key figures before investing in stocks

8/18/2019 Key Figures Before Investing in Stocks

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*+95 ratio values shares of companies with large tangible assets on their balance sheets.

*+95 ratio of less than one shows the stock is undervalued 7value of assets on the company's

books is more than the value the market is assigning to the company8. #t indicates a

company's inherent value and is useful in valuing companies whose assets are mostly liquid,

for instance, banks and financial institutions.

DEBT-TO-EQUITY RATIO

#t shows how much a company is leveraged, that is, how much debt is involved in the

business vis-a-vis promoters' capital 7equity8. low figure is usually considered better. 9ut it

must not be seen in isolation.

!#f the company's returns are higher than its interest cost, the debt will enhance value.

;owever, if it is not, shareholders will lose,! says ggarwal of S(.

!lso, a company with low debt-to-equity ratio can be assumed to have a lot of scope for

expansion due to more fund-raising options,! he says.

9ut it is not that simple. !#t is industry-specific with capital intensive industries such as

automobiles and manufacturing showing a higher figure than others. high debt-to-equity

ratio may indicate unusual leverage and, hence, higher risk of credit default, though it could

also signal to the market that the company has invested in many high-


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can be skewed by unusually large earnings driven by debt. 9#T% is earnings before

interest, tax, depreciation and amortisation.

This ratio is used to value companies that have taken a lot of debt. !The main advantage of

5+9#T% is that it can be used to evaluate companies with different levels of debt as it is

capital structure-neutral. lower ratio indicates that a company is undervalued. #t is

important to note that the ratio is high for fast-growing industries and low for industries that

are growing slowly,! says ukher4ee of ##6.

PRICE/EARNINGS GROWTH RATIO

The *: ratio is used to know the relationship between the price of a stock, earnings per

share 7*S8 and the company's growth.

:enerally, a company that is growing fast has a higher *+ ratio. This may give an impressionthat is overvalued. Thus, *+ ratio divided by the estimated growth rate shows if the high *+

ratio is 4ustified by the expected future growth rate. The result can be compared with that of

peers with different growth rates.

*: ratio of one signals that the stock is valued reasonably. figure of less than one

indicates that the stock may be undervalued.

RETURN ON EQUITY

The ultimate aim of any investment is returns. "eturn on equity, or ", measures the returnthat shareholders get from the business and overall earnings. #t helps investors compare

profitability of companies in the same industry. figure is always better. The ratio highlights

the capability of the management. " is net income divided by shareholder equity.

!" of /0-23= is generally considered good, though high-growth companies should have a

higher ". The main benefit comes when earnings are reinvested to generate a still higher

", which in turn produces a higher growth rate. ;owever, a rise in debt will also reflect in

a higher ", which should be carefully noted,! says ukher4ee of ##6.

!ne would expect leveraged companies 7such as those in capital intensive businesses8 to

exhibit inflated "s as a ma4or part of capital on which they generate returns is accounted

for by debt,! says :upta of rthaveda und anagement.

INTEREST COVERAGE RATIO

#t is earnings before interest and tax, or 9#T, divided by interest expense. #t indicates how

solvent a business is and gives an idea about the number of interest payments the business

can service solely from operations.


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ne can also use 9#T% in place of 9#T to compare companies in sectors whose

depreciation and amortisation expenses differ a lot. r, one can use earnings before interest

but after tax if one wants a more accurate idea about a company's solvency.

CURRENT RATIO

This shows the liquidity position, that is, how equipped is the company in meeting its short-

term obligations with short-term assets. higher figure signals that the company's day-to-day

operations will not get affected by working capital issues. current ratio of less than one is a

matter of concern.

The ratio can be calculated by dividing current assets with current liabilities. (urrent assets

include inventories and receivables.Sometimes companies find it difficult to convert

inventory into sales or receivables into cash. This may hit its ability to meet obligations. #n

such a case, the investor may calculate the acid-test ratio, which is similar to the current ratio but with the exception that it does not include inventory and receivables.

ASSET TURNOVER RATIO

#t shows how efficiently the management is using assets to generate revenue. The higher the

ratio, the better it is, as it indicates that the company is generating more revenue per rupee

spent on the asset. xperts say the comparison should be made between companies in the

same industry. This is because the ratio may vary from industry to industry. #n sectors such as

power and telecommunication, which are more asset-heavy, the asset turnover ratio is low,

while in sectors such as retail, it is high 7as the asset base is small8.

DIVIDEND YIELD

#t is dividend per share divided by the share price. higher figure signals that the company is

doing well. 9ut one must be wary of penny stocks 7that lack quality but have high dividend

yields8 and companies benefiting from one-time gains or excess unused cash which they may

use to declare special dividends. Similarly, a low dividend yield may not always imply a bad

investment as companies 7particularly at nascent or growth stages8 may choose to reinvest all

their earnings so that shareholders earn good returns in the long term.

! high dividend yield, however, could signify a good long-term investment as companies'

dividend policies are generally fixed in the long run,! says :upta.

)hile financial ratio analysis helps in assessing factors such as profitability, efficiency and

risk, added factors such as macro-economic situation, management quality and industry

outlook should also be studied in detail while investing in a stock.

Repr!"#e! Fr$ M%e& T!'& Sep*e$+er ,. LMIL A00 r123*4 re4er5e!


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