Five financial ratios every investor should know

Blog | TRADING 101

Stock market investors analyse stocks in two ways: Either by studying the fundamental factors of a company (e.g. profits, debt, earnings, etc.) or by studying past trends and patterns of the markets.

If you prefer the former approach (a.k.a. fundamental analysis), financial ratios could be extremely helpful to you. In this article, we break down five important financial ratios and how you could use them to make an informed investment decision because #NumbersNeverLie!

1. Price-to-earnings (P/E) ratio
Understand whether a company is overvalued or undervalued

This ratio is calculated by dividing the current share price of a company with its earnings per share. For instance, if a company’s net profits are ₹10,000 and it has 1,000 shares trading in the market, its ‘earnings per share’ would be ₹10 and if they are trading at ₹100 per share, it’s P/E ratio would be 10. In other words, this means that investors are willing to pay ₹10 to get ₹1 from the company’s net profit.

The P/E ratio helps one understand how much an investor is paying for each rupee of earnings. It helps investors to know whether a company is undervalued or overvalued, similar to how a body mass index determines whether one is underweight or overweight! Usually a higher P/E ratio (with respect to history and/or peers) means the stock is overvalued and is expensive and a low PE ratio means a stock is undervalued and is cheaper to buy.

However, fast-growing companies such as tech companies could also have a high PE ratio indicating that investors are willing to pay a higher share price today because of growth expectations in the future. To apply this ratio while investing, you could compare it with the same company's past P/E, the average industry P/E, and the market P/E.

Don’t judge a stock by this ratio alone:
While analyzing the P/E ratio of a company, it is important to know the industry benchmarks and assess its valuation accordingly and since future earning estimates are subjective, its better to use past earnings for calculating and comparing P/E ratios.

2. Return on equity (RoE)
Understand a company’s ability to turn equity investments into profits

This ratio is calculated by dividing profit after tax with shareholder equity (i.e. a company's total assets less total liabilities as listed on the company's balance sheet)

For instance, if a company’s shareholder equity is ₹100,000 and it generates an income of ₹30,000, then the RoE is 30%. Meanwhile, another company with the same total equity but an income of ₹60,000 would have an RoE of 60%.

RoE indicates the financial health of a company and by comparing the RoE of different companies from the same industry one can make informed investment decisions.

Don’t judge a stock by this ratio alone:
RoE ratios vary according to sectors and industries, so it is important to understand the industry average as well before investing. Secondly, a company could also have a high RoE ratio if it had taken on a lot of debt and its equity investment is low, so do not forget to look at the equity structure of the company before making a decision.

3. Dividend yield
Understand the returns you can expect on an investment

A dividend is a part of the company's profits given to its shareholders to reward them for their investment in the company.  The dividend yield ratio is calculated by dividing the dividend per share with the share price.

For instance, if the market price of a stock is ₹100 and it pays a yearly dividend of ₹5 per share to its shareholders, then it’s dividend yield would be 5%. Similarly, another company with a market price of ₹80 also giving a dividend of ₹5 per share would have a dividend yield of 6.25%

Examples of high dividend paying companies in India:  IDFC, NLC India, HUDCO, P&G Health, TV Today, Balmer Lawrie, Oil India, DB Corp and PTC India.


Don’t judge a stock by this ratio alone:
There may be stocks that have high dividend yields but lack quality. Also, know that low dividend yield may not always imply a bad investment, because companies that are in their growth stage may choose to reinvest all their earnings for long-term growth.

 

4. Debt-to-equity ratio
Get a glimpse of how much the company own’s versus owes

This ratio is calculated by dividing a company's total liabilities by its shareholder equity. 

For instance if a company's total liabilities are ₹50,000 and its shareholders' equity is ₹25,000, then the debt-to-equity ratio is 2. Debt-to-equity ratios vary widely by industry, but in general, debt-to-equity ratio below 2.0 is considered ideal, unless the company is in a fixed asset-heavy industry (such as mining, aviation, construction).

Lower ratios are usually considered better, but one needs to factor in returns generated by the company as well before making a decision. If the company’s returns are higher than its interest costs, the debt could be leveraged to enhance value. If not, investors stand to lose their money especially during a period when sales are down and interest costs eat into the company's profits.

Don’t judge a stock by this ratio alone:
You need to compare this ratio with peers from the industry,because capital-intensive industries such as auto and mining have a higher debt-to-equity than others.

5. Current ratio
Understand the company’s short-term debt repaying capacity

This ratio is calculated by dividing current assets with current liabilities. For instance, if a company's current assets are ₹10,000 and its current liabilities are ₹5,000, then its current ratio is 2. A current ratio that is in line with the industry average or slightly higher is generally considered acceptable and usually an ideal current ratio is between 1.2 to 2, which means that the business has 2 times more current assets than liabilities to cover its debts.

A lower current ratio indicates that the company doesn't have enough liquid assets to cover its short-term liabilities.

A higher current ratio means the company will not get affected by working capital challenges and a lower ratio (anything below 1) could be a problem. But sometimes a really high current ratio could also indicate that a company is not using its current assets efficiently or is unable to secure financing well. Like all other ratios, current assets cannot be a sole indicator and one must compare it with peers in the industry.

Don’t judge a stock by this ratio alone:
Large retailers like D-Mart, Reliance, could have longer-than-average payment terms with their suppliers because they buy products from their suppliers on credit. This shows on its balance sheet as a high payable balance relative to its receivables balance and thus indicates a lower ratio. So, in order to use this ratio correctly, one must, compare it to ratios of other companies in the same industry and then make a decision based on that.

Current ratio helps to understand short-term solvency when one compares it with past data and other companies. Thus, to make the most of this indicator while judging stocks, it is better if this ratio is calculated consistently after intervals for a particular stock.


Just like one shouldn’t judge a book by it’s cover, a company must not be judged by any single ratio independently. One must study multiple ratios, compare them with ratios of the same company in the past and with ratios of similar companies in the industry before making a buy/sell decision.


Disclaimer:

The above article is purely academic in nature and aims to provide knowledge about basic trading concepts & should not be construed as an opinion or advice to invest or trade.

Investments in the securities market are subject to market risks; please read all the related documents and/or consult your investment advisor before investing.

Past performance of an investment asset does not guarantee future returns.

Companies mentioned in the article are purely for illustrative purposes and are not meant as a recommendation to buy or sell any security.