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Some of the most common growth rate metrics investors and analysts consider in evaluating a company’s future prospects and suitability as an investment are revenues and earnings, the price-to-earnings (P/E) ratio, the price-to-earnings-to-growth (PEG) ratio, and return on equity (ROE).
From an investor’s standpoint, the purpose of using these growth ratios is to not only see how a company is performing but to also pinpoint companies that are undervalued. These companies represent potential investment opportunities that warrant the investor’s further consideration. In this article, we’ll review each of these growth rate metrics, highlighting why investors should consider them as important tools for investment analysis.
Key Takeaways
- Investors looking to pinpoint potential investment opportunities will review various growth ratios, such as revenues and earnings, the price-to-earnings (P/E) ratio, the price-to-earnings-to-growth (PEG) ratio, and return on equity (ROE).
- For many investors, the starting point in performing an investment analysis is to review the company’s revenue and earnings.
- A company with high earnings per share (EPS) is considered more profitable, leading investors to pay more for the company.
- A high price-to-earnings (P/E) ratio indicates the market is anticipating continued growth in a company’s earnings.
- Consistent increases in the return on equity (ROE) ratio indicate a company is steadily increasing in value and successfully translating that value increase into profits for investors.
Revenues and Earnings
The initial figures for investors to consider include revenue and earnings. It is difficult for a company to be sustaining growth on any front if it is not at least seeing growth in revenue—a consistent increase in the amount of money its business activities are generating in sales. Beyond the basic revenue amount, the next area to look for growth is in earnings, the amount of revenue the company retains after paying all its expenses.
The earnings of a company are determined by a number of factors, such as operating costs, financing, assets, and liabilities. Earnings per share (EPS) is one of the basic profitability metrics where analysts look for consistent increases. In general, a company with a high EPS is considered more profitable and investors will pay more for a company with higher profits.
When comparing two companies, however, knowing each company’s EPS may not be enough to decide which company is a better investment. That’s why investors frequently use EPS as a starting point in their analysis. They’ll use it to calculate ratios that help compare companies with one another and to other companies in the same industry. For example, EPS is a key component in the price-to-earnings ratio (P/E ratio).
Price-to-Earnings Ratios
The price-to-earnings ratio (P/E ratio) is one of the most widely used equity valuation metrics. It presents a measure of a company’s performance, and it provides an indication of the market’s estimation of the company’s future growth prospects. A higher P/E ratio indicates price action in the market is anticipating continued growth in a company’s earnings.
A more refined analysis of stock P/E is provided by the price/earnings-to-growth ratio (PEG ratio). The PEG ratio offers a more complete picture of earnings and growth by dividing a company’s P/E ratio by its preceding 12-month growth rate. Like the P/E ratio, the PEG ratio can be calculated on either a trailing or a forward basis, using either historical growth figures or projected growth figures. While some investors question the usefulness of P/E ratios in investment research, many investors find the ratios to be a tried-and-true component of a meticulous fundamental analysis.
Warren Buffett’s mentor, Benjamin Graham, popularized the use of P/E ratios to assess the attractiveness of a potential investment.
Return on Equity (ROE)
The return on equity (ROE) ratio is considered to be one of the best metrics for evaluating a company’s ability to efficiently generate profits from its existing financial resources. The ROE looks at earnings in comparison to shareholders’ equity. This metric can be extremely helpful to investors because it considers revenues, profit margin, leverage, and the company’s success at returning value to shareholders. Consistent increases in the ROE ratio indicate a company is steadily increasing in value and successfully translating that value increase into profits for investors.
Use Different Measures and Compare to Competitors
To evaluate potential equity investments, analysts and investors review the financial statements of companies and look at equity evaluation metrics designed to indicate the company’s profitability and growth rate. It’s important to analyze a company from more than one perspective, so it’s helpful to consider several different valuation measures. Any analysis of a company should also include a comparative analysis of the company with its closest competitors and with the market as a whole.