Just how you look at the run rate to understand your favourite cricket team’s performance, you can look at Debt to Equity Ratio, P/E Ratio and ROC to analyse companies and understand their performance.
Let’s begin with the first one - the debt to equity ratio.
First of all, What is debt?
Debt is nothing but loan funds. In simple words, the money that comes to you from someone else’s pockets is debt.
On the other hand, What is equity?
Equity is our own funds. The money which comes from our own pockets. Simply put,
Loan debt to equity is the ratio of loan funds to own funds.
Now, What is an optimal ratio?
The optimal ratio which is widely used in the industry is generally 2:1. But it also slightly differs with each industry. We say that 2:1 is the debt to equity ratio but let’s try to understand what it actually means. For that, let’s consider the following example:
A company’s debt is Rs 500 and it’s equity is Rs 250. So when we do 500:250, the debt to equity ratio becomes 2:1. But, why is more debt considered a better option?
Whenever we take a loan, we have to pay some interest on that. And this interest is tax deductible. Which means that your cost of funding gets reduced in comparison to equity funding. But does this mean that debt is a compulsion? No, not at all. Even zero debt is considered to be good.
If you can check out on the Upstox website, you will easily find companies like IRCTC, HDFC, AMC etc who have absolutely zero debt.
Price to Earnings Ratio
Now, let's move on to our next ratio - the price to earnings ratio (PE ratio).
What is Price?
Price is nothing but the current market price. We also call that as the LTP or the Last Traded Price.
What is Earnings?
Earnings or EPS is nothing but Earnings Per Share. For example, if a company’s earnings are one lakh rupees and the number of shares are 10,000. Then the EPS will be
100,000 by 10,000 or Rs10.
Now to find the PE ratio, we will have to divide the LTP by the EPS. Let’s assume that for any company I get a PE ratio of 20. What does that mean? Is it high? Is it low? How do I compare that? To do that I'll have to compare it with something and I can compare it with
- Its peers or
- With the industry average.
If we assume that the industry average is 100 and the stock PE is 80, it means that the stock is comparatively less expensive. On the contrary, if the industry PE is 100 and the stock PE is 120, then it means that the stock is a little bit expensive.
Generally, we look at the historic PE, but market participants also look at a one year forward PE. Hence, there are chances that the market also gives a PE re-rating.
What is a PE re-rating?
Let’s take a simple example:
If you remember, Reliance Industries had said that their company will be debt free by March 2021. On the day when this announcement was made, The price of the share suddenly started increasing and many other events only made it rise further. When this happens, the people who analyse say that the PE has been re-rated or that the stock has been commanding a higher PE.
If you want to check out the various PEs of various companies, you can check them out on websites like moneycontrol.com. Even Upstox is coming up with these ratios very soon.
Let's start with the last ratio for this article - the RoCE.
So what is RoCE?
RoCE stands for Return on Capital Employed. It involves two terms - the Return and the Capital Employed. Let's decode them one by one.
What is Return?
Return is nothing but how much I get. So the EBIT or the Earnings Before Interest and Tax is the return. Now we have the numerator which is the EBIT. So, what is the denominator? It is ‘on Capital Employed’.
Now, what is Capital Employed?
Capital Employed is nothing but the amount of money I’ve invested in the business. In simple words, my debt plus my equity put together will be my capital employed.
Again, let’s take a simple example:
Assume that the EBIT is 100 and that the Capital Employed is 1000. Generally, RoCE is expressed in terms of percentage, so it will be 100 by 1000 multiplied by 100 which turns out to be 10%. Now, this will be our RoCE. So you tell me, if 10% and 12% are the RoCEs of two companies, which one is better? Of course, the company with 12% RoCE is better in this specific ratio. In simple words, we can conclude that higher RoCE means better profitability.
You can check out these ratios on the website of moneycontrol.com. Upstox is also coming up with all these ratios very soon. In fact, there can be many ratios through which we can analyze companies and we have just discussed a few of them.
We hope that this article was helpful to you. You can check for more of these articles on our website or you could also check out our YouTube channel for the same.