Related topics: stocks, investing strategy, stock market, 401k, investments

Now that you've learned the basics of reading financial statements (the language of business), let's learn the basic language of investing.

Ratios are a common tool investors use to relate a stock's price with an element of the underlying company's performance. These quick and dirty ratios can be useful in their own way, as long as you're aware of the limitations.

But before we get to calculating any ratios, we must first cover some essential definitions.

## Earnings per share

Earnings per share (EPS) is a company's net income (typically over the trailing 12 months) divided by its number of shares outstanding. EPS comes in two varieties, basic and diluted. Basic EPS includes only actual outstanding shares of a company's stock, while diluted EPS represents all potential stock that could be outstanding with current stock option grants and the like. Diluted EPS is the more "conservative" number.

EPS = (Total Company Earnings) / (Shares Outstanding)

Although EPS can give you a quick idea of a company's profitability, it should not be used in isolation. Investors should also look at cash flow and other performance metrics.

## Market capitalization

Market capitalization is essentially the market value of a company. It is calculated by multiplying the number of shares outstanding by the current share price. For example, if there are 10 million shares outstanding of ABC Corporation and ABC's stock is trading at \$25 per share, the market capitalization of ABC is \$250 million. As we will find out shortly, market capitalization not only gives you an idea concerning the size of a company, it can also be used when calculating the basic valuation ratios.

Market Capitalization = (Stock Price) x (Shares Outstanding)

## Profit margins

Just as there are three types of profits -- gross, operating and net -- there are three types of profit margins that can be calculated to offer insight into a company's profitability. Gross margin is simply gross profits divided by revenues, and so on. Margins are usually stated in percentages.

Gross Margin = (Gross Profits) / Revenues

Operating Margin = (Operating Profits) / Revenues

Net Margin = (Net Profits) / Revenues

## Price-earnings and related ratios

One of the most popular valuation measures is the price-to-earnings ratio, or P/E. The P/E is the price of a stock divided by its EPS from the trailing four quarters. As an example, a stock trading for \$15 per share with earnings of \$1 per share during the past year has a P/E of 15.

P/E = (Stock Price) / EPS

The P/E ratio gives a rough idea of the price investors are paying for a stock relative to its underlying earnings. It is a quick and dirty way to gauge how cheap or expensive a stock may be. Generally, the higher the P/E ratio, the more investors are willing to pay for a dollar's worth of earnings. High P/E stocks (typically those with a P/E above 30) tend to have higher growth rates and/or the expectation of a profit turnaround. Meanwhile, low P/E stocks (typically those with a P/E below 15) tend to have slower growth or diminished prospects.

The P/E ratio can also be useful when compared with the P/Es of similar companies to see how the competitors stack up. In addition, you can compare a company's P/E with the average P/E of the Standard & Poor's 500 Index (\$INX) to get a rough idea of how richly a stock is valued relative to the broader market.