Introduction:

Understanding critical financial ratios is vital for conducting thorough fundamental research on companies. These ratios provide vital insights into a company’s financial health, performance, and growth potential. You can make informed decisions about investing in a particular company by analysing them. Here are some of the key ratios used in fundamental research.

Important ratios for fundamental research

The key ratios used in fundamental research are:

• Price-to-earnings (P/E) ratio

The P/E ratio is one of fundamental research’s most widely used ratios. It compares a company’s current stock price to its earnings per share (EPS) and helps you determine whether it is overvalued or undervalued. For instance, if a company has 1000 shares trading in the market and the EPS is Rs 100, the company’s P/E ratio will be 10 (1000/100).

A high P/E ratio suggests that investors are ready to pay more for each rupee of earnings. It indicates potential growth prospects. On the other hand, a low P/E ratio may signify undervaluation or slower growth expectations.

• Debt-to-equity (D/E) ratio

The D/E ratio is another essential ratio used in fundamental research. With it, you can measure a company’s debt relative to its equity. It reflects how much debt a company uses to finance its operations compared to its shareholders’ equity.

A high D/E ratio may pose a higher financial risk, as it suggests the company relies heavily on debt financing. On the other hand, a low D/E ratio shows a healthier balance between debt and equity.

• Return on equity (RoE) ratio

RoE measures a company’s profitability relative to its shareholders’ equity. It shows how effectively a company uses its shareholders’ funds to generate profits. Its mathematical formula is net income/ total shareholder’s equity. A high RoE generally indicates efficient use of equity capital and strong financial performance and vice versa.

However, you must consider industry norms when interpreting RoE. This is because it varies across sectors. Also, a firm can have a high RoE if it has taken a lot of debt and its equity investment is low. Therefore, you should look at a company’s equity structure before arriving at any conclusion.

• Current ratio

The current ratio is another vital fundamental research ratio. It measures a company’s ability to meet its short-term obligations with its short-term assets. It is computed by dividing a firm's current assets by current liabilities.

A ratio of 1 or higher shows that the company has ample current assets to cover its current liabilities. On the other hand, a lower ratio raises concerns about liquidity and the company’s ability to pay off its short-term debts.

• Dividend yield ratio

The dividend yield ratio measures a company’s annual dividend income relative to its current stock price. Expressed as a percentage, it’s computed by dividing the annual dividend on every share by the current market price per share. For instance, if a company pays a yearly dividend of Rs 2 on each share and its stock trades at Rs 50 per share, the dividend yield ratio would be 4% [(2/100) x 100%].

This ratio indicates that the company distributes a larger portion of its profits to shareholders as dividends. This makes it an attractive investment option. However, you need to consider other factors like the company’s growth prospects, sustainability of dividends, etc., before making any decision.

• Operating margin

Operating margin indicates the remaining percentage of revenue after deducting operating expenses. It offers insights into a company’s operational efficiency and profitability.

A higher operating margin indicates that the firm manages its operating costs effectively. It also shows that it’s generating stronger profits from its core business operations.

• Free cash flow (FCF) yield

This ratio measures the amount of free cash flow a company has relative to its market capitalisation. It shows the company’s ability to generate cash after accounting for capital expenditures. A higher FCF yield suggests that the company is generating ample cash flow. The company can reinvest it in business, distribute it to shareholders as dividends, or use it to reduce debt.

Wrapping it up ​​​​​​​

A thorough analysis of these ratios helps you gain crucial insights into a company’s financial performance, strength, and growth potential. However, it’s essential to consider these metrics in the context of industry dynamics, economic conditions, and company-specific factors. Utilising fundamental analysis alongside other research methods can help you make well-informed decisions, navigate the complexities of the financial markets effectively, and create wealth in the long run.

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