Managing your personal finance and taking a right investment decision is very crucial to create long term wealth. Stock investing is important in order to grow your wealth to meet your goals. You can invest in stocks directly or through mutual funds.
If you are not a risk averse investor, you may look at investing in the stock market directly. However, it requires careful analysis of financial data to find out the company’s true worth. Usually, this is done by examining the company’s profit and loss account, balance sheet and cash flow statement. You might find this process to be time-consuming and difficult.
So what’s the simple way of analysing the stocks?
Well, an easier way to shortlist the stocks is to look at its financial ratios. The good part is that most of these are freely available on the internet. Having said that, there are many other factors which can be seen to make a decision on picking up stocks. But checking financial ratios will get your work done to greater extent.
Ratio analysis is a good way to run a fast check on a company’s health. It not only helps in knowing how the company has been performing but also makes it easy for investors to compare companies in the same industry and zero down on the best investment option.
Let us now understand some of the important ratios you should look at before investing in a stock.
The price-to-earnings ratio, or P/E, is one of the most famous financial ratios to pick stocks. It’s a quickest and easiest method to find out how cheap or expensive the stock is compared to its peers.
It is a measure of a company’s current stock price relative to its earnings. It gives you a fair idea as what the market is willing to pay for a given company’s earnings. The simple formula is
P/E ratio = Market Price of the share / Earning per share
P/E represents the amount of money the market is willing to pay for every 1 rupee in earnings a company generates. You have to consider whether that amount is too high, a bargain, or somewhere in between.
Usually a high P/E ratio means that investors are bullish on the stock and expect company growth in future. On the other hand, a low P/E ratio is interpreted as bearish view of investors on company’s growth in future.
Related Article: How to pick stocks on the basis of PE ratio?
The price-to-book ratio is a simple comparison of a company’s market value to its book value. It compares the company’s stock price to its book value per share.
P/B ratio = Current Market price / Book value per share
If a company has a low P/B ratio, then it is said to be undervalued and a high P/B ratio means it is overvalued. It is a good way to identify companies whose stock prices have risen without any particular asset base.
The P/E ratio isn’t enough in itself and many investors use the price to earnings growth (PEG) ratio to shortlist stock to invest. Instead of merely looking at the price and earnings, the PEG ratio incorporates the growth rate of the company’s earnings. This ratio also tells you how your stock stands up against another stock.
PEG ratio = P/E ratio / Growth rate of Company’s earnings
The PEG ratio is calculated by taking the P/E ratio of a company and dividing it by the year-over-year growth rate of its earnings. The lower the value of your PEG ratio, the better the deal you’re getting for the stock’s future estimated earnings.
PEG ratio as an attempt to solve a shortcoming of the P/E ratio by factoring in the projected growth rate of future earnings. A result of 1 or lower says the stock’s either at par or undervalued based on its growth rate. If the ratio results in a number above 1, it says the stock is overvalued relative to its growth rate.
Debt to Equity Ratio
The debt-to-equity ratio is the key financial ratios and is used as a standard for ascertaining a company’s financial standing. It is a measure of a company’s ability to repay its obligations.
It indicates the relative proportion of company’s equity and debt used to finance company’s assets. This ratio is also known as financial leverage.
Debt-to-equity ratio = Liabilities / Equity
When examining the health of a company, it is critical to pay attention to the debt/equity ratio. If the ratio is increasing, the company is being financed by creditors rather than from its own financial sources.
Optimal debt-to-equity ratio is considered to be about 1, i.e. liabilities = equity, but the ratio is very industry specific. For most companies the maximum acceptable debt-to-equity ratio is 1.5-2 and less.
These are some basic market level ratios that can help you take a decision. The market uptrend will be broadly determined by the fundamentals of the market. All the above are just indicators and need to be treated as such. It is further suggested to consult your financial advisor before taking a decision based on these indicators.
Investing in stock market gives you an opportunity to accumulate wealth in the long run. Everyone would want to grow their wealth and equity market is the only asset class which helps you to earn high returns. Not only it gives you the opportunity to earn high returns but also tax efficient returns.
But a major problem that most of the investors face is how to pick stocks. Although you are very much interested to earn through stock market but it is equally important to be informed and gain knowledge to make best out of stock market.
Well, you can do it yourself by equipping yourself with more knowledge on stock market. Alternatively, you can seek the help of a financial advisor.
Some of you might be aware that you can check some financial ratios to understand more about a stock. This makes it easy to pick your stocks. In this article, we will focus on one of the key ratios and also one of the most popular i.e. P/E ratio.
We will start by understanding the basic meaning of P/E ratio. P/E stands for Price to Earnings ratio. It is a measure of a company’s current stock price relative to its earnings. It gives you a fair idea as what the market is willing to pay for a given company’s earnings. The simple formula is
P/E ratio = Market Price of the share / Earning per share
Let us take an example, say market price of a share is 200 and Earning per share is 20. We can thus calculate P/E ratio as 10 (200/20).
To put it in simple words, we can say P/E ratio is the price an investor is willing to pay for earnings of one rupee from that share. So, in the above example, we can say that investors are paying Rs.10 for one share and this one share has an earning of one rupee.
How it is useful?
It is useful ratio for evaluation of attractiveness of a company’s stock price compared to its current earnings. If you’re trying to figure out whether a stock is a good investment or not, the P/E ratio can assist you to understand the future direction of the stock and whether the price is high or low compared to its earnings or other companies.
Interpretation of P/E ratio
There is no standard number which we can say is an ideal ratio and compare it with that. Instead, it is more of a relative concept. This we can study in comparison of the stock with its own performance or industry performance.
Usually a high P/E ratio means that investors are bullish on the stock and expect company growth in future and that is why they are ready to pay a higher price now for that stock.
On the other hand, a low P/E ratio is interpreted as bearish view of investors on company’s growth in future. This is the reason that they are willing to pay a low price.
There is one more side to look at it. High P/E ratio can also mean that the stock is overvalued. Similarly, low P/E ratio can mean stock is undervalued. The concept of value investing is based on this. Let us see how.
What is value investing?
It is a strategy that involves picking stocks that appear to be undervalued. Value investors actively look out for stocks they think the stock market is underestimating.
How P/E ratio help in this?
Well, as discussed earlier, a high P/E ratio could mean that a stock’s price is expensive compared to earnings and is overvalued. Same way, a low PE ratio may indicate that the current stock price is cheap in comparison to earnings.
So one can invest in low P/E ratio to take advantage. But it is not that simple and there are factors that you need to be careful of.
So how to decide?
P/E ratio varies from industry to industry. Each industry have a different range of PE ratio that is considered normal. For Some sectors, P/E is a high number whereas for other sectors P/E is a low number. So a P/E of stock of X industry should not be compared with a P/E of stock of Y industry.
what should be done then?
1. It is suggested to compare a stock P/E ratio with its own past PE ratio to get an idea how it is performing.
2. Next, it is recommended that peers with same business activity and of similar size should be compared. This means compare P/E of other companies in the same sector.
3. It is important to note that you should not fall in value traps. This means investing in stocks which are underperforming and not undervalued.
4. Apart from PE ratio, you should also check other factors about the company like customer retention, management of the company, cash flows, past consistency in growth etc.
All these measure will ensure that you are making an informed decision in picking up a stock.
I hope you now have a better understanding of PE ratio.