The very essence of Fundamental Analysis is to make sense of the various numbers presented in the financial statements of a company. To a lay man, the Balance Sheet, Statement of Profit and Cash Flow would mean nothing unless a story can be presented to him about the company’s performance. That is the story which is presented to us through a research report by analysts.
To give meaning to those numbers, analysts use a simple yet very powerful tool- Financial Ratios.
For example, a company doing sales worth Rs.100 Crores sounds great on paper right.
But what if a company like Tata Motors generated that much? It would be outright terrible.
A simple calculation such as a Price to Sales (P/S) ratio can prove to you how a company is valued. In case you are wondering, Price to sales is a simple division of the Market Capitalization of a company with its annual revenue. The lower the resultant figure, the better it is valued.
To begin with Ratio Analysis, all you need is a company’s annual reports and a calculator. Most analysts use a handful of ratios during valuation, but for the sake of simplicity, here are 5 important Ratios to begin with.
1. PEG Ratio
The Price per Earnings to Growth (PEG) ratio is not a well-known ratio, but once you know how to interpret a company’s financial statements, this ratio can give you a clear picture of a stock’s value.
According to ace investor Peter Lynch, ideally the PEG ratio should be equal to 1. Anything below that means the stock is undervalued and above is overvalued.
But remember that you cannot compare apples with oranges using a PEG ratio. It is important to pick two companies from the same industry.
PEG = (Price/EPS)/EPS Growth
Where, EPS = Total Income/ Average Outstanding Shares
2. Dividend Yield
Before getting into the calculation of this ratio, let me explain what Dividend is and why I picked this ratio.
Dividends can be described as a reward companies pay to its shareholders out of its profits. If a company generates profits, then it usually utilizes a part of that for further growth and expansion. But in case of excess profits, the company can share those profits with all its shareholders. Such a payment is known as Dividends.
A major advantage of dividends is that even if the stock underperforms, you still make returns on your investment in the form of dividends.
Dividend Yield = Dividend/Share Price
This ratio helps in identifying how much dividend a company pays annually relative to its stock price.
For eg. If a stock is trading at Rs. 100 and pays a dividend of Rs.5. Then the Dividend yield becomes 5%. Remember, dividend yield is always expressed as a percentage.
Return on Capital Employed is a ratio which tells us how efficiently a company is using its capital to generate profits.
A good part about this ratio is that it not only tells us a company’s profitability in terms of its shareholder’s equity but also considers Debt. So for companies with a significant amount of debt, this ratio is a better measure as opposed to the Return on Equity ratio.
In order to calculate the ROCE, you first need to find out the company’s EBIT and Capital Employed.
EBIT is the earnings or profits before Interests and taxes.
Whereas, Capital Employed is the difference between the Total Assets and the Current Liabilities.
ROCE = EBIT/ Capital Employed
Where, EBIT = Earnings before interests and taxes.
And Capital Employed = Total Assets – Current Liabilities
4. Debt to Equity
The debt to equity ratio measures how leveraged a company is relative to its assets. Basically telling us how much debt the company is taking by leveraging its assets. A high Debt to Equity ratio means the company has been aggressive in its borrowings. It is usually riskier to invest in highly leveraged companies, especially during uncertain economic conditions.
One shouldn’t specifically rely only on the DE ratio before investing. This is because certain industries can be highly capital intensive and higher DE ratios could exist for every company operating in the sector.
Debt to Equity = Total Liabilities/ Total Shareholder’s Equity
5. Return on Assets
This ratio gives analysts an idea on how efficiently the management of a company utilizes its assets.
In simple terms, it tells us how much profit a company generated for every rupee of Assets the company owns. When used across a 10 year period, it allows us to see how well the assets are being utilized on a year on year basis.
A higher Return on Assets (ROA) means better efficiency. However, one should not compare the ROA of different companies operating in different sectors. This is a sector specific ratio and is expressed in percentage terms.
ROA = Net Income/ Total Assets
Raghav Agarwal is a graduate in Business Administration. With a keen interest in the world of financial markets, he loves to read and write about various financial instruments. Currently he is working with Elearnmarkets.com as a member of the Knowledge team.