Stock investing requires careful analysis of financial data to find out the company’s true worth. This is generally done by examining the company’s profit and loss account, balance sheet and cash flow statement. This can be time-consuming and cumbersome. An easier way to find out about a company’s performance is to look at its financial ratios, most of which are freely available on the internet.
Though this is not a foolproof method, it is a good way to run a fast check on a company’s health.
“Ratio analysis is crucial for investment decisions. It not only helps in knowing how the company has been performing but also makes it easy for investors to compare companies in the same industry and zero in on the best investment option,” says DK Aggarwal, chairman and managing director, SMC Investments and Advisors.
We bring you eleven financial ratios that one should look at before investing in a stock .
The price-to-earnings, or P/E, ratio shows how much stock investors are paying for each rupee of earnings. It shows if the market is overvaluing or undervaluing the company.
One can know the ideal P/E ratio by comparing the current P/E with the company’s historical P/E, the average industry P/E and the market P/E. For instance, a company with a P/E of 15 may seem expensive when compared to its historical P/E, but may be a good buy if the industry P/E is 18 and the market average is 20.
Sabyasachi Mukherjee, AVP and product head, IIFL, says, “A high P/E ratio may indicate that the stock is overpriced. A stock with a low P/E may have greater potential for rising. P/E ratios should be used in combination with other financial ratios for informed decisionmaking.”
“P/E ratio is usually used to value mature and stable companies that earn profits. A high PE indicates that the stock is either overvalued (with respect to history and/or peers) or the company’s earnings are expected to grow at a fast pace. But one must keep in mind that companies can boost their P/E ratio by adding debt (thereby constricting equity capital). Also, as future earnings estimates are subjective, it’s better to use past earnings for calculating P/E ratios,” says Vikas Gupta, executive vice president, Arthaveda Fund Management.
The price-to-book value (P/BV) ratio is used to compare a company’s market price to its book value. Book value, in simple terms, is the amount that will remain if the company liquidates its assets and repays all its liabilities.
P/BV ratio values shares of companies with large tangible assets on their balance sheets. A P/BV ratio of less than one shows the stock is undervalued (value of assets on the company’s books is more than the value the market is assigning to the company). It indicates a company’s inherent value and is useful in valuing companies whose assets are mostly liquid, for instance, banks and financial institutions.
It shows how much a company is leveraged, that is, how much debt is involved in the business vis-a-vis promoters’ capital (equity). A low figure is usually considered better. But it must not be seen in isolation.
“If the company’s returns are higher than its interest cost, the debt will enhance value. However, if it is not, shareholders will lose,” says Aggarwal of SMC.
“Also, a company with low debt-to-equity ratio can be assumed to have a lot of scope for expansion due to more fund-raising options,” he says.
But it is not that simple. “It is industry-specific with capital intensive industries such as automobiles and manufacturing showing a higher figure than others. A high debt-to-equity ratio may indicate unusual leverage and, hence, higher risk of credit default, though it could also signal to the market that the company has invested in many high-NPV projects,” says Vikas Gupta of Arthaveda Fund Management. NPV, or net present value, is the present value of future cash flow.
OPERATING PROFIT MARGIN (OPM)
The OPM shows operational efficiency and pricing power. It is calculated by dividing operating profit by net sales.
Aggarwal of SMC says, “Higher OPM shows efficiency in procuring raw materials and converting them into finished products.”
It measures the proportion of revenue that is left after meeting variable costs such as raw materials and wages. The higher the margin, the better it is for investors.
While analysing a company, one must see whether its OPM has been rising over a period. Investors should also compare OPMs of other companies in the same industry.
Enterprise value (EV) by EBITDA is often used with the P/E ratio to value a company. EV is market capitalisation plus debt minus cash. It gives a much more accurate takeover valuation because it includes debt. This is the main advantage it has over the P/E ratio, which we saw can be skewed by unusually large earnings driven by debt. EBITDA is earnings before interest, tax, depreciation and amortisation.
This ratio is used to value companies that have taken a lot of debt. “The main advantage of EV/EBITDA is that it can be used to evaluate companies with different levels of debt as it is capital structure-neutral. A lower ratio indicates that a company is undervalued. It is important to note that the ratio is high for fast-growing industries and low for industries that are growing slowly,” says Mukherjee of IIFL.
PRICE/EARNINGS GROWTH RATIO
The PEG ratio is used to know the relationship between the price of a stock, earnings per share (EPS) and the company’s growth.
Generally, a company that is growing fast has a higher P/E ratio. This may give an impression that is overvalued. Thus, P/E ratio divided by the estimated growth rate shows if the high P/E ratio is justified by the expected future growth rate. The result can be compared with that of peers with different growth rates.
A PEG ratio of one signals that the stock is valued reasonably. A figure of less than one indicates that the stock may be undervalued.
RETURN ON EQUITY
The ultimate aim of any investment is returns. Return on equity, or ROE, measures the return that shareholders get from the business and overall earnings. It helps investors compare profitability of companies in the same industry. A figure is always better. The ratio highlights the capability of the management. ROE is net income divided by shareholder equity.
“ROE of 15-20% is generally considered good, though high-growth companies should have a higher ROE. The main benefit comes when earnings are reinvested to generate a still higher ROE, which in turn produces a higher growth rate. However, a rise in debt will also reflect in a higher ROE, which should be carefully noted,” says Mukherjee of IIFL.
“One would expect leveraged companies (such as those in capital intensive businesses) to exhibit inflated ROEs as a major part of capital on which they generate returns is accounted for by debt,” says Gupta of Arthaveda Fund Management.
INTEREST COVERAGE RATIO
It is earnings before interest and tax, or EBIT, divided by interest expense. It indicates how solvent a business is and gives an idea about the number of interest payments the business can service solely from operations.
One can also use EBITDA in place of EBIT to compare companies in sectors whose depreciation and amortisation expenses differ a lot. Or, one can use earnings before interest but after tax if one wants a more accurate idea about a company’s solvency.
This shows the liquidity position, that is, how equipped is the company in meeting its short-term obligations with short-term assets. A higher figure signals that the company’s day-to-day operations will not get affected by working capital issues. A current ratio of less than one is a matter of concern.
The ratio can be calculated by dividing current assets with current liabilities. Current assets include inventories and receivables.Sometimes companies find it difficult to convert inventory into sales or receivables into cash. This may hit its ability to meet obligations. In such a case, the investor may calculate the acid-test ratio, which is similar to the current ratio but with the exception that it does not include inventory and receivables.
ASSET TURNOVER RATIO
It shows how efficiently the management is using assets to generate revenue. The higher the ratio, the better it is, as it indicates that the company is generating more revenue per rupee spent on the asset. Experts say the comparison should be made between companies in the same industry. This is because the ratio may vary from industry to industry. In sectors such as power and telecommunication , which are more asset-heavy, the asset turnover ratio is low, while in sectors such as retail, it is high (as the asset base is small).
It is dividend per share divided by the share price. A higher figure signals that the company is doing well. But one must be wary of penny stocks (that lack quality but have high dividend yields) and companies benefiting from one-time gains or excess unused cash which they may use to declare special dividends. Similarly, a low dividend yield may not always imply a bad investment as companies (particularly at nascent or growth stages) may choose to reinvest all their earnings so that shareholders earn good returns in the long term.
“A high dividend yield, however, could signify a good long-term investment as companies’ dividend policies are generally fixed in the long run,” says Gupta.
While financial ratio analysis helps in assessing factors such as profitability, efficiency and risk, added factors such as macro-economic situation, management quality and industry outlook should also be studied in detail while investing in a stock.