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Tuesday, August 10, 2010

Different Types of Financial Ratios

Income Statement Related Ratios

1) PE Ratio: This is the most common ratio used for comparing companies. PE ratio simply means how much an investor is willing to pay in the market for Rs. 1 of company earnings. So, if a company has a PE ratio of 10, it means that investors are willing to pay Rs. 10 in the market for every rupee of the company earnings. When comparing companies the thumb rule is – lower the PE ratio the more undervalued the company is relative to its peers.

PE Ratio = Market Price of Company / Earnings per Share

2) PEG Ratio: This ratio is applicable mainly to high growth industries. For companies growing at 50-60% or even more the PE ratio is not a great indicator of valuation. For such companies PEG ratio is used.

PEG Ratio = PE Ratio / Growth

For simplicity sake the growth here is the revenue growth rate for the company. Example: A company has a PE ratio of 50. This looks high and we would say that the company is overvalued. But suppose that the company is growing at 100% annually. So PEG ratio for the company is 0.5 (50/100). A PEG ratio of less then 1 means the company is undervalued with respect to its future growth potential. A PEG ratio of over 1 indicates that the company is overvalued with respect to its future growth potential.

3) Gross Margin, Operating Profit Margin and Net Profit Margin: It is very important to compare these margins for peer companies. If in the same industry a company has a better gross, operating and net profit margin then its peer then it makes a big difference. It shows that the company is more efficient and better equipped to control its cost then its peers.

Gross Margin = (Revenue – Cost of Sales/ Revenue)*100
Operating Profit Margin = (Earnings before Interest and Tax/Revenue)*100
Net Profit Margin = (Net Profit / Revenue)*100

4) Price/Sales Ratio: This is another simple to calculate as well a very useful ratio to do peer analysis and valuation. The lower the price/sales ratio, the more undervalued the stock is as compared to its peers.

Price/Sales Ratio = Stock Price / Sales per share

Sales per share can be calculated in the same way as we calculate EPS. I.e. Sales/Shares outstanding

Balance Sheet Related Ratios

1) Return on Equity: This is one of the most important ratios as it shows how efficiently the company has been using the shareholders money. The higher the ratio the better it is and indicative of an efficient management. So among peer companies this ratio can be used as a big differentiator between good, medium or bad managements.

Return on Equity = Net Income / Shareholders Equity

2) Return on Assets: This is another important ratio for giving investors an idea about how good the management is in utilizing its assets to generate returns for its shareholders. So the higher the ROA, the better is the company in extracting maximum use of its assets to generate returns for shareholders.

Return on Assets = Net Income / Total Assets

3) Debt Equity Ratio: For the same size companies in the same industry it is important to know the debt equity ratio. In general the lower the debt equity ratio the better it is for the company. The most important reason is that it reduces the interest burden for the company.

Debt Equity Ratio = Total Debt / Equity

Cash Flow Related Ratios

1) Operating Cash Flow per Share: This ratio is the most important ratio to look at in the cash flow in my opinion. This will give the real cash inflow for the company per share for any given year. So among same size companies, if a company has higher operating cash flow per share then it’s a much better bet then a company having low or negative operating cash flow per share.

Operating Cash Flow per share = Cash flow from operations / Number of shares outstanding

2) Capital Expenditure per share: It is the capital expenditure which tells how much the company will expand in the future in terms of its size and revenue. So among same size companies if a company is going for higher capital expenditure per share then its likely to have higher revenue growth also in the future. So among peer companies always go for the company with higher Capex per share.

Capital Expenditure per share = Capital expenditure / Number of shares outstanding

While these ratios are not the only thing one needs to do in order to select stocks, this process acts as a filter. So among 10 stocks in the same industry, an investor can narrow down the selection to 2-3 stocks using these ratios. Then other things can be looked into before making a final selection of stocks.

For a moment this process may look time consuming. But it works and to spend some time is essential before any investor puts his/her hard earned money in any business.