Know your Ratios

Top Risk-Adjusted Ratios in Finance: 

• Sharpe Ratio (Reward-to-Variability): Measures excess return per unit of total standard deviation (risk). A ratio over 1.0 is generally considered good, indicating the portfolio provides high returns for its volatility.

• Sortino Ratio: A variation of the Sharpe ratio that only penalizes negative volatility (downside deviation), ignoring upside fluctuations. It is better for evaluating skewed return distributions, with a ratio above 2.0 considered very good and over 3.0 excellent.

• Treynor Ratio: Similar to Sharpe, but it swaps total volatility for Beta (systematic market risk). Best For: Well-diversified portfolios where the investor only cares about risk related to the broader market. Helps to understand if the investment is more or less risker than the Index. 

• Calmar Ratio: Calculates the ratio of annualized return to the maximum drawdown (largest peak-to-trough decline). It directly measures the return gained against the worst-case pain, with a ratio > 2.0 considered excellent. 

Notable Performance Metrics

• Information Ratio (IR): Evaluates a manager's ability to consistently generate "excess returns" above a specific benchmark (like the S&P 500) relative to the volatility of those excess returns.

• Jensen's Alpha: Measures the portion of a portfolio's return that cannot be explained by market movements, often used to quantify a manager's skill.

• Modigliani-Modigliani (M2): Converts the Sharpe ratio into percentage terms, making it easier to compare an investment's performance directly against a benchmark like the S&P 500.

1. Valuation Ratios (Is the stock "cheap" or "expensive"?)

These are the most frequently cited metrics for investors trying to determine a fair entry price for a stock. 

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• Price-to-Earnings (P/E) Ratio: Compares a company's share price to its Earnings Per Share (EPS). It tells you how much investors are willing to pay for every $1 of profit.

• Price/Earnings-to-Growth (PEG) Ratio: Divides the P/E by the expected earnings growth rate. A PEG below 1.0 is often seen as a sign that a stock is undervalued relative to its growth.

• Price-to-Book (P/B) Ratio: Compares market value to the company's "book value" (assets minus liabilities). It is widely used for asset-heavy industries like banking or manufacturing. 

2. Profitability Ratios (How well does the company make money?)

These measure how efficiently a company turns sales into actual profit for shareholders. 

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• Return on Equity (ROE): Measures net income as a percentage of shareholder equity. It is a "gold standard" for seeing how effectively management uses investors' money to generate growth.

• Net Profit Margin: The percentage of revenue left after all expenses (taxes, interest, etc.) are paid. It is a direct indicator of overall financial health.

• Return on Assets (ROA): Shows how much profit a company generates for every dollar of assets it owns. It helps compare companies with different levels of debt. 

3. Liquidity & Solvency Ratios (Can the company pay its bills?) 

These ratios assess a company's ability to meet its financial obligations, both short-term and long-term. 

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• Current Ratio: Divides current assets by current liabilities. A ratio above 1.0 generally means the company can cover its bills due within the next year.

• Quick Ratio (Acid-Test): A stricter version of the current ratio that excludes inventory, focusing only on the most liquid assets like cash and receivables.

• Debt-to-Equity (D/E) Ratio: Measures the total amount of debt relative to shareholder equity. High D/E ratios can signal high risk, especially in high-interest-rate environments. 

4. Efficiency Ratios (How fast do they move?)

• Inventory Turnover: Measures how many times a company's inventory is sold and replaced over a period. High turnover is usually a sign of strong sales and efficient operations.

• Days Sales Outstanding (DSO): The average number of days it takes a company to collect payment after a sale. A lower number is better for cash flow.