key financial ratios
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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
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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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24/01/2015 KeyfinancialratiosyoumustlookatbeforemakinginvestmentMoneyToday
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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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24/01/2015 KeyfinancialratiosyoumustlookatbeforemakinginvestmentMoneyToday
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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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24/01/2015 KeyfinancialratiosyoumustlookatbeforemakinginvestmentMoneyToday
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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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24/01/2015 KeyfinancialratiosyoumustlookatbeforemakinginvestmentMoneyToday
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dividendyieldmaynotalwaysimplyabadinvestmentascompanies(particularlyatnascentorgrowthstages)maychoosetoreinvestalltheirearningssothatshareholdersearngoodreturnsinthelongterm.
"Ahighdividendyield,however,couldsignifyagoodlongterminvestmentascompanies'dividendpoliciesaregenerallyfixedinthelongrun,"saysGupta.
Whilefinancialratioanalysishelpsinassessingfactorssuchasprofitability,efficiencyandrisk,addedfactorssuchasmacroeconomicsituation,managementqualityandindustryoutlookshouldalsobestudiedindetailwhileinvestinginastock.