5 most Important Financial ratios to check before investing in a Stock
Investing in stock market and picking gem like stocks out of so many listed stocks is always a tricky task. There are certain parameters which give an idea about the Financial Health of a stock of any company. Out of these parameters, there are few ratios which help in determining about the performance of that company and its stock price. There are many Financial ratios which are defined but 5 are most important ratios which you must check before investing in a stock of any company. These ratios used for different purposes and also have different interpretations. Understanding these ratios will make your stock picking process easy and sensible. So let’s discuss these 5 ratios in detail-
- D/E ratio: It is Debt-to-Equity This ratio use to evaluate the Financial leverage of a company. It is used to know- How much a company is financing its operations from loans and borrowings i.e. Debt and from its own resources i.e. shareholders’ invested money or Equity. So it is calculated as- Company’s Total Liabilities divided by its Total Shareholders’ equity. If a company has D/E ratio: 2 it means Company is borrowing Rs. 2 against every Re. 1 invested by shareholders. The ideal D/E ratio is use to be 1 but ideal thing does not exist, hence you will barely see any company has D/E ratio of 1. D/E ratio of any company should be steady over a period of time. If D/E ratio is increasing it means company is continuously taking loans, you don’t know whether company will be able to repay its loan. This makes company sceptical about its long term performance. Now, even if D/E ratio is continuously decreasing it means company is increasing its equity base and hence its profit is divided in more no. of shareholders and by default shareholder will get less money. Moreover it is also interpreted as Company’s credit worthiness is decreasing that’s why it is not able to take loans and it has to rely only on its shareholders’ money. You can consider a company whose D/E ratio is steady over a longer period of time.
- EPS ratio: It is Earnings Per Share. It evaluates that- How much a company earns over its one share. It is calculated as- Company’s Net profit divided by Outstanding shares of the company. For EPS the net profit of the company is adjusted with gains and losses from extraordinary items. It is a profitability ratio; it shows about the company’s profitability health. Higher the EPS more is the company’s profitability. Higher EPS of a company shows that investors have confidence in the company’s performance and they are ready pay more for its shares because company is generating higher profits relative to its share price. A steady growth in EPS is good for any company; its absolute value is of no use but when it is compared with its own historical data or with its competitors’ EPS or with industry average it makes more sense.
- PE ratio: It is Price-to-Earnings It is very important ratio when it comes to gauge share price of a company. From PE ratio you can evaluate whether a Stock is overvalued or undervalued. PE ratio is calculated as- Share Price divided by EPS. Let’s say a company has PE ratio of 5, it means company is demanding Rs. 5 as its share price against its earning of Re. 1.It is a common query that- Company has only Re. 1 of earning and still it is demanding Rs. 5 for its share price then it is too expensive, so you should not buy its share. But actually it does not work in that way instead it is opposite; if PE ratio is high this shows investor has confidence in that company and they ready to pay more against the company’s earnings. It is very common practice that high P/E ratio could mean that a company’s stock is overvalued, and investors are expecting high growth in future. Like EPS, PE ratio’s absolute value is also of no use, it makes more sense when it is compared with its own historical record or with its competitors or with the industry average.
- ROE: It is Return-on-Equity. This ratio is use to evaluate the profitability and efficiency of generating profits by the company. It is calculated as Net profit divided by Total shareholders’ equity; and shareholders’ equity is nothing but Total Assets minus Total Liabilities, in short Shareholders’ equity is Net asset of the company. Therefore this ratio indicates that- How much a company generating profit with shareholders financing. ROE is calculated in percentage, higher the ROE better the efficiency of company. Higher ROE shows company is generating more profit with less financing from its shareholders which simply mean that company is quite efficient. Again, ROE as an absolute value is of no use, when it is compared with past data or with competitors’ ROE or with industry average then it makes sense. ROE and EPS are different; ROE is Profit on Total Equity while EPS is Profit on Total No. of shares.
- PB ratio: It is Price-to-Book value. Just like PE ratio, it is also an indicator that evaluates the stock is overvalued or undervalued. But it is mainly use to compare total market capitalization of the company to its book value. It’s calculated as Market price per share divided by Book value per share. So this ratio gives market valuation of a company against its book value. The PB ratio is used by investors to identify the opportunity of investment in undervalued stocks. Therefore, P/B ratio of less than 1 is considered as very good investment opportunity by investors. In PE ratio Share price is compared to earnings of the company while in PB ratio Share price compared to its book value. Moreover, ROE and PB ratio should go in same direction because ROE is for profitability and PB ratio is for market value of the company, if they are going in different directions that is one is upward while other is downward then it is a red flag for investors because when profitability increases valuation should also increase.
Conclusion: There are many parameters to analyse a stock and but these ratio put the foundation of Quantitative analysis of Fundamentals of any stock. As an investor it is very important for you to make thumb rule to check these ratios before going for investment in any stock, it will increase the chances of your gains for sure. Happy Investing.
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