Understanding Financial Ratios: A Guide for Young Investors
Investing for 11 year olds
When it comes to understanding a company’s financial health, ratios and metrics can be powerful tools. However, for young investors, these ratios can be difficult to understand and interpret. In this article, we’ll break down some of the most commonly used ratios in company valuation and explain how they can be used to assess a company’s worth. We’ll also explore how these ratios are used in the real world by investors and analysts, and provide some examples of real companies and how they use these ratios.
Commonly Used Ratios in Company Valuation
- Price to Earnings (P/E) Ratio: This ratio measures how much investors are willing to pay for each dollar of earnings generated by a company. A high P/E ratio can indicate that a company is overvalued, while a low P/E ratio can indicate that it is undervalued.
- Price to Sales (P/S) Ratio: This ratio measures how much investors are willing to pay for each dollar of revenue generated by a company. A high P/S ratio can indicate that a company has a strong sales growth, while a low P/S ratio can indicate that the sales growth is weaker and investors may have concerns about the company’s future sales.
- Price to Book (P/B) Ratio: This ratio measures how much investors are willing to pay for each dollar of book value, which is the company’s assets minus its liabilities. A high P/B ratio can indicate that investors believe the company’s assets are undervalued, while a low P/B ratio can indicate that investors believe the company’s assets are overvalued.
- Return on Equity (ROE): This ratio measures how effectively a company is using its shareholders’ investments to generate profits. A high ROE can indicate that a company is profitable and well-managed, while a low ROE can indicate that the company is not generating enough profits for its shareholders.
Real-World Examples
Here are a few examples of how these ratios are used in the real world by investors and analysts:
- Tesla Inc. (TSLA): As of December 2020, Tesla had a P/E ratio of 1,072.54 and P/S ratio of 13.36. This is significantly higher than the industry average, which suggests that investors believe in Tesla’s long-term growth potential and are willing to pay a premium for the stock.
- Apple Inc. (AAPL): As of December 2020, Apple had a P/E ratio of 29.11 and P/S ratio of 4.34. Apple’s P/E ratio is significantly higher than the industry average, which suggests that investors believe the company has strong earning potential.
- Walmart Inc. (WMT): As of December 2020, Walmart had a P/E ratio of 25.27 and P/S ratio of 0.56. Walmart’s P/E ratio is significantly higher than the industry average, which suggests that investors believe the company has strong earning potential.
Conclusion
As an economics professor, I believe that it is important for young investors to understand the basics of financial ratios and how they can be used to assess a company’s worth. However, it’s also important to keep in mind that these ratios are just one aspect of determining a company’s value and are not the only measure of a company’s health. It’s always important to consider other factors such as the company’s management, industry trends and overall market conditions. Additionally, it’s important to do your own research and analysis, and not solely rely on the ratios to make investment decisions.
I encourage the readers to seek further knowledge about the financial ratios and to stay informed about the industry and market trends. It is also important to keep in mind that investing always comes with risks, it is important to be aware and always consider and evaluate the risks before making any investment decisions. Remember, it’s never too early to start learning about the financial world, and the more you know, the better equipped you’ll be to make wise investment decisions in the future.
In the end, always remember the wise words of Benjamin Graham “Price is what you pay. Value is what you get.”
