The financial health of a company can be determined by studying the company’s financial statements (its accounts). From these certain useful ratios can be calculated, usually divided into the areas of profitability, price, liquidity, leverage, and efficiency. Ratios from a particular company are compared to other companies within the same sector in order to get a handle on the sector norm.
Net Profit Margin
A company’s net profit margin is net income divided by total sales. This ratio indicates how much profit the company makes from its sales. For example, a net profit margin of 20%, means that $0.20 of every $1.00 in sales actually profit.
The Price/Earnings ratio (or P/E Ratio) is a security’s current stock price divided by the earnings per share (EPS) of the previous four quarters. This tells you how much you must pay to get rights to $1 of the company’s earnings. For example, if a stock’s price is $50 and the EPS for the last four quarters was $5, the P/E ratio is 10 (i.e. $50 / $5 = 10). This means that you must pay $10 to “buy” $1 of the company’s earnings (buying a single share for $50 entitles you to $5 of earnings). Within a sector, comparing P/E ratios usually reveals some interesting facts – the lower the P/E ratio the better.
Book value is total net assets (assets minus liabilities) divided by total shares outstanding (in issue). Imagine a company with $5 billion in cash and no liabilities whatsoever. You wouldn’t expect the book value of that company to be only $3 billion, would you? (If it was, hungry investors would buy it up in the expectation of liquidating it and turning an instant profit). Depending on the accounting method used, the book value of a company can be overstated or understated, for example Enron used highly dubious accounting ideas to create a book value far beyond any real possible valuation.