key financial ratios

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 24/01/ 2015 Key fin anci al ra tio s you mu st lo ok at before ma kin g in vestm ent - Mo ney To day data:te xt/html ;charset=utf-8,%3Cp%20style%3D%22margin%3A%200px%3B%20 padd ing%3A%200p x%200px%201 5px%3B%20 color %3A%20rgb(61%2C%2… 1/7 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  .  P/E RATIO 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 under  valuing 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

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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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    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.