Investment Ratios

Then, our last section of ratios is for investment ratios. We will look at some investment ratios that are for a company making investments, and we will also look at investments from the perspective of individual investors.

Return on Assets Ratio

First, we have the return on assets ratio. This answers the question, “How much net income did we generate from our assets?” Since it’s called return on assets, then assets go in the denominator. 

Return on Assets = Net Income / Total Assets

This formula asks: for every $1 of assets, how much did we generate in net income? From our numbers, we know our net income is $5,100 and our total assets are $52,000. Therefore, our return on assets is approximately 10%. That means from all the assets we’re using, we’re generating about a 10% profit.

Return on Equity Ratio

The next investment ratio is the return on equity. We aim to show how much net income we generate from the equity we have in the company. 

Return on Equity = Net Income / Total Equity

Remember, the equity includes retained earnings, which is the net income that we earned but didn’t distribute to the stockholders. We keep this in our company to strengthen it and to be able to generate even more profit in the future.

Why does the return on equity ratio matter? Imagine owning a company with a return on equity of 5%. That means for all the equity you’re keeping in the company, you’re generating 5% of net income. But if the stock market is yielding a return of 7%, you’d have to decide if it’s better to keep your money in the company or take it out and invest it in the stock market.

In our example, our total equity is $15,000, and our net income is $5,100. Our return on equity is about 34%. This means that from the equity we keep in the company, we’re generating a 34% return. 

Equity Multiplier Ratio

The next ratio is the equity multiplier, which asks: for every $1 of equity, how much have we been able to multiply that into assets?

Equity Multiplier = Total Assets / Total Equity

If our total assets are $52,000 and our total equity is $15,000, then our equity multiplier is approximately 3.5. That means for every $1 that we’ve contributed to the company and kept within the company, we’ve generated $3.50 of assets.

Dividend Payout Ratio

Now, let’s talk about investment ratios for individual investors. As investors, we first want to think about the dividend payout ratio. Not all companies pay a dividend to their owners. For those that do, we need to ask, “Out of our total net income, how much is the company paying out in dividends?”

Dividend Payout Ratio = Dividends Paid / Net Income

Let’s say that our company paid out $510 in dividends this year. Our net income was $5,100, and we paid out $510 in dividends, meaning our dividend payout ratio is 10%. The company paid out 10% of what it earned, meaning 90% of the earnings stayed within the company. 

Earnings Per Share Ratio

When analyzing an investment decision, it’s not sufficient to merely ask how much in total net income the company had. Instead, we want to break that down to a per-share basis of net income. Because of this, we have what is known as earnings per share, which is simply net income divided by the number of shares outstanding.

Earnings Per Share = (Net Income – Preferred Dividends) / Average Number of

Common Shares Outstanding

For example, with our company, let’s say we have 1,000 shares outstanding and our net income was $5,100, meaning that our earnings per share would be $5.10, with every share generating $5.10 of net income. This would be significantly different if we had 5,000 shares outstanding instead because then our earnings per share would only be $1.02.

Earnings per share focuses on the common shareholders, which is why we subtract out the preferred shareholder dividends. In our example just now, we didn’t have any preferred stock or preferred dividends. It was simply $5,100 divided by 1,000. 

Price-to-Earnings Ratios

Earnings per share helps you see how much net income is generated per share of stock. What it doesn’t help you see is whether the company’s stock price is overvalued or undervalued. For that, we have the price-to-earnings ratio. 

Price-to-Earnings Ratio = Price Per Share / Earnings Per Share

Let’s say that our company’s stock price is $25. Our price-to-earnings ratio is going to be $25 divided by $5.10, which equals 4.9. What does this 4.9 price-to-earnings ratio mean? It means that if we invested $25 in buying part of a company and the company paid out 100% of net income as dividends, it would take us 4.9 years to recover our initial investment in the company.