shows what shareholders think will happen to a company's income in the future. The P/E ratio equals the present market price of the stock divided by the EPS. Depending on the information used, the P/E ratio falls under one of two classifications: trailing P/E and forward P/E. The trailing P/E uses the previous fiscal year's net income to determine the EPS, while the forward P/E uses the current quarter or upcoming year's projected income by a group of analysts.
PEG Ratio and Book Value
The PEG ratio takes the P/E ratio and divides it by the company growth rate. A lower PEG indicates a better investment. A company with a P/E of 30, and a growth rate of 30 percent, would have a PEG of 1 -- but if it only has a growth rate of 15 percent, the PEG changes to 2. Investors must watch companies closely because growth rate often changes rapidly, increasing the PEG. Book Value is a special number determined by dividing the stockholders' total amount of equity by the total number of common stocks. Book value takes into account all belongings, property, offices, owned by the company. Different from fair value or market value, book value includes items that can be difficult to liquidate. Comparing book value with EPS, P/E and PEG can help determine which stock has the best investment potential.
Dividend Yield Ratio and Return on Equity
Dividends are any income paid out to shareholders by a company. Unless the company is making greater profit than it needs to reinvest, you won't be making dividend income. To calculate the dividend rate, divide the annual cash dividend per share by the market price per share. To predict if the company can afford to continue paying the same dividends in the future, use the dividend payout ratio. To do this, take the annual cash dividend per share, then divide it by the EPS. Look for dividend rates below one for a positive outlook. Unlike the other ratios, return on equity (ROE) isn't used to determine investment risk. Instead, analysts use it to show the shareholder income compare to total equity. To find ROE, first subtract preferred shareholder dividends from the net income, then divide the total by the average common equity, or the equity per share. ROE compared to total debt or the interest rates on borrowed funds shows what kind of risk the company takes, and how it uses its capital.
- Money-Zine; Understanding Financial Ratios; 2004-2011
- Middle City; Chapter 14: Financial Statement Analysis; Malcolm E. White CPA, MA; 1999-2010
- This Matter; Price/Earnings Ratio (P/E Ratio); William C. Spaulding; 2005-2011
- EPS fraction Principles of Accounting; Chapter 15: Financial Reporting Concepts; Larry Walther, Ph.D., CPA, CMA, 2012
About the Author
Dana Griffin has written for a number of guides, trade and travel periodicals since 1999. She has also been published in "The Branson Insider" newspaper. Griffin is a CPR/first-aid instructor trainer for the American Red Cross, owns a business and continues to write for publications. She received a Bachelor of Arts in English composition from Vanguard University.
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