Before you buy a stock the most common ratio you look at is the P/E ratio. A thumb rule seems to be that a low P/E is good and a high P/E is not. However, that may not always be the right approach. The P/E ratio only gives you one side of the valuation story and to really take a view on the stock you need to look at multiple perspectives. You need to look at more number of ratios. So what are the ratios to look at when buying stock? What are the key types of investment ratios that you can focus on to give you a 360 degree view of the company’s health? Above all, what is the ratio analysis for investment decision that you must apply so that you capture the gist of the stock and have enough data points to take a reasonable investment decision?
P/E ratio and the PEG ratio
Of course, the price earnings ratio is one of the primary ratios to judge a stock. The price earnings ratio measures the ratio of the stock price to the EPS or the ratio of the market capitalization to the net profit of the company.
P/E ratio = Current Market Price / EPS -or- Market capitalization / Net Profit
The challenge is what EPS to use. Normally, the last full year EPS can become quite misleading and the projected EPS has an analyst bias to it. The best alternative is to use the cumulative EPS of the last four quarters which will give you the rolling EPS. This is historical as well as current when it comes to measuring the P/E. The thumb rule is that normally value stocks have low P/E ratios and growth stocks have high P/E ratios. This can be put in the form of a more refined format by considering the PEG ratio.
PEG ratio = PE Ratio / Profit Growth rate
The logic here is that a P/E ratio of 25X with annualized growth rate of 20% is acceptable, but a P/E ratio of 35X with annualized profit growth rate of 10% is not acceptable. That is the gap that the PEG fills in.
Debt / Equity ratio and Interest coverage
The debt equity ratio and the interest coverage are important measures of the solvency of the company. Normally, companies with lower levels of debt get better valuations in the market and vice versa. If you look at some of the examples of financial stress in the last few years, they have all resulted in huge value destruction. Examples like GVK, GMR, IVRCL, Videocon, and RCOM are all cases where solvency risk has destroyed shareholder value.
Debt Equity Ratio = Total Long Term Debt of the company / Net Worth of the company
A more granular measure is the cost of debt and the sustainability of the debt with reference to the operating profits generated by the company. It is called the interest coverage ratio.
Interest Coverage Ratio = Earnings before Interest & Taxes (EBIT) / Interest cost
This ratio measures whether the operating profits are sufficient to service the debt and also whether the company has exposure to high cost debt. Both create financial risk for the company.
Operating profit Margins
More than the absolute level of operating profits, what matters is the operating profit margins with reference to the sales and the trend in the operating margins. Firstly, the operating margins must be at par with or better than the industry benchmark. Normally, asset light companies have better levels of OPM compared to asset heavy companies. Secondly, the OPM must show either a steady or rising trend. That is what makes a company attractive.
Operating Profit Margin = Earnings before interest & tax (EBIT) / Net sales
Why does OPM consider depreciation costs even though it is a non-cash charge? You need to understand the purpose of depreciation. The idea is to use the tax shields to finance the cost of renewal of plant and machinery. That is why it is treated as an operating cost while calculating OPM. This is a measure of the profitability of the core operations of the company and also a measure of the sustainability of the business model.
EV / EBITDA ratio and the ROE
ROE measures the return on the total equity but what so we understand by EV / EBITDA? EV is a concept that values a company based on its acquisition price.
EV = (Market Cap of the equity + Total Debt – Cash on hand)
This is the net cost you pay to acquire a company as you need to pay for the market cap and repay the debt but you get the cash. But what is the relevance of the EV/EBITDA ratio? It is used in companies where the gestation is quite long and is quite capital intensive. In such companies, the PAT will take a long time and hence P/E ratio may not be a good indicator. In such cases, the EV/EBITDA can be a better alternative for P/E ratio. This is true for companies in the telecom, power and internet sector where upfront costs are huge and profit has a gestation. This ratio can also be used to gauge whether the company is question is a strong acquisition candidate.
Asset Turnover Ratio
Asset turnover ratio is a measure of efficiency of the asset usage. The most common formula of asset turnover is
Asset Turnover Ratio = Net Sales / Total Assets -or- Net Sales / Fixed Assets
The idea of this ratio is to see how efficiently the total assets of the company are churned and how often they are churned to generate sales each year. This ratio is more relevant to manufacturing companies where more efficient churning of the assets to generate sales results in better ROE. Higher the asset turnover, the better it is! Click here to know using ROE effectively - Breaking up the ROE components
You cannot evaluate a company or a stock purely based on a single ratio. Profitability, solvency, efficiency and valuation are some of the key parameters to be looked into. That is what these five sets of ratios capture.