P/E, ROE, and the handful of ratios that actually matter

There are dozens of financial ratios. You need about four to start, and understanding those four properly will serve you better than a superficial acquaintance with twenty.

A ratio is a question, not an answer. Each one below tells you what to investigate next.

Price-to-earnings (P/E)

Share price divided by earnings per share. It tells you how many years of current earnings you are paying for.

A P/E of 8 means you are paying eight times what the company earned last year. Whether that is cheap depends entirely on what happens to earnings next. A cyclical business at the top of its cycle can look cheap on a P/E precisely because its earnings are about to fall, and this is one of the most reliable traps in the market.

Use it comparatively, never absolutely: against the company's own history, and against its direct peers. A P/E in isolation is not information.

Return on equity (ROE)

Net profit divided by shareholders' equity. It measures how efficiently the owners' capital into profit, and it is arguably the single most informative ratio about business quality.

A business that consistently earns a high ROE over many years usually has something durable protecting it: a brand, a distribution network, a licence, a cost advantage. Consistency matters more than the peak. One spectacular year proves nothing.

The catch: ROE can be inflated by debt, because borrowing raises returns on a smaller equity base. Always read ROE alongside debt-to-equity, or you will mistake leverage for quality.

Debt-to-equity (D/E)

Total debt divided by shareholders' equity. How much of the business is funded by borrowing rather than by its owners.

This ratio carries particular weight in Pakistan, where interest rates have moved sharply and often. A company comfortable with heavy debt at one policy rate can find its entire profit consumed by finance costs at another. When rates rise, leveraged companies are hit twice: higher costs, and usually a weaker economy at the same time.

What counts as high varies by industry. Utilities and banks operate with structurally different balance sheets than consumer goods companies. Compare within a sector, never across.

Dividend yield

Annual dividend per share divided by share price. What you are paid, in cash, for owning the stock at today's price.

Dividend yields are a significant part of the return for many PSX investors, and they impose a useful discipline: a company paying real cash dividends year after year is generating real cash.

The trap is the yield that rises because the price fell. A yield that suddenly looks generous often means the market expects the dividend to be cut. Check the payout ratio (the share of earnings being paid out) and ask whether it is sustainable.

Reading them together

No ratio means anything alone. The combinations are where understanding starts:

• High ROE with low debt: genuine quality. Worth understanding why the company earns it.
• High ROE with high debt: leverage doing the work, and fragile if rates rise.
• Low P/E with falling earnings: probably not cheap. This is a value trap.
• High dividend yield with a payout ratio near or above 100%: the dividend is likely to be cut.

What ratios cannot tell you

Whether management is honest. Whether the competitive position is eroding. Whether a regulatory change is coming. Whether the accounting is aggressive.

Ratios summarise what already happened, in numbers the company chose how to present. They narrow the field of companies worth examining. The examining is still your job.