Behind the Numbers: How Stock Analysts Use Ratio Analysis for Smart Decisions

In the world of investments and equity research, numbers speak -- you have to learn how to interpret them. It is here that financial ratio analysis is an important tool by the stock analysts, investors, and lenders. As a serious finance person or an amateur investor, you want to know what stock analysts use in ratio analysis because it will be of great use in decoding the financial capability, output, and expansion potential of an organization.

How Stock Analysts Use Financial Ratios to Evaluate Companies

Stock analysts use Financial Ratios that involve analysis of complex financial data, which is broken down by the stock analyst into simple pointers of performance. These ratios help give a picture of profitability, efficiency, liquidity and solvency of a company, which enables comparison between two companies and even between two companies operating in two different industries.

When analyzing a stock, analysts do not only look at the superficial revenue and net income. They question such as: Is this firm utilizing its resources effectively? Is it doing well with debt? Is it paying shareholders sound returns? In many cases the answers are found in percentages.

To take an example, ROE will inform an analyst how effectively a company manages to earn profits out of shareholders equity, whereas the price-earnings (P/E) ratio is the tool to measure the fairness of a stock against its profits.

Common Ratios Used by Stock Analysts to Assess Performance

Although there are several dozens of ratios, stock analysts often use a few important ones which present them with the most valuable information regarding the company performance:

• P/E Ratio (Price to Earnings): This is used to calculate the amount of money investors are ready to spend on every dollar in terms of earnings. High P/E may be a sign that the company is expected to grow- a low P/E may be a sign that the company was undervalued, or risky.
  
  

• ROE (Return on Equity): Shows the profitability in comparison with the shareholder equity.
  
  

• Debt-to-Equity Ratio: It is used to evaluate the short-term liquidity of the firm as well as its capacity to cover debt obligations.
  
  

• Current Ratio: Displays the amount of the profit that a company distributed to each common stock outstanding..
  
  

• Earnings per Share (EPS): Displays the amount of money, which a company uses to distribute the amount in the profit to the shares of common stock existing.
  
  

It is through these ratios that equity research is based; it is a basis that enables analysts to develop models, make predictions on the performance of futures and their subsequent directive on buyers, sellers and holds.

Who Are the Main Users of Ratio Analysis Information?

Although financial ratios are mostly used by stock analysts, they are not the only people who utilize them. Other major practitioners of ratio analysis are:

• Investors: Ratios are used by both institutional and retail investors to determine high-potential stocks, get a micro advantage by evaluating risk, and compare investment opportunities.
  
  

• Lenders: Banks and credit institutions use things such as debt service coverage ratio or quick ratio to determine credit worthiness of a company.
  
  

• Corporate Managers: Corporate leaders rely on ratio analysis to observe performance and make effective and accurate decisions in relation to management of costs, pricing strategies as well as investment decisions.
  
  

• Auditors and Regulators: Ratios are used in spotting anomalies, measuring compliance and stability of financial positioning.
  
  

Depending on their aims, each of the user groups uses ratio analysis in different ways.

How Investors and Lenders Use Ratio Analysis Differently

The investors and lenders commonly look at the same financial ratios, but they mostly have different interests.

Investors are mainly interested in growth, as well as returns. They apply profitability ratio (such as ROE and net profit margin), market value ratio (such as P/E and P/B), and efficiency ratio (such as asset turnover) to decide whether a company can provide sustainable growth in income and capital increase.

On the contrary, the priority of lenders is stability and management of finances. They mostly look at current ratio, quick ratio, debt to equity ratio and the liquidity and solvency ratios as part of their analysis. These ratios show the ability of a business to settle its debt within due time and even of surviving in case of financial strains.

Simply put, an investor might feel breezy to invest in a company with a strong debt-level even though the firm tends to grow in terms of the returns, but a lender might consider it too risky to finance the company.

Role of Financial Ratio Analysis in Equity Research

The role of ratio analysis in equity research has a lot more than face value information. It is an essential tool that can be employed to understand financial statements, construct valuation models and underlying investment theses. The role of financial ratios is to assist an analyst to determine answers to questions such as:

• Is the profitability of the company doing better or worse?
  
  

• Where does it stand as far as cost structures are concerned in relation to the competitors?
  
  

• Is the price in the current market supported by fundamentals?

The analysts may commence their work through fundamental analysis by applying significant ratios in the equity research process. This is upon which future earnings would be calculated, valuation done and recommendations on whether a stock is a good buy or hold or sell to be issued in future.

The ratios are also required in the financial modeling process, especially discounted cash flow (DCF) and relative valuation. Even small modification of various assumptions surrounding margins, capital structure, or earnings growth (all ratios-based variables) may have an immense impact on the model conclusion--as well as on the implication of the recommendation provided by the analyst.

Conclusion

This greater appreciation of the manner in which the financial markets analyze companies is achieved by having an insight into what the stock analysts seek in the ratio analysis. Whether we make use of the typical ratios that stock analysts employ to make, or the various methods by which investors as well as lenders apply ratio analysis, it is apparent that they are an important tool in many of the occupations in the financial habitat.

Financial ratio analysis is not only a tool that gauges past actions of a company it can also be used to project future performance as well as to aid in high level strategic decision making. When used by a capable analyst, ratios enable raw numbers to turn into information and knowledge. When you are doing equity research or planning an investment, or even determining the risk profile of a company, the advantages of learning to analyze ratios is that you can make wise decisions in an increasingly competitive marketplace.