Purchases aren't just about price; they are about value. Financial ratios assist investors because they allow investors to know how much they are getting per dollar they invest. A stock price is meaningless in the absence of information on how much the company earns, what the growth rate is, what the dividend has been in the past and what assets are currently on the books.
Price to Earnings
The Price to Earnings, or P/E ratio, is the most commonly referred to financial ratio. It measures a company's stock price against the amount of earnings per share. Not all earnings are the same, however. You should look to see if a quoted P/E ratio uses actual earnings from last year or projected earnings ... which are nothing more than educated guesses. You should also look into the P/E to see how valid the earnings figure is. Is the last earnings report normal? Is it sustainable? Is it higher or lower than you would expect, given the trend in the past? If so, you should try to determine why that is the case.
Price to Book
The Price to Book ratio, or P/B, measures a stock price against the liquidation value of a company. Basically, the P/B addresses the question: If the company were liquidated tomorrow, and all the assets were sold off and debts paid, what would be the investor's share of the proceeds per share of the company?
The current ratio measures the creditworthiness of the company and its ability to withstand earnings declines without being forced into bankruptcy. The current ratio is defined as the value of total current assets divided by the total current liabilities—or debts payable within the year. One variation on this theme is the quick ratio, which is the amount of cash on hand, plus accounts receivable, divided by the current liabilities. The quick ratio excludes the value of inventory, and is therefore a better measure of the strength of companies experiencing sales slowdowns.
Debt to Equity Ratio
This ratio measures the relationship between debt and the total value of the company—also called shareholders' equity. Equity itself is defined as assets minus liabilities. The debt to equity ratio is liabilities divided by net worth. The higher the number, the larger the assessed risk of the company.
The PEG ratio measures earnings per share against the expected growth rate of a company. The logic behind the PEG ratio is this: When two companies with equal P/E ratios have unequal growth rates, the company with the higher growth rate should command the higher stock price. The PEG ratio recognizes this valuation consideration. The PEG ratio is defined as the price/earnings ratio divided by the anticipated growth rate.
Jason Van Steenwyk has been writing professionally since 1998. A former staff reporter for "Mutual Funds Magazine," he has been published in "Wealth and Retirement Planner," "Annuity Selling Guide," "Registered Rep." "Bankrate.com" and "Senior Market Advisor." He holds a Bachelor of Arts in humanities from the University of Southern California.