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Two Ratios for Screening Investments

Two Ratios for Screening Investments

Studying just one stock is a massive commitment that requires hundreds of hours of reading.

To avoid wasting time on dead leads, you can initially screen the stocks you’re interested in to check for any red flags.

Two common screening ratios are Return on Equity (ROE) and the Price/Earnings Ratio (P/E).

What is ROE?

ROE is profit divided by shareholders’ equity.

Let’s say you use 100 pesos of your own money to start a business. If that business can produce 20 pesos of profits at the end of the year, then your return on equity is 20/100 = 20%.

ROE tells us how well management can squeeze profits from shareholders’ capital. A high ROE is a good thing.

What is the P/E Ratio?

The P/E Ratio is the market price of a stock divided by its earnings for the year. Its inverse is the Profit Yield, which is earnings divided by the current market price.

Let’s say you find a stock selling for 50 pesos per share with profits last year of 10 pesos per share. That stock has a P/E Ratio of 50/10 = 5 and a Profit Yield of 10/50 = 20%.

These ratios tell us how cheap the company is relative to its profits. A low P/E Ratio (or a high Profit Yield) is better than the opposite.

While Profit Yield can be a more intuitive metric for beginners, P/E Ratios are the industry norm, so expect to see P/E Ratios in financial publications.

ROE and P/E Ratios are very different from one another.

It might seem like ROE and P/E Ratios are similar, so here's an example highlighting their differences:

Let's say you put up 100 pesos of your own money to make a business. That business produces 5 pesos worth of profits after 1 year.

This business therefore has an ROE of 5/100 = 5%.

Now let's say the company is listed in the stock market with a market cap of 50 pesos. This means the stock is priced as if the entire company costs only 50 pesos.

This means the company has a P/E ratio of 50/5 = 10, or a Profit Yield of 5/50 = 10%.

The difference between the ratios is that ROE relates profits with equity - the shareholder capital used to build the business. The P/E Ratio, on the other hand, simply compares the business's profits with the current market price.

It may have cost you 100 pesos to build a business (the realm of ROE), but that doesn't automatically mean that buyers will purchase your business for 100 pesos (the realm of P/E Ratios).

It's dangerous to rely solely on these ratios.

A common mistake new investors make is to just buy companies with a high ROE and low P/E Ratio.

This is dangerous because you don't know if these ratios are sustainable over the long run. If the company just had an abnormally good year, these ratios can turn south when things normalize. You'll still need to research the company thoroughly.

Conclusion

Studying a stock can take a lot of time and effort. Screening ratios can help you filter out bad stocks and make a shortlist of candidates for further research.

Two common ratios used for screening are Return on Equity (ROE) and Price/Earnings Ratios (P/E Ratio). The inverse of the P/E Ratio is the Profit Yield.

Their formulas are:

ROE = Profit / Shareholder's Equity

P/E Ratio = Market Price / Profit

Profit Yield = Profit / Market Price

A high ROE means the company can squeeze good profits out of its capital.

A low P/E Ratio (or a high Profit Yield) means that current profits are cheap relative to stock price.

Using these ratios, you can quickly screen out stocks that aren't worth your time, saving you hundreds of hours of research.

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