Personal Finance

Understanding key financial ratios4 min read

January 18, 2021 3 min read

Understanding key financial ratios4 min read

Reading Time: 3 minutes

Now that you have started researching companies and markets, it is important that you also know about financial ratios that market participants often refer to while addressing the stocks and their value.

Here is a quick crash course on understanding those ratios and making an informed decision on whether to buy the stock based on it.

P/E Ratio

As it is often referred to as the P/E ratio or a price to earnings ratio, it is the most widely used metric to determine stock valuation.

P/E ratio shows the premium that market participants are ready to pay for a stock based on their past performance or future expectations.

A high P/E ratio could mean that a stock’s price is high relative to its present earnings and that the stock is overvalued. On the contrary, a low P/E ratio might indicate that the current stock is undervalued in relation to earnings.

Calculation of P/E ratio – market value per share/earnings per share

For example:

Bajaj Auto – P/E of 16.5x = Rs. 2986.15 (24.07.2020 closing price) / Rs. 180.2 (Based on the year to June 2020)

Earnings per share are shared by companies in their quarterly results, but while calculating P/E we need to take into consideration the 12 months ended EPS (which is also disclosed by the companies in their quarterly results sheet) and not the quarterly EPS.

Here when we say that Bajaj Auto’s P/E is 16.5x it means that market players are paying 16.5 times the money they should be paying to buy the stock.

To determine whether the stock is overvalued or rightly valued you need to compare it with its peers like Maruti Suzuki India or other Automobile manufacturing companies. You can also compare it with other companies in the benchmark index since it is a part of Nifty 50 and Sensex.

D/E Ratio

D/E or debt to equity ratio of a company is a direct indicator of the company’s well being. It shows how much of its debt the company can pay off in case of liquidation of all its assets. The D/E ratio is used to assess the financial leverage and soundness of a company and is calculated using the previous financial year’s data.

A lower D/E ratio is favorable, as it indicates that the company doesn’t rely only on debt to run its operations and it is also less risky in times of increasing interest rates.

However, one must check if the company has suddenly borrowed money for expansion plans and is otherwise doing good.

Calculation of D/E ratio – Total debt / Total shareholders equity

Also, you must remember that a comfortable level of debt differs for business, for example, you cannot compare the D/E of a cement company which is very capital intensive to a D/E of an information technology company which is not as capital intensive as a cement company.

ROE Ratio

ROE or return on equity ratio will indicate the kind of potential return you may get on a particular equity investment. ROE measures the profitability of a company in relation to stockholders’ equity. It highlights the company’s profitability in relation to the investment it received from shareholders.

Calculation of ROE ratio – Net income / Average shareholder equity

The higher the ROE the more efficient a company’s management is at generating income from your investment. When you compare companies based on ROE you should select the one with higher ROE ratios.

Dividend Yield Ratio

The dividend Yield Ratio is the percentage that the company pays to its shareholders in the form of a dividend in relation to its stock price.

If you are looking to invest in the hope to fetch good returns in terms of dividends then you must take into account this ratio and compare the potential companies by their dividend yield ratio.

Calculation of Dividend Yield Ratio

A higher dividend yield ratio means that the company usually pays a high dividend to its shareholders every year.

Not all companies pay dividends, as it is an optional payout, in India typically stocks like Hindustan Petroleum Corp, Power Finance Corp, PTC India, and so on are considered high dividends paying stocks.

Conclusion

When it comes to investing in equities all kinds of research are important. These ratios are an indicator of whether a company is financially viable and worth investing in. All the above-mentioned ratios are available on the Paytm Money app.