Investment Ratio Analysis Example & Formula

Investment ratios are financial metrics that investors, analysts, and financial managers use to evaluate a company’s financial performance, profitability, and attractiveness for potential investment. They help provide a deeper understanding of a company’s profitability, stock performance, and return potential, allowing stakeholders to make informed decisions. These ratios are essential for assessing risk, growth, dividends, and overall shareholder value. Here, we will discuss in detail each of the eight key investment ratios: dividend cover, dividend yield, earnings per share, price earnings ratio, price to sales ratio, price earnings growth ratio, price to book value ratio, and payout ratio. These metrics provide insights into how effectively a company is generating earnings and distributing dividends to its shareholders.

The dividend cover is one of the most commonly used investment ratios and offers insight into how well a company can meet its dividend payments to its shareholders with its available profit. Specifically, the dividend cover ratio is a measure of the number of times a company’s profit after tax can cover the dividends it has declared. A higher dividend cover is a positive indicator, as it shows that the company has sufficient profits to pay dividends and is not overly reliant on borrowing to distribute payments to its shareholders. Conversely, a low dividend cover may indicate financial strain or that the company is not generating enough profit to support consistent dividends. This ratio reflects financial stability and operational strength by demonstrating whether a company can sustain dividend payments even during economic fluctuations. For example, if a company’s profit after tax is significantly higher than the amount it has allocated for dividends, it indicates financial resilience and that the company can withstand market downturns while still rewarding its investors.

The dividend yield is another important investment ratio, and it calculates the return on investment that a shareholder can expect from dividends relative to the market price of the company’s stock. This ratio is expressed as a percentage and provides investors with an idea of how much income they can expect to earn from dividends compared to the price they have paid for the stock. It is calculated by dividing the dividend per share by the market price per share and then multiplying by 100 to express it as a percentage. The dividend yield is a key consideration for income-focused investors who rely on dividends as a primary source of return. A higher dividend yield indicates that the stock offers better returns in the form of dividends compared to its market price, making it attractive for investors. However, a very high dividend yield may also be a red flag, as it could indicate that the stock price is declining due to investor pessimism or concerns about the company's future performance. It is important for investors to weigh this metric alongside other financial and market indicators.

The earnings per share (EPS) is one of the most widely used investment ratios as it measures a company’s profitability on a per-share basis. EPS represents the portion of a company’s profit that is allocated to each outstanding share of common stock, making it a critical indicator of a company’s financial health. EPS is calculated by dividing the profit available to equity shareholders by the number of equity shares in circulation. This metric allows investors to gauge a company's profitability in relation to the number of shares outstanding, providing insight into how much profit shareholders are earning per share. A higher EPS suggests that the company is generating strong profits and has the ability to reward its shareholders, while a declining EPS may raise concerns about a company’s operational efficiency and financial stability. EPS is also commonly used in conjunction with other ratios, such as the price-earnings ratio, to determine the value of a company's stock.

The price earnings ratio (P/E) is another vital investment ratio that measures the relationship between a company’s market price per share and its earnings per share (EPS). This ratio is used by investors to determine the market's valuation of a company’s earnings and assess whether a stock is overvalued or undervalued. A high P/E ratio indicates that investors have high expectations for a company’s future growth, as they are willing to pay a higher market price for its shares based on anticipated profits. Conversely, a low P/E ratio may suggest that the stock is undervalued or that investors lack confidence in the company’s future growth potential. However, P/E ratios can vary by industry, market conditions, and other economic factors, so investors must contextualize this ratio within the broader market and company performance. It is also essential to consider whether the company has consistent earnings and sustainable growth before making investment decisions based solely on the P/E ratio.

The price to sales ratio is another critical investment ratio used to assess a company’s valuation relative to its sales revenue. This ratio is calculated by dividing the market price per share by sales per share and provides investors with insight into how much they are paying for every dollar of a company's sales. The price to sales ratio is especially useful for evaluating companies that may not yet be profitable but have strong sales growth, as it shifts the focus from profit to revenue. A lower price to sales ratio indicates that a company is undervalued relative to its sales, making it an attractive investment opportunity. Conversely, a high price to sales ratio may suggest overvaluation, as investors are paying more for a company’s sales without a corresponding increase in profitability. This ratio is especially valuable when comparing companies within the same industry, as it provides insights into competitive positioning, profitability potential, and investor sentiment.

The price earnings growth (PEG) ratio builds on the traditional price-earnings ratio by incorporating the company’s anticipated earnings growth rate. The PEG ratio provides a more comprehensive perspective by taking into account both market price and the company’s rate of earnings growth, allowing investors to assess whether a company’s valuation is justified based on its expected growth. This ratio is calculated by dividing the price earnings ratio by the company’s annual EPS growth rate. A PEG ratio less than 1 indicates that the stock is undervalued based on its growth rate, while a PEG ratio greater than 1 suggests that the stock may be overvalued given the projected rate of earnings growth. The PEG ratio offers investors a way to balance short-term profitability with long-term growth expectations, making it a key indicator for evaluating investment opportunities and projecting future performance.

The price to book value (PBV) ratio measures the market price of a company’s stock in relation to its book value, or the balance sheet value of its assets. The PBV ratio is calculated by dividing the market price per share by the balance sheet price per share. This ratio provides insights into how much investors are paying for the company’s net assets relative to their actual book value. A PBV ratio below 1 may indicate that a company is undervalued by the market, as its stock price is trading at a discount to its net asset value. Conversely, a PBV ratio above 1 suggests that investors are willing to pay a premium for the stock, possibly due to growth expectations, competitive advantages, or other market factors. The PBV ratio is especially helpful for companies with significant assets, such as manufacturing firms or real estate companies, as it focuses on the intrinsic value of the company’s balance sheet rather than just earnings or market speculation.

Lastly, the payout ratio reflects the proportion of a company’s earnings that are distributed to shareholders in the form of dividends. It is calculated by dividing the dividend per share by the earnings per share (EPS) and provides insight into how much of a company’s profits are being returned to shareholders versus retained for reinvestment into the business. A high payout ratio may indicate that a company prioritizes rewarding its shareholders with dividends but may also suggest that the company is not retaining enough earnings to support future growth and operations. Conversely, a low payout ratio indicates that the company retains a greater portion of its earnings for strategic investments, debt reduction, and expansion. Investors use this ratio to assess a company’s dividend policy and the sustainability of dividend payments, as well as to determine how much of the company’s earnings are being utilized for growth opportunities.

In conclusion, investment ratios are powerful tools that help investors evaluate the financial performance, valuation, and profitability of companies. They allow stakeholders to make informed investment decisions by analyzing factors such as profitability, dividends, market performance, growth expectations, and financial stability. The dividend cover, dividend yield, earnings per share, price earnings ratio, price to sales ratio, price earnings growth ratio, price to book value ratio, and payout ratio each provide unique insights into different aspects of a company’s financial health and market performance. Together, these ratios form a comprehensive picture of a company’s attractiveness as an investment opportunity and are critical for evaluating risk, growth, and shareholder value.

List of investment ratios and formulas:

1) Dividend cover = Profit after tax / dividends
2) Dividend yield = ( Dividend per share/ Market price per share ) * 100 %
3) Earnings per share (EPS) = Profit available to equity shareholders / Number of equity shares
4) Price earnings ratio (P/E) = Market price per share / Earnings per share
5) Price to sales ratio = Market price per share / Sales per share
6) Price earnings growth (PEG) ratio = Price per earnings / Annual EPS growth
7) Price to book value (PBV) = Market price per share / Balance sheet price per share
8) Payout Ratio = Dividend per share / EPS

Examples:

1) Camry Ltd made a net profit of $80,000 that is available to ordinary shareholders, and the dividend declared is $20,000, then:
   Dividend cover =  80,000 / 20,000 = 4 times

2) An investor bought a share at $6.00 and he received a dividend of $0.30 on it, then:
    Dividend yield = (0.30 / 6.00) * 100 % =  5 %

3) Company ABC has an annual earning of $140,000 dollars. Total dividends of $70,000 are to be paid out, and the company has 350,000 outstanding shares.
Solution:
Earnings per share (EPS) = $140,000 / 350,000 = $0.40
Dividend per share = 70,000 / 350,000 = $0.20
The dividend payout ratio = 0.20 / 0.40 = 50%

4) Sports Ltd has ordinary share capital of 200,000 shares at $1 each. It made a net profit of $400,000 that is available to the ordinary shareholders. The market price of a share is $6.00.
Then:
EPS = $400,000 / 200,000 = $2 per share
P/E ratio = $6 / $2 = 3