# What are the financial ratios?

Financial ratios help to evaluate listed companies and their shares. They can make a key contribution to the decision on an investment. This article provides an overview of common financial ratios and their significance.

## The most important facts in brief

• Company and share ratios provide an objective basis for making investment decisions. The key to a strong analysis is to assess several ratios as a whole.
• The price-earnings ratio (P/E ratio) is one of the most frequently used ratios. A high P/E ratio could mean that the market participants' assessment of the company's profitability and future growth is strong or that a company's stock is overvalued.
• Other valuation metrics include price-to-book ratio and price-to-sales ratio, whereas key figures for company analysis include debt-equity ratio or return on equity. Deciding which key figures to analyse and with what weight is a challenge for both private individuals and investment professionals alike.

## 1. Return ratios

The purchase of a security makes it possible to participate in price developments and secures the right to potential distributions, also called dividends. In the case of shares, the return over the holding period of an investment is, therefore, composed as follows.

a) (Total dividends received) ÷ (Purchase value of the shares)
b) (Current value of the shares) ÷ (Purchase value of the shares) - 1

The purchase value of the shares is calculated by multiplying the purchase price and the number of shares purchased, plus any fees.

Example:

• Purchase of 100 ordinary shares of Example AG on 30.09.2010 at €38.50 each.
• Fees on purchase: €10.50
• Dividend payments: €1.30 per year (over 5 years)
• Price after 5 years, as of 30.09.2015: €63.40

The return on the holding period is calculated as follows:
(100 x 5 x €1,30) ÷ (100 x €38,50 + €10,50) = 16,84 %
(100 x €63,40) ÷ (100 x €38,50 + €10,50) - 1 = 64,23 %

This results in a return of 81,07% over the entire holding period.

The return an investment has generated on a yearly basis is determined with the formula for the geometric return - in technical jargon it is known as the annualised return:

Annualised return:

(1+r) (1/T) - 1

where r = total return and T = holding period of the security in years. The result in our example when substituting the values into the formula

(1 + 81,07%) (1/5) - 1

gives an annualised return of 12,61 %.

To note: When selling securities, the actual realised return may be reduced by taxes and trading fees.

## 2. Key valuation metrics

• Price-earnings ratio (P/E ratio)
• Price-to-book ratio (P/B ratio)
• Price-to-sales ratio (P/S ratio)
• Dividend yield

The P/E ratio displays the profit of a company in relation to its value, which is derived from the share price. First, the company's profit is divided by the number of outstanding shares to obtain the earnings per share.

The P/E ratio is calculated in the next step using the following formula:

Price per share ÷ Earnings per share = P/E ratio

A P/E ratio of 15, for example, means that investors are currently paying 15 times the earnings of a share. A distinction can be made between the profit of the past twelve months or the profit expected for the current year, which leads to differences in the P/E ratio. As a general rule, high P/E ratios indicate higher valued companies, which can usually be explained by optimistic market expectations of the company's future profits and growth. For one's own analysis, the future scenario priced in by the market, implied by the level of the P/E ratio, can be compared with one's own future expectations for the company. Similarly, a low P/E ratio is an indicator of companies that appear to be favourably valued at first glance.

The P/B ratio compares the book value of a company with its value. A low P/B ratio also indicates a more favourable valuation.

The book value can be read from the balance sheet. It is the difference between the balance sheet total and the liabilities. In other words, it is the value that would remain for shareholders if all assets were sold after deducting liabilities. Dividing this value by the number of outstanding shares gives the book value per share.

The P/B ratio can be calculated using the following formula:

Price per share ÷ Book value per share = P/B ratio

It is important to understand that assets on the balance sheet sometimes have a lower value than their actual sale would bring. A P/B ratio of < 1 means that the market places the value of the company lower than the amount that would remain if all assets were sold and all debts paid. Such a value could also be interpreted to mean that the market considers the actual value of the assets to be significantly lower than the values shown on the balance sheet suggest. On the other hand, companies whose business model functions without many tangible assets (e.g. production machinery) often have a P/B ratio well above 1. Technology companies are an example of this.

The P/S ratio (also known as revenue multiple) shows the turnover of the company in relation to the current valuation on the stock market. The ratio mainly helps to evaluate smaller, fast-growing companies or to compare their current valuation with other fast-growing companies. If companies do not report profits currently or in the near future, they can at least be valued using the P/S ratio. Turnover is the sum of all revenues and can be found in the respective profit and loss account, usually as the first item listed. Again, the number of outstanding shares is necessary to determine the value of the P/S ratio using the following formula:

P/S ratio:

Price per share ÷ Sales per share = P/S ratio

Another possibility is to relate the market capitalisation of the company to the total turnover without calculating the values per share in advance.

The dividend yield shows the dividends of a company in relation to its current share price. In order to calculate the ratio, the sum of the dividend distributions over a one year period are divided by the current share price:

Dividend yield:

Dividend per share ÷ Price per share = Dividend yield

The dividend yield is a measure of how high the annual distributions are in relation to the current share price and is a popular indicator used by investors to estimate future dividend payments. For example, if a share has a market value of €100 and dividends of €3 have been paid out in the last twelve months, then the dividend yield is 3%. Assuming a constant dividend yield, a shareholder would expect a dividend payment of 3% next year as well.

An important note on the analysis of dividend yields is that they depend on the share price on a given day and the dividend payments within a given period. Consequently, one-off dividend payments and sharp price movements can impact the dividend yield and make its interpretation more difficult. This means that a high or rising dividend yield is not necessarily a good sign. As a general rule, high dividends or dividend yields are no guarantee of the success of an investment. It usually makes sense to take other key figures into account as well.

## 3. Key figures for company analysis

• Equity ratio
• Debt-equity ratio
• Gross margin
• Net margin
• Return on equity
• Interest cover

In the fundamental analysis of listed companies, investors look at key figures based on the financial statements, namely the income statement, balance sheet and cash flow statement. Some frequently used ratios are explained here.

The equity ratio shows the part of the balance sheet total financed by equity. The value is usually given as a percentage and is calculated as follows.

Equity ÷ Total capital = Equity ratio

The higher the equity ratio, the healthier a company's balance sheet appears to be, since no large amounts of debt capital have to be repaid or refinanced. However, debt capital is not bad per se. In most cases, it is worthwhile for a company to maintain a certain debt ratio, as it can lower its cost of capital and save taxes through debt capital.

The debt-equity ratio of a company shows the factor by which the debt capital exceeds/falls short of the equity capital of the company. The formula is as follows:

Borrowed capital ÷ Equity = Debt-equity ratio

To assess the profitability of a company, it is worth looking initially at its gross margin. This can be explained well using the example of Coca-Cola. Assume that for each can of Diet Coke sold, the company earns, for example, $3.00 and material and production costs of$1.20 were incurred. All other costs, such as marketing, employee salaries or office rents, are not taken into account here. The gross revenue, here \$1.80, in relation to the turnover, results in the gross margin; here amounting to 60 per cent. The formula is:

Gross revenues ÷ Turnover = Gross margin

The net margin , on the other hand, looks at the actual profits of the company. Here it is important to note that the net profit is subject to much greater fluctuations than can be observed, for example, in the gross revenues. This is due, among other things, to numerous possibilities to influence the profit and loss account and special effects that can influence the profit of a company at irregular intervals. The net profit of a company results from the gross revenues, minus all other operating expenses, depreciation, interest and taxes. The net margin shows the net profit in relation to the turnover achieved:

Net profit ÷ Sales = Net margin

The return on equity gives the profit of the company in relation to its equity. The ratio can be used to evaluate the efficiency of the use of equity. Companies with a high return on equity can have advantages over competitors. If the return on equity is significantly higher than the usual returns that can be achieved on the capital market, this can be an argument for investing in such a company. However, the return on equity does not take into account the current valuation of the company. It is calculated with the following formula:

Net profit ÷ Equity = Return on equity

The interest coverage of a company shows the extent to which the interest costs to be borne annually (depending on the company's indebtedness, its credit rating and the general interest rate level) can be covered by current, operating income.

EBIT ÷ interest costs = interest coverage ratio

The higher the interest coverage ratio, the more certain investors can be that the company will continue to be able to cover its interest costs with the profit from its operating business (EBIT = earnings before interest and taxes). A low value, on the other hand, can indicate problems. The ratio differs depending on the industry in which a company operates. Comparing the interest coverage ratio of different companies in the same industry can help in classifying this ratio.

On the classification of ratios: Individual ratios are not sufficient to make sound investment decisions. Rather, in aggregate they allow a better understanding to classify profitability, debt and competitiveness of a company. They enable a comparison of companies in the same industry and facilitate the assessment of whether a share of a good company can be acquired at a "fair" price or whether the markets have already priced a positive future scenario into the share price.

Emanuel Eisel

Emanuel was Head of Capital Markets at Scalable Capital until March 2022. He holds an M.Sc. in Business Administration from the University of Hamburg and spent parts of his studies at Boston University in den USA.