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Top Financial Ratios for Stock Market Investment

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Top Financial Ratios for Stock Market Investment

Analysis of financial ratios for stock market investment is equally important as the analysis of most important financial reports. To find out a company’s true worth and to make stock investment decisions, one needs careful and good financial analysis of the available data. This can be done by close examination of a company’s:

  • Balance sheet,
  • Profit and loss account, and
  • Statement of cash flows.

But this exercise can be cumbersome and time taking. An easier approach to know about the financial performance of a company is to examine its financial ratios, most of which are available on various internet sources.

Although, this is not a complete fool-proof way, it can prove to be a reasonable way to quickly check the financial health and performance of a company.

Ratios Analysis is vital for investment related decisions. It helps to identify how well or bad a company is performing and aids in comparison of different companies from the same industry. It generally leads to the best option for investment.

Following are the most useful 11 financial ratios that any investor should look upon before deciding to invest in a particular stock.

1. PRICE TO BOOK VALUE RATIO (P/BV)

The P/BV ratio is used to make a comparison of the book value to its market price. In simple language, book value is the remaining value in case of a company’s liquidation of its assets and after all the liabilities have been paid. The price-to-book value ratio values a company’s shares with huge tangible assets on the balance sheet. If a company has a P/BV ratio of less than one, this indicates that the shares of a company are undervalued, meaning that the market assigns less value to a company’s assets as compared to the value of assets in the company’s books. The inherent value of a company is indicated through this.

USES: useful in valuing financial institutions, banks, and other companies with mostly liquid assets.

2. OPERATING PROFIT MARGIN (OPM)

Pricing power and operational efficiency is shown by the OPM. Net sales are divided by the operational profits to get this ratio.

A higher OPM indicates that the company has good raw material procuring efficiency and good skills at raw material conversion into finished goods. The ratio measures the revenue proportion left after all variable costs have been met. It is beneficial for the investors if the margins are high.

During company analysis, an investor must look into the fact whether the company’s OPM has risen over the period. OPMs of companies in the same industry should also be compared with the company under consideration.

3. RETURN ON EQUITY (ROE)

Returns are the ultimate investment aim. This ratio, ROE, is a measure of the shareholder’s return from the overall earnings of a business. Investors use this to compare profitability of different companies from the same industry. Management capability is highlighted through this ratio. Shareholder’s equity is divided by net income to get Return on Equity (ROE).

High growing companies have higher ROE but a ROE of nearly 15-20% is good. Reinvestment of earnings for higher generation of ROE is how truly one can benefit. This in turn will produce a higher rate of growth. But a point that should carefully be noted is that higher debt will also reflect a rise in ROE.

The expectation of one would be to see inflated ROEs in leveraged companies (example the ones in intensive capital businesses). For such companies, debt accounts for major capital that generates returns.

4. DEBT TO EQUITY RATIO

This shows the leverage position of a company. That is for equity (promoter’s capital) the amount of debt involved in the business. A low ratio is usually perceived as better. But this too, should not be viewed in isolation.

The debt enhances the value of a company if the interest costs are lower than the returns. If this is not the case, the shareholders are likely to lose. A company with relatively lower debt-to-equity ratio has greater fund-raising opportunities and hence more room for expansion.

Yet not as simple as it may seem. With intensive capital industries (for example the manufacturing or the automobile industries with higher comparative figures) it is very industry specific. Unusual leverage is indicated by a high debt-to-equity ratio and in turn, a higher credit default risk, although this could emit signals in the market of the company being an investor in projects with high NPV.

5. P/E RATIO

The P/E or price-to-earnings ratio is able to show for every dollar of earning how much stock is being paid by the investors. It indicates if the market is undervaluing or overvaluing a particular company.  The ideal P/E ratio can be known by comparing the current P/E ratio of a company with:

  • Industry average P/E ratio,
  • Historical P/E ratio of a company, or
  • The P/E ratio of the market.

For example, an organization with a P/E ratio of 16 may be seen as expensive in comparison to its own historical P/E but will be perceived as a good take if the average market P/E is 20 and the P/E of the Industry is 19.

Whether a stock is overpriced is indicated by a very high P/E ratio. While a stock having a low P/E ratio may seem to have a greater potential to rise in future. For informed and good decision making, P/E ratios should be used in combination of other financial ratios.

USES: These ratios are used to value stable and mature companies earning decent profits. High P/E ratio may indicate the stock being overvalued (with regards to peers or history). It further indicates that the earnings of a company will grow at a greater pace. But an important fact to take account of is that companies might boast their price-to-earnings ratios by addition of greater debt and thereby putting restriction on the equity capital. Further, the estimates of future earnings are subjective, it is always better to make use of past earnings in P/E ratios calculation.

6. PRICE/EARNING GROWTH RATIO

To evaluate the relationship between:

  • A company’s growth,
  • The stock’s price, and
  • The earnings per share.

A fast-growing company will generally have a much higher P/E ratio. This might portray an impression of overvaluation of a company. Hence, P/E ratio over estimated growth rate helps to see if growth rate expected in future justifies the relatively high P/E ratio. The result can be used to make a comparative analysis with peers having different rates of growth.

The reasonableness of stock valuation can be seen through the PEG ratio. A less than one figure may pose indications of stock’s undervaluation.

7. INTEREST COVERAGE RATIO

EBIT or earnings before the deduction of interest or tax when divided by the interest expense equals the interest coverage ratio. It is an indication of the solvency of a business and gives a snapshot of the total payments of interest a business is capable to make from its operations. EBITDA can also be used instead of EBIT for comparison of companies in sectors where the amortization or depreciation expense differs by great variation. Earnings after tax, before interest can also be used to get a clearer idea of the solvency of a company.

8. ASSET TURNOVER RATIO

It indicates management’s efficiency in the usage of assets for revenue generation. Higher ratios are better as it is a clear indication of the company’s greater generation of revenue per dollar that is spent on assets. As per experts, this comparison should be made between same industry companies. The reason for this is constant variation of the ratio from one industry to another. In heavier asset sectors such as telecommunication and power, the ratio of turnover of asset is low, while in retail type sectors this ratio is fairly higher.

9. CURRENT RATIO

How well a company can meet its short term obligations with the available short term assets is assessed by this ratio. In simple words, this shows the liquidity position of a company. A higher ratio is an ascertainment that any working capital issues will not affect the daily operations of a company. Less than one of a current ratio is a concerning matter for the company.

Current assets are divided by current liabilities to get this ratio. Receivables and inventory are included in the current assets. At times, it may be difficult for a company to convert into cash all of its receivables or its inventory into sales. This may affect an Entity’s ability to settle its obligations when they are due. Acid test ratio may be calculated by an investor in such situations, which is similar to the current ratio but excludes receivables and inventory from the current assets.

10. DIVIDEND YEILD

It is the share price of a company divided by the dividend per share. A high ratio may indicate that the company is performing well. But an investor should be aware of stocks called the penny stocks (have good dividend yield but lacks quality). Also, investors should also be aware of companies that benefit from unused excess cash or gains that are one-time, which may be used by these companies for special dividend declaration. Similar to this, a lower dividend yield may not necessarily mean a bad investment (most importantly at growth stages). These companies might have the strategy to make investments from the earnings to provide the stakeholders with a long term return.

However, high dividend yield could signal an excellent long term prospect from a particular company.

11. EV/EBITDA

EV (enterprise value) by EBITDA, is a ratio often used in connection with the P/E ratio to ascertain a company’s value. Debt plus market capitalization minus cash equals EV. Since it includes debt, it is able to give a more accurate valuation for takeover purposes. This is its main advantage in comparison to a P/E ratio, which can easily be skewed through debt driven large earnings. EBITDA represents earnings before taking account of:

  • Tax,
  • Interest,
  • Amortization and
  • Depreciation

USES: This particular ratio is used in the valuation of companies that have acquired great amount of debts. The most significant advantage of this ratio is that because it is capital-structure neutral, it can be used in evaluation of companies having various level of debt structures. A company’s undervaluation is shown by a low ratio. An important point to take account of is that this ratio is low for slow growing industries and high for industries that are growing at a greater speed.   

Conclusion

Factors such as a company’s efficiency, profitability and risk is assessed by financial ratios yet added factors like management quality, situation of the macro economy and outlook of the industry should also be studied before making an investment decision in any stock.

 

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