If you are new to investing in shares, then the thought of using financial ratios to identify the best shares to buy for your share portfolio probably conjures up images of painstaking analysis of company accounts, endless financial figures that you don’t understand and an ultimate feeling of frustration, confusion and overwhelm?
If this sounds like you, then it doesn’t have to be this way.
Picking the best shares for your portfolio is obviously key to improving the returns that you get from your share investments and learning how to use financial ratios to identify the most undervalued companies is a great method of doing this.
Using financial ratios or fundamental analysis as it is called is the method that I use to identify a shortlist of shares to buy.
It is also the method used by famous investors like Warren Buffett for example and that’s a good enough endorsement for me!
The Best Financial Ratios
Whenever I am looking to buy a share and I don’t have a share in mind, I usually start by searching for shares that meet certain criteria.
Those criteria always include a number of financial ratios.
The ones I’m going to talk about below are my favourites and I never buy a share without analyzing it against these financial ratios beforehand.
I can’t promise you that using these financial ratios yourself will turn you into the next Warren Buffett, but I can promise you that using the following 4 financial ratios will improve your stock picking results and thus the quality of your share portfolio.
1. PE Ratio
The first fundamental financial ratio that I check for or use to screen shares for is the Price to Earnings Ratio or PE Ratio.
I often use this financial ratio to analyze whether a company share is undervalued or overvalued relative to its earnings i.e. profits.
For more information on the PE Ratio, how to calculate it and how to use it, click here.
2. PBV Ratio
The second fundamental financial ratio that I check is called the Price to Book Value Ratio or PBV Ratio (also known as the Price to Book Ratio or PB Ratio).
I use this financial ratio to analyze whether a company share is undervalued or overvalued relative to its assets.
For more information on the PBV Ratio and how to calculate it, use it, etc. click here.
3. PEG Ratio
The third fundamental financial ratio that I use is the Price to Earnings Growth Ratio or PEG Ratio that was made popular by Jim Slater in his famous book “The Zulu Principle.”
The PEG Ratio is not as widely available in newspaper listings and on web sites as the others and it is more difficult to calculate but it is essential for buying growth shares because it tells you whether the growth in the company’s earnings are fully priced into the shares or not.
For more information on the PEG Ratio, how to calculate it and use it, etc. click here.
4. Dividend Yield
The fourth and final financial ratio that I’m going to mention here is the Dividend Yield.
There are a number of dividend ratios I use (you can get the full list here) but this is the main one and it is widely published everywhere.
I use the dividend yield to analyze how much income I am going to get from holding these company shares so if income is important to you, like it is to me, then you will be able to search for high income shares using this financial ratio.
For more information on the Dividend Yield click here.
Putting It All Together
There is no doubt that fundamental analysis using financial ratios, as I have described here, is key to improving your investment success.
When you get into the habit of doing it properly and consistently, you will not only improve your stock picking, but you will time your buys and sells better and make fewer mistakes.
Ultimately, you will achieve bigger returns with your investments than you have hitherto, so why not give it a go?
If you’d like to follow a tried and tested process with more detailed checklists of what to analyze then you can find out about our Company Analysis Workbook by clicking here.
Otherwise, leave me a comment below about the kinds of things that you like to analyze when you pick your stocks or ask me a question you have with regard to improving stock picking.