Know the financial ratios essential for identifying stocks for investment

Many new investors start investing in direct equities to get a huge return. But without understanding the valuation of a particular stock, it is very dangerous to invest in direct equities. In this article, the author discusses eight essential ratios necessary for valuation of the companies. Read to understand.

Thanks to the financial education, many people are aware that equity market gives the best return on a long-term basis. Although the financial experts generally state that equity mutual funds are ideal for wealth generation for the retail investors, because most of the retail investors do not have time or knowledge to identify stocks for investing, some retail investors invest in direct equity. These retail investors get attracted to the interesting volatility of the stock market. But without proper guidance to identify stocks, many of such investors lose money in the stock market and leave the world of equity investment forever.

So, we must learn the ratios which are essential to identify stock for long-term investment. There are some well-known ratios which indicate the fundamentals of the stock. The investors must know about these ratios which are essential to examine the stocks. These ratios give an indication whether the identified stock(s) is/are fit for long-term investment or not. Let us know about these important ratios.

#1: Price-to-Earnings (P/E) Ratio

The P/E Ratio indicates how much the investors are paying for each rupee of earnings. This shows if the market is overvaluing or undervaluing the company. It is usually used to value mature and stable companies which earn a profit. P/E Ratio of a company is compared to the P/E Ratio of the industry and the P/E Ratio of the market.

#2: Debt-to-Equity (D-E) Ratio

This ratio indicates how much a company is leveraged. This means it indicates how much debt is involved in the business compared to the capital of the promoters. Generally, the less is the ratio, the better is the company. But it does not hold true in case of capital-intensive industries, where the D-E Ratio is comparatively more than the D-E ratio of other industries.

#3: Price-to-Book Value (P/BV) Ratio

This ratio is used to compare a company's market price to its book value (the amount which will remain in case the company liquidates its assets and repays all liabilities). If the value of the ratio is less than 1, then we can say that the stock is undervalued. This ratio indicates the company's inherent value and is useful for finding out the true valuation of a company.

#4: EV/EBITDA Ratio

This ratio is used along with P/E Ratio to value a company. This ratio is particularly useful to value companies which are under a lot of debt. A lower EV/EBITDA Ratio indicates that the stock is undervalued.

#5: Price/Earnings Growth (PEG) Ratio

This is another well-known ratio. This ratio establishes the relationship among the price of a stock, Earnings per Share (EPS) and the growth of the company. A PEG Ratio of 1 indicates that the stock is reasonably valued. If it is less than 1, then it signifies that the stock is undervalued and if the ratio is more than 1, then the stock is overvalued.

#6: Return on Equity (RoE)

This well-known ratio measures the return the shareholders would get from the business and overall earnings. It helps the investors to compare the profitability of various companies which they are tracking, or which belong to the same sector. RoE of 20% or above is considered good.

#7: Operating Profit Margin (OPM)

This ratio signifies the operational efficiency of a company and its pricing power. The investors check whether the OPM of the company has been continuously increasing over the years, or not.

#8: Current Ratio

This ratio indicates the capability of a company to meet the short-term obligations with short-term assets of the company. This ratio is calculated by dividing current assets by current liabilities. The more the value of the Current Ratio, the more capable is the company to meet its short-term obligations.

Final few words

The experienced investors use the aforestated ratios to check the valuation of the company and to decide whether to purchase a particular stock, or not. However, the new investors must remember that these ratios help us to understand the fundamentals of a company for long-term investment purpose. Further, these ratios must not be checked in isolation, rather these ratios are used for comparison purpose.

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Author: Reena Upadhya18 Sep 2018 Member Level: Diamond   Points : 10

All the eight financial ratios described by the author are essential to determine a company’s status. Only after thorough valuation of the company, one must make an investment in direct equities. Carefully one must analyze the company’s financial data to evaluate its worth in the market.

Here are a few more financial ratios which are equally important in determining a company’s worth.
The ratio of interest coverage- The ratio of interest coverage is determined by dividing EBIT which stands for earnings before interest and tax by interest expense. This ratio shows the financial stability of the company. Instead of EBIT, EBITDA can also be used. It helps in the comparison between companies who differ in terms of amortization and depreciation. However, using EBIT in calculation gives a perfect idea if one wants to know the financial security of the company very accurately.

The ratio of asset turnover- This ratio determines the efficiency of the company to generate revenue out of assets. If the ratio of asset turnover is high, it shows the company is efficient enough to generate good revenue. However, only compare companies that fall in the same industry. The reason is that ratio of asset turnover varies greatly from one industry to another. This ratio is low in sectors where asset base is heavy such as in telecommunications. This ratio is high in the retail sector where the asset base is small.

Dividend Yield- It is obtained by dividing dividend per share by price of the share. If the resultant figure is high, it is an indication that management is efficient. Rule out penny stocks where the dividend yield is high but the quality is not good at all. Beware of those companies where dividend yield is high as they enjoy one-time profits or are left with unused large cash. Also, if the dividend yield is low does not necessarily mean that management has a bad reputation. New companies which are still growing show low dividend yield as they prefer to reinvest their entire earned amount. The reason is that they want their shareholders to reap huge benefits in the long run.

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