How to Calculate Trading Ratios - dummies

How to Calculate Trading Ratios

By Michael Griffis, Lita Epstein

Here, you will discover how to calculate four key trading ratios — P/E, Price/book, ROE, and ROA — but luckily you can find all these where fundamental statistics are reported. Each of these ratios gives you just one more piece in the puzzle of determining how much you want to pay for a stock.

By comparing each of the ratios for each of the companies you’re considering, you can make a more educated case about the price you want to pay for any stock.

Price/earnings ratio

The P/E ratio is probably the one that’s quoted more often in news stories. This ratio reflects a comparison of a stock’s earnings with its share price. You calculate this ratio using this formula:

P/E ratio = Stock price ÷Earnings per share

You’ll probably find two types of P/E ratios for a stock. The trailing P/E is based on earnings reported in previous quarters, and the forward P/E is based on projected earnings.

At Yahoo! Finance, the trailing P/E for Home Depot was 23.02 on March 15, 2013, and its forward P/E, expectations as of Feb. 3, 2015, was 16.97. Lowe’s trailing P/E was 22.96, and its forward P/E, expectations as of Feb. 1, 2015, was 15.34. There isn’t much difference in the trailing P/E ratios for Home Depot and Lowe’s, but analysts seem to favor Home Depot with a higher forward P/E.

Historically, market analysts believed a P/E ratio of 10 to 15 was reasonable. For a while, much higher P/Es were tolerated, but during the 2008 market conditions, people drifted back to historical P/Es. In March 2013, the trend is back toward higher trailing P/Es, but many people expect that a market correction is coming.

When comparing companies, you can get a good idea of how the market values each stock by looking at its P/E ratio. Although the P/E ratio is actually a percent, it is rarely stated that way. However, you will sometimes hear it called a price multiple because the P/E ratio represents how much you are paying for each dollar of a company’s earnings.

Price/book ratio

The price/book ratio compares the market’s valuation of a company to the value that the company shows on its financial statements. The higher the ratio, the more the market is willing to pay for a company above its hard assets, which include its buildings, inventory, accounts receivable, and other clearly measurable assets.

Companies are more than their measurable assets. Customer loyalty, the value of their locations, and other intangible assets add value to a company. Investors looking to buy based on value rather than growth are more likely to check out the price/book ratio. Price/book ratios are calculated using this formula:

Price/book ratio = Stock price ÷(Book value – Total liabilities)

Lowe’s price/book ratio at Yahoo! Finance was 3.14, and Home Depot’s was 5.84. Based on price/book ratio, the market is willing to pay a higher premium for Home Depot’s stock.

Return on assets

Return on assets (ROA) shows you how efficiently management uses the company’s resources. ROA, however, doesn’t show you how well the company is performing for its stockholders. To calculate return on assets, use this formula:

Return on assets = Earnings after taxes ÷Total assets

Home Depot’s ROA at Yahoo! Finance was 11.91 percent; Lowe’s was 6.72 percent. Home Depot is doing a more efficient job using its resources based on those two ROA numbers.

Return on equity

Investors are more interested in return on equity (ROE), which measures how well a company is doing for its shareholders. This ratio measures how much profit management generates from resources provided by its shareholders. Investors look for companies with high ROEs that show signs of growth. You calculate ROE by using this formula:

Return on equity = Earnings after taxes ÷Shareholder equity

Home Depot’s ROE was 25.42 percent, and Lowe’s was 12.89 percent.

The ROEs show that Home Depot is doing a better job for its shareholders, which, again, is reflected in the price investors are willing to pay for its shares. As of March 15, 2013, Home Depot’s stock price was $69.05 and Lowe’s was $38.81.

As a trader, you may not make your buy and sell decisions based on fundamental analysis, but collecting and having access to this information as part of your arsenal certainly helps you to make better and more informed stock choices.

Knowing a company has strong fundamentals helps to back up what you’re seeing in the technical analysis. If you’re trying to decide between two stocks whose technical charts are positive, you can use the fundamental analysis to tip the scale toward your best trading opportunity.