6 financial ratios you must look at before making investment

6 financial ratios you must look at before making investment

A single financial ratio cannot reflect all aspects of a company, i.e., profitability, leverage, turnover, etc. Therefore, we need a couple of them to analyze all these aspects in order to know the strengths and weaknesses of a company and figure out if it’s worth investing in or not. Let us look at six financial ratios that we must not miss before purchasing the stocks of a company. To calculate the financial ratios, we look into the annual report of the company.

1. Earnings Per Share (EPS)

Earnings Per Share (EPS) is a profitability ratio and determines how much profit is earned per share in one year. It is calculated by using the given formula.

EPS = Net Income / Shares Outstanding

We can find the net income in the profit and loss account of a company while shares outstanding in the balance sheet. It is wise to compare the EPS of a company with its industry average or its competitors because looking at EPS alone will not help us make the right decision. This comparison allows us to see if the company we are seeking to invest in is profitable or not, and if not, which company is more profitable. Similarly, we should look at the EPS of the company for the last five years. Fluctuating EPS denotes a red flag. The quality of EPS is determined by its steadiness; therefore, if we find that the growth of EPS is consistent over the years, then we mark it as a good company that is safe for investing in.

2. Price to Earnings (P/E) Ratio

Price-Earnings (P/E) ratio determines whether the share price of a company is cheap or expensive. It is calculated by using the given formula.

P/E ratio = Share price / EPS

If the P/E ratio of a stock is 30, this means that you are paying thirty times the amount that the company earns in a year. This translates to an overvalued or expensive stock. Now let us suppose that the P/E ratio of a company is 5. It means you are paying Rs 5 for the stock of a company that earns Re 1 in a year. It is said that the lower the P/E ratio, the better it is since we can earn more on our investment. However, an expensive stock has a direct influence on the investor’s psychology. A company with a high share price has a history of good past performance, making it a reputable company to invest in. Investors generally believe that this growth in share price will soon increase the stock holding value, i.e., their profits resulting in other buyers’ willingness to invest in that stock.

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A lower P/E ratio doesn’t necessarily mean the stock is cheap or a bargain. This might indicate that the company’s earnings may not be qualitative and investors have less confidence in the performance of the company. A Higher P/E ratio indicates that investors have positive sentiments towards the goodwill of the company and have expectations of huge growth in the future.  Hence, the P/E ratio alone may be less conclusive to make an investment decision.

As with any other ratio, it is wise to compare the P/E ratio of a company with its industry average to have a general view of what the P/E ratio looks like or should look like in the same industry.

3. Debt to Equity (D/E) Ratio

D/E ratio tells us how much a company’s activities are financed by debt and equity, respectively. Debt is the long-term borrowing for which interest payment is mandatory, and equity is obtained from shareholders of the company who receive dividends only when the company makes profits. Hence, D/E ratio highlights outsiders’ and insiders’ money in the company. It is calculated by using the given formula.

D/E ratio = Total debt / Total equity

Let us suppose the total debt of a company is Rs 30 lakhs and the total equity is Rs 10 lakhs. This gives us a D/E ratio of 3:1 by using the above formula. This translates to the company taking more loans for which interest payment is mandatory. Here, the profits earned by the company will be used to pay interest for the loan taken. The ideal D/E ratio is 1:1, while the maximum should be 2:1. If the debt is greater than two times the equity, then this means the profit earned is being spent on repaying the debt and the interest attached instead of being distributed to the shareholders.

On top of that, a high debt to equity ratio questions a company’s creditworthiness as banks become reluctant to provide loans if the company cannot clear its debt on time. Therefore, shareholders should be wary before investing in a company with a high debt to equity ratio. We might end up thinking that a low D/E ratio is a positive indicator. However, this means that the shareholder base is increasing. When a company is inclined towards issuing shares to raise capital over taking loans, the profit earned will be distributed to more shareholders, decreasing earnings per shareholder. Therefore, the measure of the D/E ratio should neither be too high or too low.

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4. Return on Equity (ROE)

ROE gives us the percentage of return to the shareholders on the total investment. A significant difference between EPS and ROE is that while EPS provides us with profit on one share, ROE determines the profit on total equity. The formula used to calculate ROE is given below.

ROE = (Net Income / Shareholder’s equity) * 100

Simply looking at the profit of a company isn’t enough to make investment decisions. For instance, two companies, X and Y, can have the same profits of Rs 1 lakh each. So, which one should we invest in? The answer is given by the number of people the profit needs to be distributed to. In the same example, let’s say that the shareholder equity equals Rs 10 lakhs in Company X and Rs 100 lakhs in Company Y. (Shareholder equity is the amount shareholders will be receiving once the total assets of a company are liquidated and the debts are repaid.) After calculation, ROE in Company X is 10% while ROE in Company Y is 1%. This shows that Company X is more profitable than Company Y, and an investor should opt for a company with a relatively higher ROE.

5. Price to Book Value (P/B) Ratio

The Price to Book Value (P/B) ratio helps us know whether a stock is overvalued or undervalued. It is calculated using the given formula.

P/B ratio = Market value per share / Book value per share

In the above equation, book value per share is calculated by dividing net assets (total assets-total liabilities) by total shares outstanding. It denotes the net worth of the company, i.e., the value of a share when a company has liquidated all its assets and paid off its debts. Market value is the market price of the share.

By comparing market value to its book value through the P/B ratio, we identify how much a stock is overvalued or undervalued. For example, the market value of a stock is Rs 100, and its book value is Rs 25. Using the above formula, we derive a P/B ratio of 4. So, an investor would be paying Rs 100 for the stock while he/she would receive only Rs 25 if the company is to close down shortly. Here, the stock trades at four times its book value which is why the stock is overvalued. Therefore, the P/B ratio makes you question if you are paying too much for a company that would give you barely anything if it went bankrupt.

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Generally, overvalued stocks show a combination of low ROE and a high P/B ratio. While ROE determines profitability, the P/B ratio determines valuation, which is why they are studied together. When profitability increases, it is only natural for the valuation to increase. So, if both ROE and P/B ratios are in an increasing trend, it denotes natural growth. However, if the ROE is low, which means declining profitability, but the P/B ratio is high, which means an increase in valuation, one should be cautious.

In contrast, a lower P/B ratio means that a stock is undervalued. Generally, if the P/B ratio is below 1, it is regarded as a good investment by value investors as they believe they can generate a return once the market catches up to the company’s true value. However, an undervalued stock could also point out fundamental problems within a company.

6. Current Ratio

The current ratio tells us if a company is capable of paying back its liabilities in the short run. It is calculated using the following formula.

Current ratio = Current assets / Current liabilities

It determines if a company has enough liquidity to operate smoothly. Suppose the current ratio of a company is 2:1. In that case, it means if the company has liquid assets worth Rs 2, then it can use half of it to clear its liabilities and the remaining to carry on its operations efficiently. It need not be worried about the short-term obligations. Generally, 1.5 to 2 is considered a good current ratio. However, it isn’t the sole ratio to look upon before making significant decisions as it only deals with short-term concerns.