My 5 Favourite Financial Ratios

I know, I know. I should get out more. Favourite financial ratios? Give me a break.

But actually, I am rather fond of these ratios. And for the best of reasons.

Because, simply put, keeping a watchful eye on these numbers helps me to build my wealth. And that's logic with which you can't really quibble.

So what are my favourite financial ratios for evaluating prospective shares in which to invest my money? Let's take a look.

Yield

Solid, bankable dividends are the surest way to build long-term sustainable total return, as studies repeatedly show.

And, of course, income investors appreciate dividends for another reason: the dividend stream forms their income.

But how deep is that dividend stream? That's where dividend yield -- often simply abbreviated to"yield" comes in.

And it's expressed very simply:

Dividends per share

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   Price per share

Some people like looking at historic dividend yield, while some -- like me -- prefer forecast dividend yield. But, if using the forecast yield, compare the forecast dividend to the previous year's dividend, and ask yourself if it's reasonable.

Dividend cover

Now, one reason why a forecast dividend might be wrong, or why this year's dividend is less than last year's dividend, is that the business simply hasn't got the money to pay it.

The business's earnings, in short, aren't large enough to support a distribution to shareholders at historic levels.

Put another way, actual earnings per share aren't sufficiently when large compared to the anticipated dividend per share.

Which is where dividend cover comes in:

 Earnings per share

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Dividends per share

A ratio of close to one is definitely the danger zone. A ratio much bigger than two indicates a certain parsimony. A ratio of 1.5-2.5 is usually what I'm looking for.

Price to Tangible Book Value

Right, that's dividends out of the way. Now it's time to look at how much you have to pay to actually acquire those dividends.

Now, not all assets are equal. And so while a simple 'price to book value' throws up candidates shares to have look at, you'll want to satisfy yourself that the book value of the assets is likely to be realised if the business went bust and the assets had to be sold.

It's for that reason that I'm leery of big chunks of 'intangibles' in the books -- the value placed on brands and other intellectual property, for instance.

But property in the form of land, buildings, inventory and cash is another matter -- and yes, some businesses are valued by the market at prices at, or close to, the money that is sitting in their bank accounts!

How to spot such bargains? Here's the ratio to set your favourite screening tool to work on:

                      Share price

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(Total tangible assets - liabilities) per share

P/E ratio

Another way of seeing whether you're getting those all-important dividends at a bargain price is to look directly at the value the market places on that stream of earnings.

Which is where the price-to-earnings (P/E) ratio comes in.

Now, it's not a perfect measure, by any means. And again, it comes in historic and forecast flavours. But it's a reasonable guide, and P/E ratios that are too low (below five, say) or too high (much above 25) should ring warning bells -- particularly at the lower end of the scale.

And here's the formula:

   Price per share

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Earnings per share

But if using a published P/E, do make sure of what you're looking at. Is it forecast P/E? Or historic P/E? And if historic, over exactly which period? Another tip: look at trend data, where possible. In other words, how does today's quoted P/E compare to previous years' quoted P/E values?

Gearing

Now, P/E levels can simply get beaten down by market sentiment. Perfectly good businesses with sound financials fall out of favour, and the P/E consequently gets slaughtered. At that point, investors with an eye for a bargain start to salivate.

One share that certainly meets this description has recently caught the eye of investing legend Warren Buffett, for example. Which share? And why? Read this free Motley Fool report,"The One UK Share Warren Buffett Loves" to find out.

But equally, P/E ratios get beaten down because the market sees signs of danger -- and the earliest sign of danger is usually excessive debt.

But "excessive", compare to what? That's where the gearing ratio comes in, which compares the debt that the business owes to the net tangible assets (total tangible assets less liabilities) held by the business.

There are various ways of calculating gearing, but I like one of the simplest approaches:

                 Net debt

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Total tangible assets - liabilities

What's a 'good' level of gearing? What's a 'bad' level? The answer depends on the business: some businesses, like utilities, are non-cyclical cash cows and therefore able to withstand more debt than others. And it also depends on the economy: being highly geared going into a recession or period of high interest rates isn't good news.

Foolish bottom line

So there we have it: my five favourite financial ratios. Now, as with all such figures, common sense is required. In short, following metrics blindly is a recipe for serial disappointment.

Personally, I like several of them to be pointing to a buy, rather than just one or two. But in that, I reckon I'm in good company -- ask Warren Buffett.