One of the most common applications of financial analysis is that of selecting stocks. An equity analyst uses various tools (such as valuation ratios) before recommending a security to be included in an equity portfolio. The valuation process consists of the following steps:
This section, in particular, focuses on the ratios used to value equity. Research has shown that ratios are useful in forecasting earnings and stock returns. Note that this material is covered in more detail in the equity segment of the curriculum.
Valuation ratios aid in making investment decisions. They help us determine if a stock is undervalued or overvalued.
Valuation Ratio  Formula  Interpretation 
P/E  Most often used valuation measure. Prone to earnings manipulation. Nonrecurring earnings may distort the ratio.  
P/CF  Less prone to manipulation than P/E.  
P/S  Used when net income is not positive.  
P/BV  An indicator of what the market perceives. A value greater than 1 means future rate of return is higher than required rate of return. 
Per share quantities  
Basic EPS  Net Income Minus Preferred Dividends / Weighted Average Number of Ordinary Shares Outstanding 
Diluted EPS  (Adjusted Income) / Weighted Average Number of Ordinary Shares Outstanding 
Cash flow per share  Cash Flow from Operations / Weighted Average Number of Ordinary Shares Outstanding 
EBITDA per share  EBITDA / Weighted Average Number of Ordinary Shares Outstanding 
Dividends per share  Common Declared Dividends / Weighted Average Number of Ordinary Shares Outstanding 
Dividendrelated formulae  
Dividend Ratios  Formula  Interpretation 
Dividend payout ratio  Measures the percentage of earnings a company pays out as dividends to equity shareholders.  
Retention rate 
1 – payout rate

Measures the percentage of earnings a company retains. 
Sustainable growth rate  Measures how much growth a company is able to finance from its internally generated funds. Higher retention rate and ROE result in higher sustainable growth rate. 
Ratios serve as indicators of some aspect of a company’s performance and value. Aspects of performance that are important in one industry may be irrelevant in another. These differences are reflected through industryspecific ratios. For example, companies in the retail industry may report samestore sales changes because in the retail industry it is important to distinguish between growth that results from opening new stores and growth that results from generating more sales at existing stores.
Credit risk is the risk that the borrower will default on a payment when it is due. For example, if you are a bondholder, credit risk is the risk that the bond issuer will not pay you the interest on time. Credit analysis is the evaluation of this credit risk. Just as ratio analysis is useful in valuing equity, it can also be applied to analyze the creditworthiness of a borrower.
Credit ratings are based on a combination of qualitative and quantitative factors. Qualitative factors include an industry’s growth prospects, volatility, technological change, competitive environment, operational effectiveness, strategy, governance, financial policies, risk management practices, and risk tolerance. Quantitative factors include profitability, leverage, cash flow adequacy, and liquidity.
Credit Analysis Ratio  Formula  Interpretation 
EBITDA interest coverage  *Gross interest include noncash interest on conventional debt instruments  A high value implies good credit quality. 
FFO (Funds from operations) to debt  FFO / Total debt  A high value implies good credit quality. 
Free operating cash flow to debt  CFO (adjusted) minus capital expenditures / Total debt  A high value implies good credit quality. 
EBIT margin  EBIT / Total revenue  A high value implies good credit quality. 
EBITDA margin  EBITDA / Total revenue  A high value implies good credit quality. 
Debt to EBITDA  Low debt/EBITDA implies good credit quality.  
Return on capital 
EBIT / Average beginningofyear and endofyear capital 
A high value implies good credit quality. 
Debt to EBITDA  Low debt/EBITDA implies good credit quality.  
Return on capital 
EBIT / Average beginningofyear and endofyear capital 
A high value implies good credit quality. 
A business or geographic segment is a portion of a company that has risk and return characteristics distinct from the rest of the company and accounts for more than 10% of the company’s sales or assets. Companies are required to report some items for significant segments separately.
Ratios can be computed for business segments to evaluate how units within a business are performing. Some of the key segment ratios are listed below:
Ratio  Formula  Measures 
Segment margin  Operating profitability relative to revenue.  
Segment turnover  Overall efficiency of the segment.  
Segment ROA  Operating profitability relative to assets.  
Segment debt ratio  Solvency. 
Analysts use several methods to forecast future performance. One commonly used method is to project sales and to combine the forecasted sales numbers with expected values for key ratios. For example, by using sales numbers and gross profit margin, one can determine cost of goods sold and gross profit. This method is particularly useful for mature companies with stable margins.
Besides ratio analysis, techniques such as sensitivity analysis, scenario analysis, and simulations are often used as part of the forecasting process.