Five Important Financial Ratios to Look Before Investing in Stocks

Are you a newbie in equity market investing? Are you struggling on picking the stocks to buy? The financial ratios are a great savior for you. The financial statements such as balance sheet and profit & loss statements are sometimes too difficult to understand for a common investor. You can screen some of the good fundamental quality stocks with the help of these five important financial ratios. Those who don’t want to go into so many details of stocks can invest in mutual funds where professional fund managers are investing in the stocks on behalf of investors.

In this regard, I would like to suggest you to use a discount broker instead of a full brokerage service.

Though there are numbers of ratios for evaluating a company’s financials, these five important financial ratios are considered very crucial for a company. Strategy depends on individual and varies for the person to person. However, picking a stock by analysing these financial ratios holds good for many of the investors for making money in a long term.

Return on Equity (ROE):

Return on equity is the most important of all ratios to measure a company’s profitability as it measures how efficiently it has used the shareholder’s equity for its earnings.

ROE = Earnings/ Shareholder’s equity

As a shareholder of the company, you will surely want to have a return of more than the debt instruments. A continuous ROE of 15% – 20% is taken as a good indicator for a company. ROE can be higher with higher debt also. But that should be taken care while choosing a stock.

When I have searched for companies with ROE of more than 15% for last five years, Hindustan Unilever is the top in the list with whooping 106.5. Other than HUL, there are Colgate, Castrol, Hawkins etc. which have very high ROEs.

Return on Capital Employed (ROCE):

Return on capital employed (ROCE) is the measure of a company’s profitability by indicating the efficiency at which company uses the capital. The source of capital can be equity and debt both. It is the addition of equity and short-term borrowings. ROCE means the percentage return on the capital investment.

ROCE = Earnings before interests and Taxes (EBIT)/ Capital Employed

But ROCE has disadvantage also. For a long tenure, the assets are depreciated and the depreciated value is taken for calculating the ROCE.  A company has higher profit margin even if its ROCE is low because its ability to use the capital for revenue generation is low. ROCE should be higher than the cost of capital. Hence, a continuous ROCE of more than 15% is considered as good for the company.

Hindustan Unilever is the top in terms of ROCE also. It has very good ROCE of 145.7. Other than HUL, There are Colgate, Castrol, Hawkins, Page Industries are the front runners.

Debt to Equity Ratio:

Debt to Equity Ratio is the financial ratio of debt the company has taken to the shareholders’ equity. Generally, all liabilities are considered as the debt of the company. Total asset comprises of debt and equity. Hence, if the debt is 40% of total asset, then equity is 100-40=50%.

Debt-Equity Ratio =Total liabilities / Equity

In this case, Debt to Equity Ratio is 0.8. The stock is good if its debt to equity ratio is low. Experts say not to pick a stock for which debt to equity ratio is more than 0.5 because of high risk. Also, the company with low debt-equity ratio can borrow more capital to grow in the market.

Price to Earnings Ratio:

Price to earnings (P/E) ratio is the ratio of stock price to its earnings per share. It is a measurement of a stock’s price in the stock market. A stock with a low PE is considered a good buy as its price is less.

PE Ratio = Price of stock/ Earnings per Share

Low PE means it has more room to grow in the market. In the other case, a higher PE means the stock is overpriced and it has very little chance to grow in the market. But PE should be compared to the peers or industry. The companies which belong to the different industry have the different range of PE ratios.

 

 Price to Book Value Ratio:

Price to book value (P/BV) ratio is the ratio between the stock prices to its book value. Bok value means the amount which will remain with the company if it sells all its assets after repaying all the liabilities.

P/BV = Stock Price / (Assets – Liabilities)

A lower P/BV ratio means it is undervalued and higher probability of growing. It may also happen that something is wrong with the company.

A P/BV ratio of less than 1 show that the stock is undervalued with respect to its actual price. The actual value in the books of accounts is more than it value of stock. Hence, you can invest in the stock as it has the probability to grow to a better price.

Promoters’ Holding:

Promoters; holding is the percentage of ownership in the company by promoters or promoter group. Even if the article is on some of the financial ratios, I have not restrict myself to put this parameter into this list because of its importance in the Indian equity market.  A promoter’s share of more than 50% is considered as good for the investment on the company.  It means promoter has the belief in the company potential and he or she better control on the company due to single large ownership.

Through some of the companies in India are professionally managed companies, a large number of companies are controlled by their promoters. In the Indian market, when promoters are increasing their stake in the company, it is observed that company is doing well.

Moreover, it is also to be observed that how many shares are pledged by promoters. Some promoters have pledged their almost entire amount of shares to finance the capital for the company’s growth. It is a bad sign for a company as the management is struggling to arrange the capital.

Also ReadHow to Calculate Capital Gain Tax on Stock, Mutual Fund and Property

There are many other factors in the stock market for valuation of a company. But I have figured out five simple ratios which can help common investors to figure out a fair idea about the company. The investors are also requested to use their own wisdom while selecting a stock for the investment.

If you like the article, share with the world. Also request, if you use some other parameters while selecting a stock, do share in the comment box below. I am loving to hear from you.