Stock Market Ratio Analysis (with Examples)

Stock market ratios are essential tools used by investors, analysts, and financial managers to evaluate the performance of a company’s stock and make informed investment decisions. These ratios help assess the financial health, profitability, and value of a company by providing insights into key financial metrics that are crucial for analysis.

Stock market ratios are widely used because they provide investors with a way to compare companies, evaluate trends over time, and determine the attractiveness of a company’s stock as a potential investment. Some of the most common stock market ratios include Earnings Per Share (EPS), the Price-Earnings (P/E) ratio, Dividend Yield, and Earnings Yield. These ratios offer important perspectives on a company's performance and valuation, helping investors analyze profitability, dividends, and the overall financial strength of a business.

The first of these common stock market ratios is Earnings Per Share (EPS). EPS is one of the most significant and widely used financial ratios, as it allows shareholders to measure a company’s profitability in relation to the number of common shares outstanding. EPS is calculated by taking the net profit after taxes, subtracting any preferred dividends, and dividing that by the total number of common shares outstanding. Essentially, this ratio shows the amount of profit that is allocated to each common share of the company. EPS is a critical tool because it enables investors and shareholders to assess whether a company is generating profits that are attributable to equity holders.

EPS is important because it provides a comparative framework for shareholders to analyze a company's performance over different periods or compare it with other companies within the same industry. For instance, by examining changes in EPS over multiple years, investors can determine trends in a company’s profitability, its ability to grow earnings, and how well it can generate returns for its shareholders. A consistently high or rising EPS suggests strong operational performance and efficient management, which can foster investor confidence and lead to stock price appreciation. Conversely, declining EPS may be a warning sign that the company is facing challenges, such as reduced revenue, higher costs, or market competition. Investors rely on this ratio to gauge a company's ability to generate income and reward its shareholders, making it one of the most widely referenced indicators in the stock market.

The second important stock market ratio is the Price-Earnings (P/E) ratio, which compares the market price of a company’s share to its earnings per share (EPS). The P/E ratio is one of the most popular and widely used valuation metrics in equity markets. This ratio helps investors determine how much they are paying for each dollar of earnings generated by a company. Essentially, the P/E ratio reveals the market’s expectations about a company’s future growth potential and profitability.

When analyzing a company’s P/E ratio, investors often compare it with the P/E ratios of other companies in the same industry or with historical trends of the company itself. A higher P/E ratio suggests that the market has high expectations for the company’s growth or that it is considered a strong investment. This could be driven by factors such as innovation, competitive advantages, or strong market positioning. On the other hand, a low P/E ratio could indicate that the stock is undervalued or that the market has low growth expectations for the company. While the P/E ratio is a valuable tool for making investment decisions, it should be interpreted with caution, as market sentiment, economic conditions, and other factors can influence the stock price and, consequently, the P/E ratio.

The Dividend Yield is another commonly used stock market ratio. It calculates the rate of return on a stock by comparing the dividends paid by a company to the market price of its shares. Specifically, the dividend yield is determined by dividing the annual dividends paid per share by the stock’s current market price. This ratio provides investors with insights into the income they can expect to earn from dividends relative to the stock’s price. It is a particularly important measure for income-oriented investors who prioritize regular income over capital gains.

Dividend yield can vary depending on market conditions and a company’s dividend policy. A high dividend yield suggests that a company is returning a significant portion of its earnings to shareholders in the form of dividends, which can be attractive to investors seeking stable income streams. Conversely, a low dividend yield may indicate that the company is retaining most of its earnings for growth, reinvestment, or other strategic initiatives. While a high dividend yield can be appealing, it is important for investors to assess the sustainability of a company’s dividend payments. A high yield may also indicate that the stock price has dropped significantly, which could be a sign of financial trouble or declining investor confidence. Thus, investors must look at both the company’s financial stability and its dividend history when assessing dividend yield as part of their investment decision-making process.

The Earnings Yield is another important stock market ratio that complements the P/E ratio and offers additional insights into the valuation of a company. Earnings Yield is calculated by dividing the earnings per share (EPS) by the stock's market price per share. This ratio provides a way for investors to assess how much return a company is generating for each dollar invested in its shares. Essentially, the earnings yield measures the percentage return that investors can expect based on a company’s current market price.

A higher earnings yield indicates that the stock may be undervalued because investors are paying less for each dollar of earnings, making it a potentially attractive investment opportunity. Conversely, a lower earnings yield suggests that investors are paying a higher price for the company’s earnings, which could indicate overvaluation. Earnings yield is a helpful metric for value investors who are focused on identifying stocks that are undervalued by the market and are expected to generate steady returns. Similar to the P/E ratio, the earnings yield should not be analyzed in isolation but should be compared with historical trends, industry averages, and market conditions.

Each of these stock market ratios—Earnings Per Share (EPS), the Price-Earnings (P/E) ratio, Dividend Yield, and Earnings Yield—offers unique insights into a company’s financial performance, valuation, and market positioning. EPS provides a direct measure of profitability per share, while the P/E ratio assesses the market price of the stock relative to a company’s earnings. Dividend yield helps income-focused investors evaluate the income return relative to share price, while earnings yield provides insights into the return investors can expect compared to the stock’s market price. These ratios collectively offer a comprehensive view of a company's financial health, profitability, investor sentiment, and market valuation.

Investors and analysts rely on these ratios to make strategic decisions, such as identifying potential investment opportunities, comparing companies within the same industry, and determining trends over time. When used together, these stock market ratios can provide valuable insights into a company’s overall financial condition, growth prospects, and market positioning, enabling informed and strategic decision-making in the dynamic and complex environment of financial markets.

Below are the most common stock market ratios:

1) Earnings per share (EPS) = (Net profit after tax − Preferred dividend) / Common shares outstanding
Definition: EPS is the most important ratio which gives shareholder a chance to compare earnings over a period of years.

2) Price-earnings ratio (P/E) = Market price per share / EPS
Definition: This ratio compares the price of a share to the earnings per share.

3) Dividend yield = Annual dividends / Price per share
Definition: This calculates the rate of return by comparing dividend paid to the share price.

4) Earnings Yield = (EPS / Market price per share)
Definition: This is the ratio of EPS to the stock market price.

Example 1:
An investor purchased a common stock at $6 and received a dividend of $0.15 on it, then the Dividend Yield Ratio = (0.15 / 6) * 100% = 2.5%

Example 2:
ABC Stock is currently trading at $20 per share and earnings over the last 12 months were $1.50 per share. Find the P/E ratio and the Earnings Yield.

Formula and Calculation:
P/E ratio = Market price per share / EPS = 20 / 1.50 = 13.33
Earnings Yield = (EPS / Market price per share) = 1.50 / 20 = 0.075 = 7.5%