Essential financial ratios every Indian investor should understand

Introduction

The US stock market offers a wide range of investment opportunities, attracting Indian investors seeking global diversification. However, with thousands of stocks available, how do you decide which ones to invest in?

This is where financial ratios play a crucial role. They help investors analyze a company's profitability, valuation, debt levels, and financial health before making investment decisions.

In this guide, we will break down essential financial ratios and provide real-world scenarios where each ratio can help you decide whether to buy, hold, or sell a stock.

1. Price-to-earnings (P/E) ratio: Evaluating stock valuation

The P/E ratio helps investors understand how much they are paying for each dollar of a company's earnings.

Formula:

P/E ratio = current stock price / earnings per share (EPS)

Scenario: Should you invest in Tesla?

Imagine you are considering investing in Tesla. You check its financials and see:

• Stock price: $900
• Earnings per share (EPS): $30
• P/E ratio = 900 / 30 = 30

Tesla's P/E ratio is higher than the average auto industry P/E of 15, meaning investors expect high future growth. If you are looking for a growth stock and believe in Tesla’s potential, a high P/E might not be a bad sign. However, if you prefer value investing, you might find General Motors with a P/E of 8 more attractive.

Investor insight: Compare the P/E ratio within the industry before making decisions.

2. Price-to-book (P/B) ratio: Finding undervalued stocks

The P/B ratio helps investors determine whether a stock is overvalued or undervalued based on its book value.

Formula:

P/B ratio = market price per share / book value per share.

Scenario: Is Bank of America a good buy?

You want to invest in the banking sector and are comparing two banks:

• Bank of America (BAC) P/B ratio: 0.9
• JP Morgan Chase (JPM) P/B ratio: 1.8

A P/B ratio below 1 suggests that Bank of America might be undervalued—meaning its assets could be worth more than its market price. However, you should also check its financial health to ensure it is not struggling.

Investor insight: Use the P/B ratio to find undervalued stocks, especially in banking, real estate, and manufacturing.

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3. Debt-to-equity (D/E) ratio: Assessing risk in leverage

The D/E ratio shows how much a company relies on debt compared to shareholder equity.

Formula:

D/E ratio = total debt / shareholders’ equity

Scenario: Comparing Amazon and Netflix

• Amazon (AMZN) D/E ratio: 0.5 (low debt)
• Netflix (NFLX) D/E ratio: 1.8 (high debt)

Since Netflix heavily relies on debt to fund its content production, it has a higher D/E ratio, which makes it riskier, especially in an economic downturn. On the other hand, Amazon’s lower D/E ratio suggests it has less debt and is more financially stable.

Investor insight: Companies with high D/E ratios are riskier, especially in volatile industries like entertainment.

4. Return on equity (ROE): Measuring profitability

ROE measures how efficiently a company generates profit from shareholders' investments.

Formula:

ROE = net income / shareholders' equity

Scenario: Is Apple a good investment?

• Apple (AAPL) ROE: 35%
• HP (HPQ) ROE: 10%

Apple’s high ROE suggests that it efficiently converts shareholder investment into profit, making it a stronger candidate for investment compared to HP.

Investor insight: A higher ROE is a good sign, but make sure it is not driven by excessive debt.

5. Earnings per share (EPS): Identifying growing companies

EPS tells you how much profit a company generates per share.

Formula:

EPS = (net income – preferred dividends) / total outstanding shares

Scenario: Should you buy Microsoft?

• Microsoft (MSFT) EPS: $9
• Intel (INTC) EPS: $4

Since Microsoft’s EPS is growing year-over-year, it indicates that the company is increasing profitability, which is a strong buy signal for investors.

Investor insight: A steadily increasing EPS signals long-term profitability.

6. Dividend yield: Choosing stocks for passive income

Dividend yield shows how much a company pays in dividends relative to its stock price.

Formula:

Dividend yield = (annual dividend per share / stock price) × 100

Scenario: Coca-Cola vs. Google

• Coca-Cola (KO) dividend yield: 3.5%
• Google (GOOGL) dividend yield: 0% (does not pay dividends)

If you are looking for passive income, Coca-Cola is a better option than Google, which reinvests earnings instead of paying dividends.

Investor insight: High dividend yield stocks are ideal for long-term, income-focused investors.

Final thoughts

By using these financial ratios in real-world scenarios, you can make better investment decisions when analyzing US stocks.

Key takeaways:

• The P/E ratio helps identify undervalued or overvalued stocks.
• The P/B ratio is useful for finding undervalued assets.
• The D/E ratio measures financial risk.
• ROE and EPS indicate profitability.
• Dividend yield helps passive income investors.
• The current ratio checks liquidity.
• The PEG ratio evaluates growth stocks.

By mastering these ratios, you will be better equipped to navigate the US stock market.

Disclaimer: This article is for informational purposes only and should not be considered financial or investment advice. Investing in stocks carries risk, and past performance is not indicative of future results. Always conduct your own research and consult with a professional financial advisor before making investment decisions.

Contributed by Denila Lobo

Denila is a content writer at Winvesta. She crafts clear, concise content on international payments, helping freelancers and businesses easily navigate global financial solutions.