In stock investing, most experts will tell you about conducting the fundamental analysis of the company before picking their stocks, which technically means that you need to look at the financial records of the company and assess the company’s financial health, future projections, and hopefully help you decide if its stocks are worth investing in right now or not.
Reading the financial reports of a company can be a very tedious job. The annual reports of many of the companies are over hundreds of pages which consist of a number of financial jargon. Moreover, if you do not understand what these terms mean, you may not be able to read the reports efficiently.
Nevertheless, there are a number of financial ratios that have made the life of investors very simple. Now, you do not need to make a number of calculations and you can just use these financial ratios to understand the gist.
Price to Earnings (PE) ratio
As the name suggests, a P/E ratio is the ratio of the current share price to the earnings of the company per share. This ratio can tell you if the company is undervalued or overvalued in the market.
The price to earnings ratio is one of the most widely used ratios by investors throughout the world. PE ratio is calculated by:
P/E ratio = (Market Price per share/ Earnings per share)
Let’s say that a company has an overall earning of Rs.100. Also, it has 10 shares trading in the market.
Therefore, its ‘earning per share’ is Rs.10.
Further, let’s say that the shares of the company are trading at Rs.100 per share. Hence, we have
P/E Ratio = 100/10 = 10
In the simplest terms, this means that you are paying Rs.10 for getting Rs.1 from the company’s earnings. Hence, it is easy to deduce that if a company has a higher P/E ratio, it is that much valued (or sometimes overvalued!).
A company with a lower PE ratio is considered under-valued compared to another company in the same sector with a higher PE ratio. The average PE ratio value varies from industry to industry.
For example, the industry PE of Oil and refineries is around 10-12. On the other hand, the PE ratio of FMCG & personal care is around 55-50.
Therefore, you cannot compare the PE of a company from the Oil sector with another company from the FMCG sector. In such a scenario, you will always find oil companies undervalued compared to FMCG companies. However, you can compare the PE of one FMCG company with another company in the same industry, to find out which one is cheaper.
Return on Equity (RoE) Ratio
As the name suggests, the RoE Ratio is a measure of the rate of return on the stock of a company. In other words, it tells investors how good the company is in generating returns on stock investments.
It can be calculated as:
ROE= (Net income/ average stockholder equity)
A higher ROE means that the company generates a higher profit from the money that the shareholders have invested. Always invest in companies with an average ROE for the last 3 years greater than 15%.
Let’s say that you contributed Re.1 in equity of XYZ company and the total equity of the company is Rs.10.
Using this equity if the company generates an income of Rs.2, then the RoE is 20%. Imagine another company with the same total equity but generating an income of Rs.4 – its RoE ratio will be 40%. The company that generates better RoE is considered better.
However, you should not look at RoE as a standalone factor. Here is a quick example:
Last year, Coal India had an RoE of 70%
The RoE of HEG was > 100%
Does this mean that these are good companies to invest in?
There is no straightforward answer, and there are a couple of important things that you need to understand about RoE ratios first:
- Like the P/E ratios, the RoE ratios can vary according to sectors and industries. Hence, it is important to understand the industry average too.
- A company can also have a high RoE ratio because it has taken a lot of debt and its equity investment is low. Hence, you must look at the equity structure of the company along with its complete financials to make the decision.
Dividends are the profits that the company shares with its shareholders as decided by the board of directors. Dividend yield can be calculated as:
Dividend yield = (Dividend per share/ price per share)
Now, how much dividend yield is good? It depends on the investor’s preference. A growing company may not give a good dividend as it uses that profit for its expansion. However, capital appreciation in a growing company can be large.
On the other hand, well established large companies give a good dividend. But their growth rate is saturated. Therefore, it depends totally on investors whether they want a high yield stock or growing stock.
As a rule of thumb, a consistent and increasing dividend yield over the past few years is typically an indicator of healthy financial performance by the company.
Debt to Equity (D/E) Ratio
As the name suggests, this ratio gives you an overview of the debts and equity of the respective company. It is calculated by dividing the company’s total liabilities (debts) by its total shareholder equity.
It can give you an indication of how much the company is running on loans versus owned funds.
There is no ideal D/E ratio as it can vary with industries and sectors.
Usually, if a company has a lot of debt, then it is assumed that the company will find it difficult to pay it back. Also, since debt attracts interest, it will directly impact the company’s profit and loss statement and negatively impact its net income leading to a drop in the cash flow.
The D/E ratio can help you determine the magnitude of debt that the company has. A high D/E ratio means higher debt and vice-versa.
Although having debt is not always a bad thing, debt also means that if the company repays the interests on time, it can help in the growth of the company.
It tells you the ability of a company to pay its short-term liabilities with short-term assets. The current ratio can be calculated as:
Current ratio = (Current assets / current liabilities)
While investing, companies with a current ratio greater than 1 should be preferred. This means that the current assets should be greater than the current liabilities of a company.
A lower current ratio indicates that the company doesn't have enough liquid assets to cover its short-term liabilities.
A higher current ratio means the company will not get affected by working capital challenges and a lower ratio (i.e. below 1) could be a problem. But sometimes a really high current ratio could also indicate that a company is not using its current assets efficiently or is unable to secure financing well.
While a detailed fundamental analysis of a company is a must, these ratios can help you get a bird’s-eye view of the company’s financials. It is also important to remember that these ratios are dynamic in nature and should be evaluated time to time in order to have the correct current situation.