Financial ratios are important to the investor and I group them into two categories: operating ratios and market ratios. The former address the operating characteristics of the business, such as "net profit margin." This takes the "net profits" (addressed in a prior post) and divides it by revenues. These ratios are important to understanding the business models itself.
Market ratios, on the other hand, reveal the general assessment of the value of the business. There are several, but the most attended is the "P/E ratio," which means Price to Earnings. Like any measure, simplification has occurred and is important. Any time a "P/E" is discussed, an investor should ask does this mean Price to last year's Earnings or Price to Trailing Twelve Months Earnings or Price to next year's Earnings. I have seen all of these used almost interchangeably.
As companies continue to creatively account for and present their results, the investor needs to use these ratios as a passageway to gaining greater qualitative understanding. For years, the "value" investor was simply focused on such ratios as a means of identifying a "margin of safety." In a world of change accelerating by globalization, the internet and cheap capital, such ratios may be misleading if they are not specifically connected to underlying qualities.
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