Most Important Financial Ratios That Will Make You a Better Investor

Ratios, eww, am I right?

The term financial ratio is enough to put some people to sleep, but to really follow the world of finance and investing it’s important that a few financial ratios are burned into your memory and are part of your vocabulary.

In fact, if you take the time to fully understand the ratios we talk about below, it will make you a far more informed investor, able to make sense of all the information that can be found in a company’s financial statements.

At the very least, you won’t be so lost at your next cocktail mixer!

We are going to take a look at the most important financial ratios and how they are calculated for one company: Shake Shack. If you’d like to follow along, please go ahead and take a look at their most recent annual report.

1) Price-to-Earnings Ratio (P/E)

Ah yes, the majestic P/E ratio. This ratio tells you how expensive (or not) a company is.

Here’s how it’s calculated:

P/E Ratio = Price per Share / Earnings Per Share

So you take the price per share and divide it by the earnings per share. Let’s take a second to think about what that is telling us. The price per share is how much you would pay for a single share of Shake Shack, currently $34.54. The earnings per share is the total earnings of the company divided by the number of shares in existence. Typically investors look at the last 12 months of earnings, so if Shake Shack made $1,000,000 in earnings and had 1,000,000 shares then they earned $1 for every share out there. In that fictional example, with a price per share of $34.54 and earnings per share (EPS) of $1 then the P/E ratio would be, drumroll please….34.54!

Put another way, a P/E ratio of 34.54 means as an investor you are paying around $34.5 dollars for every dollar that Shake Shack generates in earnings.

So let’s figure out what the P/E ratio for Shack Shack is for real. If you are following along then check out Item 6. Selected Financial Data (page 47 of the document). Under per share data, Shake Shack’s 10k tells us what the Earnings per Share is: $0.65 for 2015.

So Shake Shack’s P/E Ratio is $34.54/$0.65, or 53.14.

Taken on its own it’s a bit hard to figure out whether that number is good or bad. You are paying $53 for every $1 that Shake Shack generates in earnings. Right away that doesn’t sound great, but who knows right? You have to compare it to something for P/E ratios to really make sense. Everything is relative.

For instance, how does Shake Shack stack up against McDonalds? They’re both public fast food companies so it’s a fair start.

McDonald’s P/E ratio is about 25. Half that of Shake Shack.

Put another away, if you spent $34.50 on a share of Shake Shack it would take 53 years for the burger company to earn back that money. That definitely doesn’t sound good. Granted these things can change and aren’t set in stone but it’s a good financial ratio to look at when evaluating a company.

2) Return on Equity (ROE)

Equity refers to ownership and the return on equity is a measure of how much value you are getting out of an asset you own. If you own some shares in a company you probably want to know what sort of value, or return, you’re getting from it.

Here’s how ROE is calculated:

Return on Equity = Net Income / Shareholders’ Equity

Looking back at item 6 on Shake Shack’s 10k we see that its net income (before other expenses) is reported as $3,124,000 for 2015. Let’s ignore that Shake Shack actually made a loss last year so as to keep our numbers clean.

All we have left to do is figure out what shareholder equity is. Further down on item 6 (still on page 47) we see Total Equity and it is listed as $157,019,000.

Great, we’ve got what we need to figure out ROE!

Return on Equity = $3,124,000/ $157,019,000 = 1.99%

So for every dollar that a shareholder (potentially you) owns Shake Shack is generating 2%, or 2 cents, in profits every year. Obviously, the higher ROE is, the better.

Out of curiosity, how does that stack up versus the good ole golden arches? How about 45%? For every dollar invested by a shareholder in McDonald’s there were 45 cents in profit. Not too shabby!

3) Current Ratio

The current ratio tells an investor how well a company is able to fulfill their short-term debts. Here’s how we calculate the current ratio:

Current Ratio = Current Assets / Current Liabilities

If you have more current assets than current liabilities (i.e. the ratio is greater than 1) then you get the sense that a company is able to meet its current (short-term) debt obligations. Assets are like how much money you have in your bank account and liabilities are kind of like the balance on your credit card that you haven’t gotten around to paying off yet.

Of course when that ratio is less than 1 then you might be worried that a company could be put under some real stress if something unexpected were to happen with the economy or their standard business operations.

So one more time, let’s turn our attention to item 6 on Shake Shack’s 10k. We see both current assets and current liabilities and they are reported as being $78,934,000 and $24,005,000 respectively.

Ok we don’t really need to do the math to figure out that the current ratio is going to be greater than 1 but let’s do it anyway.

Current Ratio = $78,934,000/25,005,000 = 3.15

So it looks like Shake Shack’s doing alright and they are probably not to be put under any debt pressure in the very near future.

Just for comparison McDonald’s current ratio is very similar, at 3.27.

The verdict

key financial ratiosHopefully now you have 3 tools in your arsenal with which to evaluate companies you are interested in investing in. Please be aware that there is far more nuance to each of these calculations than we able to go into detail for but the hope is that we’ve demystified these very important financial ratios.

Taken together what do these ratios tell us about Shake Shack?

We know that its P/E Ratio is about 53, its ROE is 2% and its current ratio is 3.15; this starts to paint a picture. With just this information Shake Shack would appear to be an overpriced, poor-profit generating company with enough money to stick around for a while as they try to grow and improve.

This isn’t the full picture though and it’s important to take into account that ability to grow. These three financial ratios alone aren’t enough to condemn Shake Shack to the scrap heap. Shake Shack might be worth $34.50 a share now but what if it could be worth $130 in the future, like McDonald’s is now?

Answering that question will take careful investigation but a serious investor should not shrink away from that task!

Tell us in the comments if you think Shake Shack could be the next McDonalds and why.

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One response to “Most Important Financial Ratios That Will Make You a Better Investor”

  1. Kritesh says:

    Hi, Great Article. Really helpful for the quick evaluation of a company. Keep up the good work. I have written a similar blog post here: http://www.tradebrains.in/financial-ratio-analysis-must-know/ Thank You.