The stock universe is so vast that it’s not easy to find the diamond in the rough. Especially with the market hovering near an all-time high, finding good bargains is a challenge.

As an investor though, you should always want to try to find the best stock for your hard-earned money. You’ll want to know which stock may be overpriced and which may be underpriced. This is where comparing financial ratios is helpful.

Putting numbers into ratios lets you make comparisons on the same scale.

## Using Ratios to Compare

Consider the following. Let’s say you are choosing between Company A and Company B.

Company A had profits of \$300 million last year and Company B had \$150 million. On the surface A may seem better but what if I told you had A has 300 million shares outstanding but B only had 50 million shares outstanding?

In this case, A’s earnings per share (EPS) would be \$1 and B’s would be \$3. Put another way, as a Company A shareholder you have claim to \$1 of company profit per share, and as a Company B shareholder, your claim would be \$3 per share. B now looks better.

But that’s not the end of the story. What if I told you that shares of A are trading for \$20 and shares of B are trading for \$90? This means that you would pay \$20 per \$1 (\$20/\$1) A’s profit and pay \$30 per \$1 (\$90/\$3) of B’s profit. Now A looks cheaper.

What I just talked about is the price-to-earnings (P/E) ratio, a commonly used and commonly cited metric. Of course, you will have to keep in mind the differences between companies such as their relative sizes, industries, and other attributes, but if you were comparing two companies in the same industry, the P/E ratio can be quite a useful tool to help you make a decision.

## Don’t Ignore the ROE

While P/E is perhaps the best-known financial metric to the public, I want to draw your attention to a related ratio, the return on equity (ROE), which tells you more about the company.

The simplest way to calculate a company’s ROE is to divide its net income by its shareholders’ equity. The ratio measures how well a company turns shareholders’ investment into profits.

On the balance sheet, a company’s assets must equal to liabilities plus shareholders’ equity. Therefore, equity is also assets minus liabilities. Thus, the ROE can also be thought of as a company return on net assets.

When comparing two companies, the one with the higher ROE is doing a comparatively better job of using shareholder equity to grow and to create shareholder value. A high and growing ROE is even better. It indicates that management is doing a good job of continuing to reinvesting earnings into profitable projects.

## Extrapolating Growth Rate from ROE

Note that if you know a company’s ROE and you know its earnings retention rate—what percent of its earnings it does not pay out as dividend—then you can calculate its “sustainable” growth rate.

To give an example, let’s say a company has a ROE of 12%, and it pays out 60% of its earnings to shareholders. This means its retention rate is 40%. Now you can calculate the sustainable growth rate by multiplying 12% by 40%, which is 4.8%. This means that the company can be expected to increase earnings at a rate of 4.8% over the long run.

Obviously, whenever you make projections, it’s only an estimate. Over time the actual growth rate year to year can naturally fluctuate quite a bit because economic conditions change. Management can also change ROE through internal operational adjustments.

However, it is useful to compare a company’s ROE to the ROE of its individual peers and the industry. It can reveal insights about how good a job that company is doing and help you pick the company that’s better managed or uses its resources more efficiently.

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