Here we are presenting some basic simple but important financial ratios those are used in stock market both by traders and investors for stock fundamental analysis.
When analyzing any stock or to select any stock, we have the read its balance sheet, quarterly results and financial reports. But most of the time we may be confused with the huge numbers in the financial reports and balance sheets. So to make analysis simpler we can check the financial ratios, those represent the numbers in percentage basis or in average fractional basis.
Then we can easily analyze the stock fundamental and also could compare it whether it is good to buy, hold or sell. But always we should compare the ratios with the sector of the stock or with other companies in its sector (that is called the peer comparison) for a better analysis.
Table of Contents
- Earnings per Share (EPS)
- Price to Earnings ratio (PE)
- How to use PE ratio for stock selection
- PEG ratio
- Price to Book ratio (PB)
- Basic concept of Capital, Reserves, Equity & Debt
- Debt to Equity ratio
- Return on Capital Employed (ROCE)
- Return on Equity (ROE)
- Compounded Annual Growth Rate (CAGR)
- Dividend Yield
- Conclusion
Earnings per Share (EPS)
As it says, EPS is the net profit that is the earnings of the company per share. Hence more EPS means the company is generating more profit.
How to calculate EPS :
If we divide the total earnings of the company with the total number of shares issued to its shareholders or that is the total number of outstanding shares, then we will get the Earnings per share amount.
EPS = Total Earnings / Total number of outstanding shares
Example of EPS calculation :
If the net profit of a company is 10,000 and the company has issued total 1,000 numbers of shares to its shareholders, then its EPS would be –
EPS = 10,000 / 1,000 = 10
EPS is presented in quarterly results and in financial statements both in annualized and non annualized form. In annualized form it shows total earning per share of one year and in non annualized form it shows Earnings per share of that particular quarter only.
Price to Earnings ratio (PE)
PE is the comparison value of it’s per share markets price to the per share earnings of the company. So, most of the analyst considers it as the proper valuation indicator of a stock. Less PE shows the stock is undervalued and more PE means the stock is overvalued. This is not so simple but a basic concept to find valuation of a stock and the PE ratio is used by most of the analysts.
There are various other ways also to find proper valuation of a stock. We have discussed some of them in another article, you can check it.
How to calculate PE ratio :
To calculate the PE of a stock, we have to divide the stock price with the EPS, and then we will get the PE ratio.
PE = Stock price / EPS
Example of PE calculation :
If the stock price is 100 and the Earnings per Share of the stock is 10, then the PE of the stock would be –
PE = 100 / 10 = 10
How to use PE ratio for stock selection
Generally stocks having PE less than 20 are considered good. But PE depends upon the stock price and profits of the company and some companies have higher profit margins because of asset light businesses and some have lower margins depends upon the industry and sector of the stock.
Some stocks have higher price due to their good reputation and market demand and some may have good future growth prospects for which market give them more price, hence may have higher PE.
So, while considering the PE of a stock, we must compare it with the stocks of its own sector only and not with a stock of another sector.
We should not compare PE of a FMCG or IT stock with the PE of an Infrastructure or Power sector stock, because FMCG & IT are asset light businesses and Infrastructure and Power are asset heavy, low margin businesses.
And most of the time the sector leaders or the popular company stocks have more PE compared to other stocks of the sector. This is normally because of their higher share price due to higher demand, reputation and goodwill in the market.
Hence, higher PE stock is always not bad and sometimes it shows higher demand and higher growth prospects of the stock.
PEG ratio
There is a method to calculate valuation of a stock by comparing its PE to its average growth percentage. That is called the PEG Ratio.
While considering valuation of a stock, growth of the company also has an important role. Because, future of the business is totally dependent on the earnings growth of the company but we cannot predict it. Hence the past earnings growth is calculated to estimate its actual growth.
How to calculate PEG ratio :
PEG = PE / Growth Percentage
To calculate PEG ratio we have to divide the Annual Growth percentage from its PE ratio. If the Growth percentage is more than the PE then the PEG ratio would be less that 1, which is considered as a good valuation of a stock.
Example of PEG ratio calculation :
If a company has given 1000 profit last year and this year gives 1500 profit,
Then increase in profit is = 1500 – 1000 = 500
That is a 50% growth in profit.
If its PE ratio is 30, then its PEG ratio would be –
PEG = 30 / 50 = 0.6
Which is less than 1, hence would be considered as an undervalued stock. And if the PEG ratio is more than 1 then it would be considered as an overvalued stock.
Price to Book ratio (PB)
PB ratio is the per share price of the company compared to it’s per share book value. Book value of a stock is generally known as the valuation of the company as per its books of account, which is also known as the net worth of the company.
How to calculate PB ratio :
First we need the Book Value or the Book Value per share.
Book Value = Total Assets – Total Liabilities (basically debts)
Book Value per share (BVPS) = Book Value / Number of total shares outstanding
Then to find the PB ratio we have to divide the current market price with the book value of the stock.
PB Ratio = Per share market price / Book value per share
Example of PB ratio calculation :
If the Book Value per share of a stock is 500 and its Current Market Price (CMP) is 1000, then –
PB Ratio = 1000 / 500 = 2
Lower PB ratio shows the company is available at a good value. If PB ration is less than 1, then it is considered as an undervalued stock.
Basic concept of Capital, Reserves, Equity & Debt
To know about some more financial ratios like ROCE & ROE which are known as profitability ratio, first we have to know the basic concept of Capital, Reserves, Equity & Debt. There is another concept called cash flow, but that we are not going to cover in this chapter.
Capital – basically referred to the funds those are used by the company to run its business. The funds primarily divided in three parts; Shareholder’s Equity, Reserves and Debt or loans.
Equity – is referred to the funds invested by the shareholders of the company in the business.
Reserves – When the company makes any profits, it may distribute it to shareholders in shape of dividend or it may keep it to invest in the business for more growth. The portion of profit it keeps to use as capital is known as Reserves.
Debt – When a company raises money from the market in shape of loan that is called as Debt and for this the company has to pay interest periodically.
Debt to Equity ratio
Debt to Equity ratio is the ratio between total debts or liabilities of the company compared to its total shareholders’ equity. It shows how much debt or loans a company has raised to run its business.
From the figure of debt amount only we may not get a proper clarity whether it is high or low, we have to compare it with another attribute for better analysis. Hence the debt amount is compared with the shareholders equity to calculate whether the debt amount is higher than the owner’s contribution.
Formula of Debt to Equity ratio
Debt to Equity ratio is calculated by dividing the total liability or debt amount with the total shareholders’ equity.
Debt to Equity ratio = Total debt / Shareholders equity
Example of Debt to Equity ratio
If the shareholders of a company have invested in it (total equity) = 10000
And the company has raised in shape of loan or debt (total debt) = 5000
Then the debt to equity ratio would be
5000 / 10000 = 0.5
Risk involved in high debt companies
Higher Debt to Equity ratios indicates that the company is more dependent on debt rather than its own funds and for which it has to pay more interest also. Whether the business is earning profit or loss, it has to pay interest and in case the interest amount cross the net profit then the company will get in to losses.
And sometimes in adverse economic conditions which may affect the running & profitability of businesses, the debt and interest might be a burden for survival of the company. In these situation many high debt companies becomes bankrupt.
Therefore Debt free companies are considered good for investment, but in case it has some debts then it should be less than the value of shareholders equity, where the Debt to Equity ratio would be less than 1.
Ideally stocks having Debt to equity less than 0.5 is considered suitable to invest and if it is more than 2 then most of the analyst avoid such stocks.
Return on Capital Employed (ROCE)
ROCE is a profitability ratio which shows how efficiently and how much profit the company is generating compared to the capital it uses in the business. Basically the Operating profit is considered to calculate ROCE.
How to calculate ROCE :
We have to divide the operating profit or the Earnings Before Interest & Tax (EBIT) with the total Capital Employed or utilized to generate that profit.
ROCE % = (Operating Profit (EBIT) / Capital Employed ) X 100
Example of ROCE calculation :
If a company generated 1000 operating profits by using total capital of 5000, then
ROCE = (1000 / 5000) X 100 = 20%
Higher ROCE shows good profitability of the business. In case the company has debt, then analysts prefer to consider ROCE to analyze the profitability of the business. Also the ROCE gives a broad picture of the operating activities of the business, whether it is running good or not and whether there is a growth in its business.
Return on Equity (ROE)
ROE is also a profitability ratio which shows the ability of the company to generate profit compared to its total shareholders’ equity. Here the Net Profit of the company is considered for calculation and the shareholder’s equity is calculated by subtracting the debt from the capital amount that is the shareholders equity plus the reserves.
Formula of Return on Equity
ROE % = (Net Profit / Shareholders Equity) X 100
Here the formula to calculate the shareholders equity is –
Shareholders equity = Total Assets – Total liabilities
Or in simple it may be calculated as
Shareholders equity = Total Capital Employed – Total debt
Example of ROE calculation :
If a company generated Net profit of 800 by using total capital of 5000, in which the shareholders equity is 4000 then –
ROE = (800 / 4000) X 100 = 20%
Generally Net profit is derived after subtracting the Interest and Tax amount from the Operating profit, which presents the actual earnings of the business. And company pays interest in return of the debt, so they don’t relate directly with the profit or loss of the business. Hence some analyst consider comparing net profit with the shareholders equity will give a better picture of the company’s profitability, they prefer to analyze the ROE of the stock to evaluate its profitability and growth.
Compounded Annual Growth Rate (CAGR)
CAGR is the per year average growth rate of the company. Generally CAGR is calculated on the basis of return generated or given by the stock on its market price. More CAGR shows higher growth stock.
We may have heard the famous quote “Compounding is the Eighth wonder of the world.” Actually investors make wealth from the compounding return of the stocks in long term. Hence most of the investor focus on the CAGR of the stock while analyzing its fundamental.
Calculation of CAGR is slightly difficult as it has typical mathematical calculations. So we can use CAGR calculators available online. And also we don’t need to calculate any of the above ratios, because we can find them on any of the finance apps and websites online. Just for a basic knowledge we have given the formulas of different ratios.
Formula of CAGR
To calculate CAGR we need the price (starting price) on date from where we will start counting and price (final price) on the last date up to which we will calculate the CAGR return. The difference between the first date and last date is the period of return and it must be in shape of Years because CAGR is calculated on annual basis.
If Final Price = FP, Starting Price = SP, Number of Years = n, then
CAGR Calculation Example :
If the initial Starting Price of the stock = 1000
After 5 year the stock price is Final Price = 5000
Number of Years = 5 Then the CAGR would be –
Dividend Yield
Dividend Yield is the ratio percentage of the total dividend paid in a year per share compared to it’s per share market price. Generally it is considered to analyze how much dividend the company is paying to its shareholders.
Formula of Dividend Yield
Dividend Yield = (Dividends paid annually per share / Stock Current market price) X 100
Dividend Yield Example
Suppose the Current market price of a stock is = 500.
Total dividend paid in a year per share is = 10, then
Dividend Yield = (10 / 500) X 100 = 2%
When company earns profits from its business it may distribute some part of its profit among its partners or shareholder that is called dividend. And the rest amount which the company retains with it to utilize in business is added to its reserves.
Dividend is the only actual amount a shareholder gets in return of its investment, the gain of the stock price is notional and it will be materialized only after selling the stock. There are some companies who does not pay dividend, rather invest back it in the business for more growth. In that case investors would not get any regular return from their investment.
So, regularly paying dividend is also considered as a positive factor in fundamental analysis. But paying higher dividend could not be considered as a good metrics if the business doesn’t have proper growth.
Hence stocks having proper growth and also paying decent amount of dividend are considered preferable for long term investment. In this case analyzing the dividend yield will give a broad view about how much the company is paying dividend to its shareholders.
Conclusion
These are some of the financial ratios, which are mostly used in fundamental analysis while selecting stocks to invest. Although there are a lot of financial ratios and metrics to analyze the fundamentals and financial performance of a business but we need in depth knowledge about accounting and commerce to properly study all of them.
So we have presented here those ones which are mostly used, easily understandable and also gives a broad overview about the stock fundamentals. And a small beginner investor also can understand these with minimum efforts and use it for stock fundamental analysis.
That’s all in this chapter. You can check our other articles for basic knowledge about stock market, fundamental analysis, technical analysis, trading, investing, news and quarterly results of different stocks. If you like our content please give you opinion, suggestions and feedback in comment section below, that will encourage us to make better content in future. Thank you.
