Investing in stocks is not that easy, as it requires careful analysis of financial data to find out a company’s true worth. It demands rigorous analysis of a company financial statements such as balance sheet, profit and loss account, cash-flow statement, etc.
An easier way to find out about a company’s performance is to look at its financial ratios. They can be important tools for making decisions about a company that an investor might want to invest in.
So, what is the common financial ratio analysis that every stock investor should know? The most common ones include Earnings Per Share (EPS), Price to Earnings (P/E) ratio, Return on Equity (RoE), Price-to-Book (P/B) Ratio , net profit margin and debt-to-equity, among others. Though this is not a foolproof method, yet it is a good way to run a quick check on a company’s financial health.
Earnings Per Share (EPS): It is basically the net profit that a company has made in a given time period for each of its investor. It is calculated by dividing the total profit by the total number of outstanding shares of a company. Generally, EPS is calculated on an annual basis or quarterly basis. But one needs to keep in mind that preferred shares are not included while calculating EPS.
EPS = (Net Income – Dividends on Preferred Stock) / Average Outstanding Shares
Price-to-earnings (P/E) ratio: The price-to-earnings ratio is one of the most widely used parameters. A company with a lower P/E ratio is considered undervalued compared with another company in the same sector with a higher P/E ratio. The average P/E ratio value varies from industry to industry.
P/E ratio = (Market price per share/ Earnings per share of Last 12 months)
Price/Earnings Growth ratio: The PEG ratio is used to determine the relationship between the share price, earnings per share (EPS) and the company’s growth. A company with PEG ratio less than 1 is considered good for investment.
PEG ratio = (PE ratio/ Projected annual growth in earnings)
Price-to-Book (P/B) ratio: Book value is the net asset value of a company. As a thumb rule, a company with a lower P/B ratio is considered undervalued compared with one with a higher P/B ratio. However, this ratio varies from industry to industry.
P/B ratio = (Market price per share/ book value per share)
Return on Equity (RoE) Ratio: RoE is the amount of net income returned as a percentage of shareholders’ equity. It shows how good a company is in rewarding its shareholders. A higher ROE means that the company generates a higher profit on the money that shareholders have invested.
ROE= (Net income/ average stockholder equity)
Interest Coverage Ratio: It is a combination of debt ratio and profitability ratio used to determine how easily a company can pay interest on its outstanding debt. A higher interest coverage ratio is considered better, although the ideal ratio may vary from industry to industry.
Interest Coverage Ratio = EBIT/Interest expense
Current Ratio: This reflect a company’s ability to pay its short-term liabilities with short-term assets. While investing, companies with a current ratio higher than 1 should be preferred. This means the current assets of a company should be greater than the current liabilities.
Current ratio = (Current assets / current liabilities)
Asset Turnover Ratio: It reflect how good a company is in using its assets to generate revenue. The higher the asset turnover ratio, the better it is for the company, as it means the company is generating more revenue per rupee spent.
Asset turnover ratio = (Sales/ Average total assets)
Net Profit Margin: The net profit margin is equal to the net income or profit generated as a percentage of revenue. Net profit margin is the ratio of net profits to revenues for a company or business. Net profit margin helps investors assess if a company’s management is generating enough profit from its sales and whether operating costs and overhead costs are being contained.
Net Profit Margin = Revenue – Cost /Revenue
Debt-to-Equity Ratio: It shows how leveraged or indebted a company is, that is how much debt is involved in the business compared with the promoters’ capital (equity). When examining the health of a company before investing, it is critical to pay attention to the debt-equity ratio. If the ratio is increasing, it means the company is being financed by creditors rather than its own financial sources which may be a dangerous trend. Lenders and investors usually prefer low debt-to-equity ratios, because their interests are better protected in the event when the business faces any headwind. Any company with a high debt-to-equity ratio may not be able to attract additional lending capital, leading to growth slowdown.
Debt to Equity Ratio = Total Debt / Shareholders’ Equity
These ratios can help investors get a bird’s eye view of a company’s financials. Investors can choose the right companies to invest in or compare the financials of two companies to find out which one is a better investment opportunity. It is also important to remember that these ratios are dynamic in nature. Hence, it is important to recalculate them once every quarter, especially after the declaration of quarterly financial results.
(DK Aggarwal is the CMD of SMC Investment and Advisors)