Ratio Analysis forms the backbone of fundamental analysis and equity valuation in the capital markets. You would be surprised to know that they are used not only by analysts and investors worldwide to identify the best stocks, but also by the key managerial personnel of companies.
Managing a multinational corporation is no easy task. For the top management, it can become a daunting challenge to evaluate every nook and cranny of a company. From analyzing the operational efficiencies to understanding where improvements are to be made, all can be gleaned by learning about Financial Ratios.
In the world of equity valuation and investments, Financial Ratios have been made to sound very complicated. As a result, most young investors are attracted more towards technical analysis and day trading using indicators. But on the contrary, analysts today do not need to calculate such ratios on their own. All you need to know is the essence of a ratio and what it means.
There are a number of apps and software that can calculate various ratios in a matter of seconds. All you have to do is to search for the company you want to evaluate and an entire list of ratios will be available for their latest financial results.
The important part therefore becomes to know the reasoning behind each ratio and to understand the relevance of each during your equity analysis. A technical trader can make short term profits but to truly multiply one’s wealth, identifying fundamentally sound companies becomes important. So here are a list of 5 important financial ratios you should use to identify financially strong companies:
1. PEG Ratio
One of the most popular ratios is the P/E ratio. Many retail investors rely on this particular measure for identifying what they believe to be expensive and cheap stocks.
But we believe that P/E ratio in isolation does not tell us anything about a company. At times a PE multiple of 70 looks cheap to investors while the same stock at 80 apparently becomes expensive for them.
The Price to Earnings ratio becomes much more relevant in our valuation method when it is used by adding earnings growth projections to its calculation.
The Price Per Earnings To Growth (PEG) ratio is not a well-known ratio, but it can give us a good picture about a stock’s value in comparison to its peers. Even one of the greatest fund managers, Peter Lynch has relied upon this ratio for his stock pickings.
PEG = (Price/EPS)/EPS Growth
Where, EPS = Total Income/ Average Outstanding Shares
The PEG ratio according to most pundits should be close to or equal to 1. With 1 as the base, it can be said that a value more than 1 implies a stock is overvalued and a value below 1 implies an undervalued stock.
Bear in mind that PEG ratio should be used during peer analysis and not be looked at without any industry research.
2. Dividend Yield
A Dividend can be defined as a reward a company pays to its fellow shareholders out of its profits. A dividend paying company is considered to be financially sound as only profit-making companies can pay dividends.
On the other hand, a non-dividend paying company doesn’t necessarily mean a weak company by any means. This is because many companies choose to reinvest the profits for further expansion and may not have funds left to pay dividends.
There are 2 reasons why we chose Dividend Yield in this list. First is that when we consider Dividend as a factor, Profitability of a company becomes considered too. The second is because during uncertain periods or during economic downturns, even if a stock underperforms in terms of capital appreciation, you can still make returns in the form of dividends.
Dividend Yield = Dividend/Share Price
For instance, if a stock is trading at Rs.200 and pays a dividend of Rs.10. Then the Dividend yield becomes 5%. Dividend yields are always expressed as a percentage.
Return on Capital Employed is a ratio which tells us how efficiently a company is using its capital to generate profits. A good part about this ratio is that it not only tells us a company’s profitability in terms of its shareholder’s equity but also considers Debt.
So for companies with a significant amount of debt, this ratio is a better measure as opposed to other ratios such as the Return on Equity ratio.
In order to calculate the ROCE, you first need to find out the company’s EBIT and Capital Employed. EBIT is the earnings or profits before Interests and taxes.
Capital Employed is the difference between the Total Assets and the Current Liabilities.
ROCE = EBIT/Capital Employed
Where, EBIT = Earnings before interests and taxes.
And Capital Employed = Total Assets – Current Liabilities
4. Debt to Equity
The debt to equity ratio measures how a company finances its assets. It may be interpreted as
the amount of leverage of a company relative to its assets.
A Low Debt to Equity ratio implies the need for a lower amount of debt for financing. On the other hand, a high Debt to Equity ratio means the company has been aggressive with its
It could be risky to invest in companies with a high DE ratio, as the companies might not possess the cash flow to repay its debt.
It is important to know that while measuring a firm’s DE ratio, you should consider doing a peer analysis first. This is because the DE ratio is industry specific and capital-intensive sectors usually attract higher DE figures in general.
Debt to Equity = Total Liabilities/ Total Shareholder’s Equity
5. Return on Assets
This ratio helps us to measure a firm’s ability to deploy its assets in an efficient manner to generate higher profits. It basically gives us an idea about the effectiveness of the management and how well it can utilize a company’s assets.
ROA can also be interpreted as the amount of revenue a company generates for every rupee of an Asset that the company owns. It is a great ratio to use to compare YoY performance of a company over a prolonged period.
ROA = Net Income/ Total Assets
A higher ROA implies better efficiency. This is because an efficient firm will limit its investments in non-productive assets. Also remember, that like a few other ratios on the list, this is another sector specific ratio and should be used for peer analysis.
This ratio is expressed in percentage terms.
Financial ratios are an important tool as it shows us the real performance of a company. A few ratios can be used to evaluate a company’s short term performance while some can be used to measure long term financial and operational performance.
Ratios can also be used in combination with technical analysis to make our trading decisions even more effective. It can also help us in avoiding huge losses because if you trade in only financially sound companies, you will certainly limit the impact of market downturns.
Raghav Agarwal is a graduate in Business Administration. With a keen interest in the world of financial markets, he loves to read and write about various financial instruments. Currently he is working with Elearnmarkets.com as a member of the Knowledge team.