Ratios in Equity Investing- What to look out for?
Ratios in Equity Investing- What to look out for?
Effective planning and financial management are the keys to running a financially successful small business. Ratio analysis is critical for helping you understand financial statements, for identifying trends over time and for measuring the overall financial state of your business. In addition, lenders and potential investors often rely on ratio analysis when making lending and investing decisions.
Versatility and Usefulness
Ratios are critical quantitative analysis tools. One of their most important functions lies in their capacity to act as lagging indicators in identifying positive and negative financial trends. The information a trend analysis provides allows to you to make and implement ongoing financial plans and, when necessary, make course corrections to short-term financial plans.
Ratio analysis also provides ways for you to compare the financial state of your business against other businesses within your industry or between your business and businesses in other industries. The sheer numbers of available financial ratios makes it important to research and choose ratios most applicable to your business.
Price to Cash Flow Ratio
Some investors prefer to focus on a financial ratio known as the “price to cash flow ratio” instead of the more famous “price-to-earnings ratio” (or p/e ratio for short). Sit back, relax, and grab a cup of coffee because you’re about to learn everything you ever wanted to know about this often overlooked stock valuation tool.
Earnings Per Share (EPS):
This is one of the key ratio and is really important to understand Earnings per share (EPS) before we study other ratios. EPS is basically the profit that a company has made over the last year divided by how many shares are on the market. Preferred shares are not included while calculating EPS.
Earnings Per Share (EPS) = (Net income — dividends from preferred stock)/(Average outstanding shares)
From the prospective of an investor, it’s always better to invest in a company with higher EPS as it means that the company is generating greater profits. Also, before investing in a company, you should check the it’s EPS for the last 5 years. If the EPS is growing for these years, it’s a good sign and if you EPS is regularly falling or is erratic, then you should start searching another company.
Price to Earnings Ratio (P/E):
The Price to Earnings ratio is one of the most widely used financial ratio analysis among the investors for a very long time. A high P/E ratio generally shows that the investor is paying more for the share. As a thumb rule, a low P/E ratio is preferred while buying a stock, but the definition of ‘low’ varies from industries to industries. So, different sectors (Ex Automobile, Banks etc) have different P/E ratios for the companies in their sector, and comparing the P/E ratio of company of one sector with P/E ratio of company of another sector will be insignificant. However, you can use P/E ratio to compare the companies in the same sector, preferring one with low P/E.
P/E ratio is calculated using this formula:
Price to Earnings Ratio= (Price Per Share)/( Earnings Per Share)
It’s easier to find the find the price of the share as you can find it from the current closing stock price. For the earning per share, we can have either trailing EPS (earnings per share based on the past 12 months) or Forward EPS (Estimated basic earnings per share based on a forward 12-month projection. It’s easier to find the trailing EPS as we already have the result of the past 12 month’s performance of the company.
Price to Book Ratio (P/B): Price to Book Ratio (P/B) is calculated by dividing the current price of the stock by the latest quarter’s book value per share. P/B ratio is an indication of how much shareholders are paying for the net assets of a company. Generally, a lower P/B ratio could mean that the stock is undervalued, but again the definition of lower varies from sector to sector.
Price to Book Ratio = (Price per Share)/( Book Value per Share)
Debt to Equity 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, as a firm’s debt-to-equity ratio increases, it becomes more risky A lower debt-to-equity number means that a company is using less leverage and has a stronger equity position.
Debt to Equity Ratio =(Total Liabilities)/(Total Shareholder Equity)
As a thumb of rule, companies with debt-to-equity ratio more than 1 are risky and should be considered carefully before investing.
Return on Equity (ROE): Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested. In other words, ROE tells you how good a company is at rewarding its shareholders for their investment.
Return on Equity = (Net Income)/(Average Stockholder Equity)
As a thumb rule, always invest in a company with ROE greater than 20% for at least last 3 years. A yearly increase in ROE is also a good sign.
Price to Sales Ratio (P/S): The stock’s price/sales ratio (P/S) ratio measures the price of a company’s stock against its annual sales. P/S ratio is another stock valuation indicator similar to the P/E ratio.
Price to Sales Ratio = (Price per Share)/(Annual Sales Per Share)
The P/S ratio is a great tool because sales figures are considered to be relatively reliable while other income statement items, like earnings, can be easily manipulated by using different accounting rules.
Current ratio is a key financial ratio for evaluating a company’s liquidity. It measures the proportion of current assets available to cover current liabilities. It is a company’s ability to pay its short-term liabilities with its short-term assets. 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
Current Ratio = (Current Assets)/(Current Liabilities)
As a thumb rule, always invest in a company with current ratio greater than 1.
A stock’s dividend yield is calculated as the company’s annual cash dividend per share divided by the current price of the stock and is expressed in annual percentage.
Dividend Yield = (Dividend per Share)/(Price per Share)*100
For Example, If the share price of a company is Rs 100 and it is giving a dividend of Rs 10, then the dividend yield will be 10%. It totally depends on the investor weather he wants to invest in a high or a low dividend yielding company.
In short, Don’t forget to check the following points before investing:
- Earnings Per Share (EPS) — Increasing for last 5 years
- Price to Earnings Ratio (P/E) — Low compared to companies in same sector
- Price to Book Ratio (P/B) — Low compared companies in same sector
- Debt to Equity Ratio — Should be less than 1
- Return on Equity (ROE) — Should be greater that 20%
- Price to Sales Ratio (P/S) — Smaller ratio (less than 1) is preferred
- Current Ratio — Should be greater than 1
- Dividend Yield — Depends on Investor/ Increasing preferred
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