Ratios Used in Predicting Stock Prices

by Dennis Hartman

Making sense of the financial data that surrounds a business, or the stock market as a whole, can be daunting for investors. One way to organize data is by computing ratios, which synthesize several pieces of information into a single number. Ratios can reveal a great deal about the future performance of a stock. However, investors must know which ratios to use and how to compute them accurately.

Price-Earnings Ratio

One of the key ratios that investors and economic analysts use to predict the future price of a stock is the company's price-earnings, or PE, ratio. This simple equation divides a company's stock price per share, as set on the open market, by the earnings per share for a fiscal year. This allows investors to analyze earnings with respect to how much it costs to buy shares of a company to gain those earnings. A company with higher earnings, but a higher stock price, may have a higher PE ratio, which means it costs more for investors to take advantage of the company's growth. The same investment could earn more in a company with lower earnings per share but a much lower share price.

Profitability Ratios

Business growth is based on the ability to make a profit and sustain that profit in the future. Profitability ratios are a series of financial ratios that divide income by the value of a business. Return on assets, or ROA, is a ratio of income to total assets. Return on equity, or ROE, is the ratio of income to the value of a company's shareholder equity, which is another way to measure the value of a business. A higher profitability ratio indicates the likelihood of a higher future stock price, because the business is able to make more money by spending less than its competitors.

Liability Ratios

Liability ratios indicate the status of a business's debt and expenses. A business with uncontrolled, rising expenses will have trouble making a profit, which will depress stock prices. One useful ratio in this area is the cash asset ratio, which compares the value of a company's cash and cash equivalents to its total current liabilities. A high cash asset ratio indicates that a business has more than enough cash and investments to meet its upcoming expenses, making it easier to turn a profit and increase stock price for investors.

Market Share

Market share is a different type of ratio that examines a company's performance in the context of its competitors. Because investors can buy stock from whichever company they choose, market share can point them toward industry leaders and companies experiencing growth in one or more markets. Market share is the ratio of a company's sales to the total sales for a specific market. Large market shares indicate industry leaders, while small market shares belong to companies that are minor players in the markets where they compete. Rising market share indicates growth with respect to competitors, regardless of how well the market is performing as a whole.

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