So from the last post I hope you have picked your company and the next step is to analyse whether they are fundamentally strong and financially stable. When you analyse a business there are lot of parameters to look for, sometimes it is overwhelming to look at the data that you have collected from their annual reports, rating agencies and other financial sites. So first let’s make that process simple and easy.
Let me explain some of the key financial ratios that compulsorily needs to be looked when analysing a business.
I categorised some of the key ratios into four categories:
- Price ratio
- Profitability ratio
- Liquidity ratio
- Solvency ratio
Price Ratio :
Earnings Per Share (EPS) :
Earnings Per Share (EPS) indicates how much money a company makes for each share of its stock and it’s a widely used metric for corporate profits. It is how much your single share of the company earns profit for the company.
EPS = Net income/ No. Of shares outstanding
It is the most important number for calculating all other ratios.
Price to Earnings ratio (P/E ratio) :
This is the most commonly used number among the investors to know whether the company is overvalued or undervalued.
P/E = Market value per share/ Earnings per share
When you look at the PE of a single company it doesn’t give you much details. You have to compare that PE with its peers to arrive at the conclusion of overvalued or undervalued.
When you compare the PE of two businesses in the same sector one must be higher and other must be lower. So what does it tell you ?
>> A higher PE tells us the stock price is overvalued compared to its peers and also investors belief in the company is huge and they expect the company to grow exponentially even at higher valuations.
>> A lower PE tells us that the stock price is undervalued compared to its peers. Also it doesn’t mean that investors lost faith in the company. It means that the company has lots of headroom to grow.
Price to Book Value (P/B ratio) :
Before getting into the ratio let’s understand what is book value first.
Book value per share is the value you get for your shares if the company went bankrupt today. It is also known as the net asset value of a company which is calculated by
B.V = [Total asset-( intangible assets+ liabilities)] / No. Of outstanding shares
Intangible assets – Patents, goodwill
P/B ratio = Market Price / Book Value
A lower P/B could mean that the stock is undervalued. However it could also mean something is fundamentally wrong with the company. Traditionally any value under 1 is considered a good P/B for value Investor, indicating a potentially undervalued business. Also P/B greater than 3 is usually considered as overvalued business.
PEG ratio :
The PEG ratio enhances the P/E ratio by adding in the expected earnings growth into the calculation.
PEG ratio = (P/E ratio)/(EPS growth rate)
Similar to PE, a lower PEG may indicate that the stock is undervalued and vice-versa.
According to well-known investor Peter Lynch, a company’s P/E and expected growth should be equal, which denotes a fairly valued company and supports a PEG ratio of 1.0. When a company’s PEG exceeds 1.0, it’s considered overvalued while a stock with a PEG of less than 1.0 is considered undervalued.
Profitability Ratio :
Profitability ratios tell you how good a company is at converting business operations into profits. Profit is a key driver of stock price, and it is undoubtedly one of the most closely followed metrics in business, finance and investing. Management efficiency can also be found in these numbers.
Return on Assets (ROA) :
A company buys assets (factories, equipment, etc.) in order to conduct its business. ROA tells you how good the company is at using its assets to make money. For example, if Company A reported ₹10,000 of net income and owns ₹100,000 in assets, its ROA is 10%. For ever ₹1 of assets it owns, it can generate ₹0.10 in profits each year.
ROA = Net income / Average total assets
Higher ROA means that the company is efficiently using its assets to generate profits.
Return on equity (ROE) :
Equity is another word for ownership. ROE tells you how good a company is at rewarding its shareholders for their Investment. It also tells us how efficiently the management is using its shareholders money to generate profit for the company.
ROE = Net income / Shareholders equity
If a company reports ROE of 20% then every ₹1 held by shareholders, the company generates ₹0.20 in profit each year.
Return on Capital Employed (ROCE) :
ROE is calculated only based on the shareholders equity but ROCE includes all the capital that the company employed into the business in order to generate sales and profits.
ROCE = EBIT / Capital Employed
EBIT – Earnings before interest and tax.
If a company reports ROCE of 20% then every ₹1 spent in capital, the company can generates ₹0.20 in profit each year.
Rule of thumb :
Always look for companies with more than 20% in ROE & ROCE respectively.
Liquidity ratio :
Liquidity ratios indicate how capable a business is of meeting its short-term obligations. Liquidity is important to a company because when times are tough, a company without enough liquidity to pay its short-term debts could be forced to make unfavorable decisions in order to raise money (sell assets at a low price, borrow at high interest rates).
There are several ratios for measuring liquidity position of the company but they all tell us one thing more or less. So let’s discuss on of them as an example.
Current ratio :
The current ratio compares all of a company’s current assets to its current liabilities. These are usually defined as assets that are cash or will be turned into cash in a year or less, and liabilities that will be paid in a year or less.
Current ratio = Current assets / Current liabilities
If the ratio is over 1.0, the firm has more short-term assets than short-term debts. But if the current ratio is less than 1.0, the opposite is true and the company could be vulnerable to unexpected bumps in the economy or business climate.
Solvency Ratio :
As an individual borrows money for their short term needs big companies will do the same for their expansion, to pay short term liabilities.
Having debt is not a bad sign for a company as long as they are in a position to pay the those debts and interest on time. When it comes to debt we should look at two numbers.
Debt to equity ratio (D/E ratio) :
The debt to equity ratio measures the relationship between the amount of capital that has been borrowed (i.e. debt) and the amount of capital contributed by shareholders (i.e. equity). Generally speaking, as a firm’s debt-to-equity ratio increases, it becomes more risky because if it becomes unable to meet its debt obligations, it will be forced into bankruptcy.
D/E ratio = Total liabilities/ Shareholders equity
Liabilities and shareholders equity both can be found in balance sheet of the company.
Interest coverage ratio :
So now that you know the company has debts in their balance sheet. Is it manageable debt ? To know the answer for that question we need to calculate the interest coverage ratio.
I.C.R = EBIT / Interest expenses
EBIT – Earnings before interest and tax.
The interest coverage ratio will give you how many times a company can pay its interest on the outstanding debts.
These are some of the key ratios that you should look in your company before actually invest in the company.
The best part is you don’t have to calculate those metrics all by yourself. They are available in many financial sites for free. You just have to collect and compare the data from those sites.
If you still confused about these ratios don’t worry. We will analyse a company based on these ratios and conclude whether it is a good investment or not in the next post.
If you want me to analyse any particular company of your choice do comment that company in the comments section.
Until then stay home, stay safe, take care of your loved ones.