Last Updated on May 24, 2022 by Anjali Chourasiya
Stock markets run on a simple principle of buying and selling stocks to generate profits. When you invest in stocks, the idea is to buy at a certain price (generally low) and sell at a higher price. The bigger the gap between the price you buy versus the price you sell, the higher your earnings.
Apart from all these, stocks can be an excellent investment avenue for the long term. Using fundamental analysis, one can pick potential stocks and profit from their growth later. This can be done with the help of financial ratios. Let’s explore further.
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Why do investors need financial ratios?
Stock prices are affected by demand and supply, news and a host of other factors that might have nothing to do with the actual financial performance or value of a company. Some stock prices might be inflated purely due to hype. However, at some point, the hype may die out, and the stock price would be guided by the company’s fundamentals.
Fundamentals are largely the macroeconomic factors that affect the economy, industry, sector and finally, the company. A company that stands strong on its fundamentals i.e. does well in its industry and on growth is touted to make for a great investment. However, sometimes, due to controllable and uncontrollable factors, the stock of such companies may remain ignored and undervalued on the markets. If you succeed in identifying such stocks, you could earn stellar returns.
But, how can you identify when a stock is undervalued or selling at a discount? Well, you use financial ratios to determine a stock’s valuation.
Five important financial ratios for fundamental analysis
Price to earnings ratio is the profit per rupee that an investor derives by investing in a company. It is calculated as :
P/E ratio = Current share price / Earnings per share
A company’s P/E ratio holds its earnings against its share price to give investors an idea of whether the stock is undervalued or overvalued.
Let us use a simple example to understand the P/E ratio. Assume that company ABC ltd has earnings of Rs. 2,00,000. It has 1000 shareholders and a share price of Rs. 100. The earnings per share is Rs. 200, which means that the shareholder pays Rs. 100 for Rs. 200 worth of earnings.
Generally, the lower the P/E ratio, the more favourable the stock is from a value investing perspective. On the contrary, the higher the P/E ratio, the more overvalued the stock is. A valuation is arrived at when you compare the P/E ratio of one stock with peers or the industry average. Note that the healthy P/E ratio range for every sector is different.
Return on equity ratio
This is arguably the most important ratio in equity analysis. This ratio measures how efficiently the company generates profit per unit equity. Companies with higher ROE are preferred for investments. It is calculated as:
ROE = (Net income/Profit) / Shareholder’s equity
However, investors should keep in mind one loophole in ROE. A company could display a good ROE on account of high debt and low equity. In such a case, if you add its borrowings and equity, its earnings might pale in comparison. You can maintain a clear lens when using ROE by checking the company’s debt to equity structure.
Debt to equity ratio
Debt and equity are the two most basic sources of finance. How a company uses one source compared to another defines debt to equity ratio. In other words, the debt to equity ratio can be defined as the ratio at which a company uses debt and equity channels for financing.
Debt to equity ratio = Total debt / Total equity
Expanding companies will generally have a debt to equity ratio higher than 1 as they typically use debt as a means of finance. However, there is no healthy debt to equity ratio – it not only differs from one sector to the next but also is more of a support to ROE rather than a standalone metric.
Price to book ratio
To understand the P/B ratio, it is important to understand book value. Book value is derived by deducting borrowings and adding asset value to a company’s present value, and then dividing that figure by 100.
In the same light, the P/B ratio is calculated as:
P/B = Market price per share / Book value per share
Ideally, a lower P/B ratio makes companies preferable because it means that they are undervalued. However, a negative P/B ratio might indicate that the company is fundamentally weak or has poor financial health. Like the other ratios on this list, P/B ratio must account for sector and business environment specifics when making comparisons.
Dividend yield ratio
This ratio measures the quantum of cash dividends paid out to shareholders per share. It is simply calculated by dividing the annual dividends paid by a company against its stock price. It is given:
Dividend yield ratio = Annual dividend per share / Price per share
If Company A pays a total dividend of Rs. 100, trading at Rs. 1,500, then the dividend yield ratio is 6.6%. Companies with a higher dividend yield are also seen as preferable because besides stock price appreciation; investors earn by way of dividends.
Investors should proceed with caution when using this ratio because there is no guarantee of dividend payment (or its volume) in the future. Moreover, dividend yield differs largely from one sector to the next.
Trade with a safe and foolproof strategy instead of guessing, or worse – getting conned by ‘insider tips’. Use a combination of financial ratios to time your investment correctly. Understand the markets fully and only then invest. Consult your financial advisor before investing.