Now that you've learned the basics of reading financial statements (the language of business), let's learn the basic language of investing.

Ratios are a common tool investors use to relate a stock's price with an element of the underlying company's performance. These quick and dirty ratios can be useful in their own way, as long as you're aware of the limitations.

But before we get to calculating any ratios, we must first cover some essential definitions.

Earnings Per Share

Earnings per share (EPS) is a company's net income (typically over the trailing 12 months) divided by its number of shares outstanding. EPS comes in two varieties, basic and diluted. Basic EPS includes only actual outstanding shares of a company's stock, while diluted EPS represents all potential stock that could be outstanding with current stock option grants and the like. Diluted EPS is the more "conservative" number.

EPS = (Total Company Earnings) / (Shares Outstanding)

Although EPS can give you a quick idea of a company's profitability, it should not be used in isolation without also looking at cash flow and other performance metrics.

Market Capitalization

Market capitalization is essentially the market value of a company. It is calculated by multiplying the number of shares outstanding by the current share price. For example, if there are 10 million shares outstanding of ABC Corporation and ABC's stock is currently trading at $25 per share, the market capitalization of ABC is $250 million. As we will find out shortly, market capitalization not only gives you an idea concerning the size of a company, it can also be used when calculating the basic valuation ratios.

Market Capitalization = (Stock Price) x (Shares Outstanding)

Profit Margins

Just as there are three types of profits--gross, operating, and net--there are also three types of profit margins that can be calculated to offer insight into a company's profitability. Gross margin is simply gross profits divided by revenues, and so on. Margins are usually stated in percentages.

Gross Margin = (Gross Profits) / Revenues
Operating Margin = (Operating Profits) / Revenues
Net Margin = (Net Profits) / Revenues

Price/Earnings and Related Ratios

One of the most popular valuation measures is the price/earnings ratio, or P/E. The P/E is the price of a stock divided by its EPS from the trailing four quarters. As an example, a stock trading for $15 per share with earnings of $1 per share during the past year has a P/E of 15.

P/E = (Stock Price) / EPS 

The P/E ratio gives a rough idea of the price investors are paying for a stock relative to its underlying earnings. It is a quick and dirty way to gauge how cheap or expensive a stock may be. Generally, the higher the P/E ratio, the more investors are willing to pay for a dollar's worth of earnings from a company. High P/E stocks (typically those with a P/E above 30) tend to have higher growth rates and/or the expectation of a profit turnaround. Meanwhile, low P/E stocks (typically those with a P/E below 15) tend to have slower growth and/or lesser future prospects.

The P/E ratio can also be useful when compared with the P/Es of similar
companies to see how the competitors stack up. In addition, you can compare a company's P/E with the average P/E of the S&P 500 or some other benchmark index to get a rough idea of how richly a stock is valued relative to the broader market.

One useful variant of P/E is earnings yield, or EPS divided by the stock price. Earnings yield is the inverse of P/E, so a high earnings yield indicates a relatively inexpensive stock while a low earnings yield indicates a more expensive one. It can be useful to compare earnings yields with 10- or 30-year Treasury bond yields to get an idea of how expensive a stock is.

Earnings Yield = 1 / (P/E ratio) = EPS / (Stock Price)

Another useful variant of P/E is the PEG ratio. A high P/E generally means that the market expects the company to grow its profits rapidly in the future, so a much greater percentage of the company's potential earnings are in the future. This means its market value (which reflects those future earnings) is large relative to its present-day earnings.

The PEG ratio can help you determine if a stock's P/E has gotten too high in these cases by giving you an idea of how much investors are paying for a company's growth. A stock's PEG ratio is its forward P/E divided by its expected earnings growth over the next five years as predicted by a consensus of Wall Street estimates. For example, if a company has a forward P/E of 20 with annual earnings estimated to grow 10% per year on average, its peg ratio is 2.0. Again, the higher the peg ratio, the more relatively expensive a stock is.

PEG = (Forward P/E Ratio) / (5-Year EPS Growth Rate)

As with other measures, the PEG ratio should be used with caution. PEG relies on two different Wall Street analyst estimates--next year's earnings and five-year earnings growth--and thus is doubly subject to the possibility of overly optimistic or pessimistic analysts. It also breaks down at the extremes of zero-growth or hyper-growth companies.

Price/Sales Ratio

The price/sales (P/S) ratio is figured the same way as P/E, except with a company's annual sales as the denominator instead of its earnings. An advantage to using the P/S ratio is that it is based on sales, a figure that is much harder to manipulate and is subject to fewer accounting estimates than earnings. Also, because sales tend to be more stable than earnings, P/S can be a good tool for screening cyclical companies and other companies with fluctuating earnings patterns.

P/S = (Stock Price) / (Sales Per Share) = (Market Capitalization) / (Total Sales)

When using the P/S ratio, it is important to keep in mind that a dollar of earnings has essentially the same value regardless of the level of sales needed to create it. Meaning, a dollar of sales at a highly profitable firm is worth more than a dollar of sales for a company with narrow profit margins. This means comparing price/sales is generally useful only when comparing companies in similar industries.

To understand the differences across industries, let's compare grocery stores with the medical-device industry. Grocery stores tend to have very small profit margins, earning only a few pennies on each dollar of sales. As such, grocers have an average P/S ratio of 0.5, one of the lowest in Morningstar's coverage universe. It takes a lot of sales to create a dollar of earnings at a grocery store, so investors do not value those sales dollars very highly.

Meanwhile, medical-device makers have much fatter profit margins. Relative to the grocer, it does not take nearly as much in sales for a medical-device company to create a dollar in earnings. It is little wonder the device makers have a high average price/sales ratio of 5.0. A grocer with a P/S ratio of 2.0 would look quite expensive while a medical-device maker with the same P/S could be dirt-cheap.

Price/Book Ratio

Another common valuation measure is the price/book ratio (P/B), which relates a stock's market value with its book value (also known as shareholder equity) from the latest balance sheet. Book value can be thought of as what would be left over for shareholders if a company shutters operations, pays off its creditors, collects from its debtors, and liquidates itself.

Book Value Per Share = (Total Shareholders Equity) / (Shares Outstanding)

P/B = (Stock Price) / (Book Value Per Share) = (Market Capitalization) / (Total Shareholder Equity)

As with the other ratios we've covered so far, there are caveats to using P/B. For instance, book value may not accurately measure a company's worth, especially if the firm possesses significant intangible assets such as brand names, market share, and other competitive advantages. The lowest price/book ratios tend to be in capital-intensive industries such as utilities and retail, whereas the highest P/B ratios are in fields such as pharmaceuticals and consumer products, where intangibles are more important.

Price/book is also tied to return on equity (ROE), which is net income divided by shareholder equity. Given two companies that are otherwise equal, the one with the higher ROE will have a higher P/B ratio. A high P/B shouldn't be cause for alarm, especially if the company continually earns a high ROE.

Price/Cash Flow

The price/cash flow (P/CF) ratio is not as commonly used or as well known as the other measures we've discussed. It's calculated similarly to P/E, except that it uses operating cash flow instead of net income as the denominator.

P/CF = (Stock Price) / (Operating Cash Flow Per Share)

Cash flow can be less subject to accounting shenanigans than earnings because it measures actual cash, not paper or accounting profits. Price/cash flow can be helpful for firms such as utilities and cable companies, which can have more cash flow than reported earnings. Price/cash flow can also be used in place of P/E when there are so many one-time expenses that reported earnings are negative.

Dividend Yield

There are two ways to make money when buying a stock--capital gains (when a stock goes up in price) and dividend payments. Dividends are payments that companies make directly to shareholders.

Dividend yield has been an important measure of valuation for many years. The dividend yield is equal to a company's annual dividend per share divided by its stock price per share. So, if a company pays an annual dividend of $2.00 and has a stock that trades for $100, its dividend yield is 2.0%. If that same stock's price fell to $50 per share, its dividend yield would rise to 4.0%. Conversely, all else equal, the dividend yield falls when a stock's price goes up.

Dividend Yield = (Annual Dividends Per Share) / (Stock Price)

Stocks with high dividend yields are generally mature companies with few growth opportunities. The economic reasoning behind this is that these companies can't find enough promising projects to invest in for future growth, so they pay a larger portion of profits back to shareholders. While utility companies are considered the typical dividend-paying stocks, you can also find dividends in sectors with lots of room left for growth such as the pharmaceutical industry.

Dividends have recently begun to garner investors' attention again. A big driver of this new focus was a recent change in the United States tax code that lowered the tax rate on dividends. So if you are looking for dividend income from your stock investments, remember that the best high-yielding stocks have strong cash flows, healthy balance sheets, and relatively stable businesses. And, if you're relying on that stream of dividends for income, checking for a steady history of dividend payments is also a good idea.

The Bottom Line

We've gone over how to calculate a lot of ratios in this lesson, but understanding the components of these ratios is key to learning the lingo of investors. It is also essential in beginning to understand when a stock is cheap or expensive. The good news is that if you invest long enough, the ratios highlighted here will become second nature.