9 Key Financial Ratios to Find Winning Stocks
2018 is the year which most investors do not aim to remember (although it is essential to keep everything in mind along with key financial ratios if you want to become a successful investor) where they have lost a major part of the gains that they have earned in 2017.
All sorts of things have happened whether it is higher crude oil prices, Indian rupee depreciating against USD; US-China trade war, NBFC crisis, BREXIT issue, etc. which forces the market to come down and offer almost no return throughout the year and obviously making the investor nervous.
But, keeping all these things aside, Indian Stock Markets have recovered sharply (after February 2019) and offered more than 10 percent gain since then. Beyond that both Sensex and Nifty hit fresh record highs and this is something which forces the individuals to look at the Stock Market again.
Whether you’re a newbie or a veteran in the field of stock market and looking to buy stocks but not sure how to pick them, don’t fear. Finblab listed nine key financial ratios and their meaning that assists you to make the best possible choice.
Price to Earnings Ratio (P/E Ratio)
P/E Ratio is one of the most commonly used ratios by investors across the globe when picking stocks. P/E reveals the fact “how much the investors are happy to pay for a rupee of the company’s earning”
Another way of looking at the P/E ratio is the number of years it will take to gain back the initial investment assuming that the company doesn’t grow at all.
For example, say the P/E is 30; it means the share price is 30 times its earnings. So if the company’s EPS remain constant, it will need about 30 years to make up for the purchase price of the share.
P/E Ratio can be further classified into trailing P/E and forward P/E
When an investor calculates the P/E based on the past 12 months of earnings, it is referred to trailing P/E; and when the P/E is calculated on the basis of estimated future earnings it is referred to forward P/E
In short, to use the P/E ratio accurately, take into account the future earnings and growth prospects of the company. If the current P/E is low, as against the strong future prospect then the stocks make an attractive investment option. But if the company is loaded with falling sales and huge losses, stay away from it, despite having low P/E.
Analysts and Investors are of the view that P/E ratios should be used in combination with other key financial ratios for informed decision-making.
P/E Ratio = Market Price of the Share / Earnings per Share
Price to Book Value Ratio (P/BV Ratio)
Apart from P/E, another ratio that is commonly used by the investors is a price-to-book value or P/BV ratio. This ratio shows the worth of each share of a company as per the company’s accounting book.
Book Value, in simple words, is the amount that will remain if the company liquidates its assets and repays all its liabilities.
Stocks priced at less than book value are purchased on the assumption that, in time, their market price will reflect at least their stated book value, i.e., what the company itself has paid for its own assets.
Price to Book Value Ratio can help you judge if the share price is overpriced or underpriced.
P/BV Ratio = Shareholders’ Funds / Total Number of Equity Shares Issued
Reserves
Every year, the company divides its Net Profit into two portions; (1) Plough Back and (2) Dividends
While dividends are handed over to the shareholders, plough back is kept by the company for its future use and generally included in its reserves.
Hence, if you’re looking for a company with good growth/future prospects, check its reserve figures. If a company’s reserves are two times its equity capital, the company can reward its shareholders going forward with bonus shares.
Also, an increase in the company’s reserves will push its share price as well.
Dividend Yield
The Dividend is the portion of the profit that is distributed among shareholders. While dividend yield of a stock is the dividend of a stock as a percentage to the current market price.
Historically it has been observed that companies offering high dividends don’t have much of growth to talk about. Similarly, companies in high growth sector hardly give any dividend.
To become a successful equity investor and create wealth over a long period of time it is advisable to invest for capital appreciation instead of dividends.
Dividend Yield = (Dividend per Share / Market Price of Share) x 100
Debt to Equity Ratio
The debt-equity ratio is the amount of debt that a company raises for each rupee of shareholders fund.
A low debt to equity ratio is usually considered better, while a high debt to equity ratio indicates a higher level of risk.
As an intelligent investor, your job is to pick a company which has a debt to equity ratio below 1.
Earnings per Share (EPS)
Earnings per Share or EPS are one of the most popular investment ratio used by investors globally. It is a key financial measure, which shows the profitability of a company.
To compute EPS which is the Net Profit divided by the number of shares one will have to exclude the non-recurring income and expenses as adjusted for the tax payment.
EPS = (Net Profit – Preference Dividend) / Weighted Average Number of Shares
ROCE: Key Financial Ratios
Return on Capital Employed (ROCE) is the ratio of operating profit to the capital employed.
To put it simply, it serves as a measure of return generated from each unit of capital deployed in the business.
Historically, operating profit is a far better indicator of the profits earned by the company instead of the net profits. Hence this ratio is the better indicator of the general performance of the company and its operational efficiency.
Companies having a higher ROCE are more likely to be wealth creators when compared to businesses with a low ROCE.
ROCE = (Operating Profit / Capital Employed) x 100
ROE: Key Financial Ratios
Return on Equity (ROE) is the ratio of the net profit to the shareholder funds and is a good indicator of the robustness of the business model.
This ratio gives you an idea of the returns generated by investing in the company.
When used Return on Equity along with ROCE, you get an impression of the company’s capability, financial standing, and its ability to generate returns on shareholders’ finances and capital employed.
ROE = (Net Profit / Shareholders Fund) x 100
Price Earnings Growth Ratio (PEG Ratio)
PEG is an extensively used ratio for computing the intrinsic worth of a share. This ratio helps you decide whether the stock is underpriced, totally-priced or overpriced.
In general, a PEG below 0.5 is a lucrative investment opportunity, whereas PEG exceeds 1.5 is a time to sell.
PEG = PE / Expected Growth Rate Of the EPS of A Company
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These are some of the key financial ratios that must be kept in mind when purchasing a share.
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