24/01/2015 KeyfinancialratiosyoumustlookatbeforemakinginvestmentMoneyToday

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Stockinvestingrequirescarefulanalysisoffinancialdatatofindoutthecompany'strueworth.Thisisgenerallydonebyexaminingthecompany'sprofitandlossaccount,balancesheetandcashflowstatement.Thiscanbetimeconsumingandcumbersome.Aneasierwaytofindoutaboutacompany'sperformanceistolookatitsfinancialratios,mostofwhicharefreelyavailableontheinternet.

Thoughthisisnotafoolproofmethod,itisagoodwaytorunafastcheckonacompany'shealth.

"Ratioanalysisiscrucialforinvestmentdecisions.Itnotonlyhelpsinknowinghowthecompanyhasbeenperformingbutalsomakesiteasyforinvestorstocomparecompaniesinthesameindustryandzeroinonthebestinvestmentoption,"saysDKAggarwal,chairmanandmanagingdirector,SMCInvestmentsandAdvisors.

Webringyouelevenfinancialratiosthatoneshouldlookatbeforeinvestinginastock.P/ERATIOThepricetoearnings,orP/E,ratioshowshowmuchstockinvestorsarepayingforeachrupeeofearnings.Itshowsifthemarketisovervaluingorundervaluingthecompany.

OnecanknowtheidealP/EratiobycomparingthecurrentP/Ewiththecompany'shistoricalP/E,theaverageindustryP/EandthemarketP/E.Forinstance,acompanywithaP/Eof15mayseemexpensivewhencomparedtoitshistoricalP/E,butmaybeagoodbuyiftheindustryP/Eis18andthemarketaverageis20.

SabyasachiMukherjee,AVPandproducthead,IIFL,says,"AhighP/Eratiomayindicatethatthestockisoverpriced.AstockwithalowP/Emayhavegreaterpotentialforrising.P/Eratiosshouldbeusedincombinationwithotherfinancialratiosforinformeddecisionmaking."

"P/Eratioisusuallyusedtovaluematureandstablecompaniesthatearnprofits.AhighPEindicatesthatthestockiseitherovervalued(withrespecttohistoryand/orpeers)orthecompany'searningsareexpectedtogrowatafastpace.ButonemustkeepinmindthatcompaniescanboosttheirP/Eratiobyaddingdebt(therebyconstrictingequitycapital).Also,asfutureearningsestimatesaresubjective,it's

24/01/2015 KeyfinancialratiosyoumustlookatbeforemakinginvestmentMoneyToday

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bettertousepastearningsforcalculatingP/Eratios,"saysVikasGupta,executivevicepresident,ArthavedaFundManagement.

PRICETOBOOKVALUE

Thepricetobookvalue(P/BV)ratioisusedtocompareacompany'smarketpricetoitsbookvalue.Bookvalue,insimpleterms,istheamountthatwillremainifthecompanyliquidatesitsassetsandrepaysallitsliabilities.

P/BVratiovaluessharesofcompanieswithlargetangibleassetsontheirbalancesheets.AP/BVratiooflessthanoneshowsthestockisundervalued(valueofassetsonthecompany'sbooksismorethanthevaluethemarketisassigningtothecompany).Itindicatesacompany'sinherentvalueandisusefulinvaluingcompanieswhoseassetsaremostlyliquid,forinstance,banksandfinancialinstitutions.

DEBTTOEQUITYRATIO

Itshowshowmuchacompanyisleveraged,thatis,howmuchdebtisinvolvedinthe

'Ratioanalysisiscrucialforinvestmentdecisions.Itnotonlyhelpsinknowinghowthecompanyhasbeenperformingbutalsomakesiteasyforinvestorstocomparecompaniesinthesameindustryandzeroinonthebestinvestment

option',saysDKAggarwal,ChairmanandManagingDirectoratSMCInvestmentsandAdvisors

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businessvisavispromoters'capital(equity).Alowfigureisusuallyconsideredbetter.Butitmustnotbeseeninisolation.

"Ifthecompany'sreturnsarehigherthanitsinterestcost,thedebtwillenhancevalue.However,ifitisnot,shareholderswilllose,"saysAggarwalofSMC.

"Also,acompanywithlowdebttoequityratiocanbeassumedtohavealotofscopeforexpansionduetomorefundraisingoptions,"hesays.

Butitisnotthatsimple."Itisindustryspecificwithcapitalintensiveindustriessuchasautomobilesandmanufacturingshowingahigherfigurethanothers.Ahighdebttoequityratiomayindicateunusualleverageand,hence,higherriskofcreditdefault,thoughitcouldalsosignaltothemarketthatthecompanyhasinvestedinmanyhighNPVprojects,"saysVikasGuptaofArthavedaFundManagement.NPV,ornetpresentvalue,isthepresentvalueoffuturecashflow.

OPERATINGPROFITMARGIN(OPM)TheOPMshowsoperationalefficiencyandpricingpower.Itiscalculatedbydividing

'AhighP/Eratiomayindicatethatthestockisoverpriced.AstockwithalowP/Emayhavegreaterpotentialforrising.P/Eratiosshouldbeusedin

combinationwithotherfinancialratiosforinformeddecisionmaking',saysSabyasachiMukherjee,AVPandProductHeadatIIFL

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operatingprofitbynetsales.

AggarwalofSMCsays,"HigherOPMshowsefficiencyinprocuringrawmaterialsandconvertingthemintofinishedproducts."

Itmeasurestheproportionofrevenuethatisleftaftermeetingvariablecostssuchasrawmaterialsandwages.Thehigherthemargin,thebetteritisforinvestors.

Whileanalysingacompany,onemustseewhetheritsOPMhasbeenrisingoveraperiod.InvestorsshouldalsocompareOPMsofothercompaniesinthesameindustry.

EV/EBITDA

Enterprisevalue(EV)byEBITDAisoftenusedwiththeP/Eratiotovalueacompany.EVismarketcapitalisationplusdebtminuscash.Itgivesamuchmoreaccuratetakeovervaluationbecauseitincludesdebt.ThisisthemainadvantageithasovertheP/Eratio,whichwesawcanbeskewedbyunusuallylargeearningsdrivenbydebt.EBITDAisearningsbeforeinterest,tax,depreciationandamortisation.

Thisratioisusedtovaluecompaniesthathavetakenalotofdebt."ThemainadvantageofEV/EBITDAisthatitcanbeusedtoevaluatecompanieswithdifferentlevelsofdebtasitiscapitalstructureneutral.Alowerratioindicatesthatacompanyisundervalued.Itisimportanttonotethattheratioishighforfastgrowingindustriesandlowforindustriesthataregrowingslowly,"saysMukherjeeofIIFL.

PRICE/EARNINGSGROWTHRATIO

ThePEGratioisusedtoknowtherelationshipbetweenthepriceofastock,earningspershare(EPS)andthecompany'sgrowth.

Generally,acompanythatisgrowingfasthasahigherP/Eratio.Thismaygiveanimpressionthatisovervalued.Thus,P/EratiodividedbytheestimatedgrowthrateshowsifthehighP/Eratioisjustifiedbytheexpectedfuturegrowthrate.Theresultcanbecomparedwiththatofpeerswithdifferentgrowthrates.

APEGratioofonesignalsthatthestockisvaluedreasonably.Afigureoflessthanoneindicatesthatthestockmaybeundervalued.

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RETURNONEQUITY

Theultimateaimofanyinvestmentisreturns.Returnonequity,orROE,measuresthereturnthatshareholdersgetfromthebusinessandoverallearnings.Ithelpsinvestorscompareprofitabilityofcompaniesinthesameindustry.Afigureisalwaysbetter.Theratiohighlightsthecapabilityofthemanagement.ROEisnetincomedividedbyshareholderequity.

"ROEof1520%isgenerallyconsideredgood,thoughhighgrowthcompaniesshouldhaveahigherROE.ThemainbenefitcomeswhenearningsarereinvestedtogenerateastillhigherROE,whichinturnproducesahighergrowthrate.However,ariseindebtwillalsoreflectinahigherROE,whichshouldbecarefullynoted,"saysMukherjeeofIIFL.

"Onewouldexpectleveragedcompanies(suchasthoseincapitalintensivebusinesses)toexhibitinflatedROEsasamajorpartofcapitalonwhichtheygeneratereturnsisaccountedforbydebt,"saysGuptaofArthavedaFundManagement.

INTERESTCOVERAGERATIO

Itisearningsbeforeinterestandtax,orEBIT,dividedbyinterestexpense.Itindicateshowsolventabusinessisandgivesanideaaboutthenumberofinterestpaymentsthebusinesscanservicesolelyfromoperations.

OnecanalsouseEBITDAinplaceofEBITtocomparecompaniesinsectorswhosedepreciationandamortisationexpensesdifferalot.Or,onecanuseearningsbeforeinterestbutaftertaxifonewantsamoreaccurateideaaboutacompany'ssolvency.

CURRENTRATIO

Thisshowstheliquidityposition,thatis,howequippedisthecompanyinmeetingitsshorttermobligationswithshorttermassets.Ahigherfiguresignalsthatthecompany'sdaytodayoperationswillnotgetaffectedbyworkingcapitalissues.Acurrentratiooflessthanoneisamatterofconcern.

Theratiocanbecalculatedbydividingcurrentassetswithcurrentliabilities.Currentassetsincludeinventoriesandreceivables.Sometimescompaniesfinditdifficulttoconvertinventoryintosalesorreceivablesintocash.Thismayhititsabilitytomeetobligations.Insuchacase,theinvestormaycalculatetheacidtestratio,whichis

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similartothecurrentratiobutwiththeexceptionthatitdoesnotincludeinventoryandreceivables.

ASSETTURNOVERRATIO

Itshowshowefficientlythemanagementisusingassetstogeneraterevenue.Thehighertheratio,thebetteritis,asitindicatesthatthecompanyisgeneratingmorerevenueperrupeespentontheasset.Expertssaythecomparisonshouldbemadebetweencompaniesinthesameindustry.Thisisbecausetheratiomayvaryfromindustrytoindustry.Insectorssuchaspowerandtelecommunication,whicharemoreassetheavy,theassetturnoverratioislow,whileinsectorssuchasretail,itishigh(astheassetbaseissmall).

DIVIDENDYIELD

Itisdividendpersharedividedbytheshareprice.Ahigherfiguresignalsthatthecompanyisdoingwell.Butonemustbewaryofpennystocks(thatlackqualitybuthavehighdividendyields)andcompaniesbenefitingfromonetimegainsorexcessunusedcashwhichtheymayusetodeclarespecialdividends.Similarly,alow

'Ahighdividendyieldcouldsignifyagoodlongterminvestmentascompanies'dividendpoliciesaregenerallyfixedinthelongrun',saysVikasGupta

ExecutiveVicePresidentatArthavedaFundManagement

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dividendyieldmaynotalwaysimplyabadinvestmentascompanies(particularlyatnascentorgrowthstages)maychoosetoreinvestalltheirearningssothatshareholdersearngoodreturnsinthelongterm.

"Ahighdividendyield,however,couldsignifyagoodlongterminvestmentascompanies'dividendpoliciesaregenerallyfixedinthelongrun,"saysGupta.

Whilefinancialratioanalysishelpsinassessingfactorssuchasprofitability,efficiencyandrisk,addedfactorssuchasmacroeconomicsituation,managementqualityandindustryoutlookshouldalsobestudiedindetailwhileinvestinginastock.