How to check the stock fundamentals using key ratios?

Introduction

Are you an avid stock trader?. How are you assessing the good stocks?. Is it based on the technical chart or based on the fundamentals?. It is common for short term traders to look for the technical charts and invest based on the current trend. It is long term investor who will be keen to understand the fundamentals on the stock. Here fundamentals means understanding the complete details of the company and its business. It helps investors to park their money with confidence, the price may go down even if the company has good fundamentals. But, in the long term the stock will give the better returns.

Understanding the fundamentals of a stock is one of the tough task for the investors. It is not so easy for a novice investor. One can gain the knowledge on understanding the fundamentals by reading the basics on financial statements and through experience. One of the key factor is the ratios which shows the clear ideas to the  investors. There are number of ratios each has the different significance to reveal the facts about the company’s financial strength. This article looks into the seven key financial ratios which would be more important for an investor to choose the best stock. If you have any thoughts, please post it in the comments section. Subscribe to our future articles here.

Price to Earnings Ratio

This is one of the important ratio and mostly used by the investors to see the earnings potential of a stock. The Price/Earnings ratio can be derived using the market price of the share and the earning per share. Assume the share price of a company is Rs.250 and its Earnings Per Share (EPS) is 50, then the price/earnings ratio will be 150/50=5. How do we know that the P/E ratio is stretched or not?. Just looking into the P/E ratio will not provide any further details.

The P/E ratio indicates the growth of the company in future. If the company is growing at the rate of 50% every year for the next 5 year, the P/E ratio 5 is fine for the above example. If the rate of the growth is very slow, but the P/E is very high, then it is warning signal that the price is over valued. It is better avoid those stocks.

The following formula is used for calculating the P/E ratio:

Price to Sales Ratio

This ratio compares the share price with the revenue per share. Price to sales is calculated by dividing a stock’s current price by its revenue per share for the trailing 12 months. This ratio doesn’t have much significance to take any major decision.

The following formula is used for calculating the price to sales ratio:

Price to Book Value Ratio

This ratio can be calculated using the price of the stock and book value per share. Book value means the total assets of the company minus liabilities. This implies that the shareholders will be getting the book value when the company goes bankrupt. It is the real value of the stock in terms of assets in the company.

The good indicator is the low book value for the stock. If the value is less than one, it indicates that the stock price is lower than its real value for the business. This indicator is very useful for weighing the banking stocks. But, sectors IT or Phrama will not be much useful with this ratio.  Also keep in mind that, one can not just go with the ratio. If the ratio is less than one, it may be because of some other bad reason too.

The following formula can be used for calculating the price to book value ratio:

Debt to Equity Ratio

This ratio indicates how much money a company can borrow without any problems. This ratio can be derived using the total debts (both short term and long term debts) and total equity shares/reserves. When a company keeps borrowing, its fixed costs will be increased due to the interest payments. The good indicator is that debt equity ratio is less than 1.

It is only the indicator but it may be some other reason the ratio is high. The ratio can be high for the newly started companies because of the too much debt. If you take example, Idea cellular when its started has more debts because of the initial investments need for expanding the company. In this case, the funding would be supported from its parent company Aditya Birla Group which is strong enough to  invest in the Idea cellular. Like this you have to look for the reason why the ratio is high whether it has good reason to pay back all the outstanding dues and come back the profit path.

The above explanations are only indicative and need more research to find the root cause of the ratio movement. Don’t take any investment decision by just looking into the ratios.

The following formula is used for calculating the debt equity ratio:

Current Ratio

The simple meaning of current ratio is to find how the company can manage the short term debt obligations. The current ratio can be derived from the current assets and the current liabilities. The current assets include inventories, cash, accounts receivables (debtors), loans and advances. The current liabilities include interest payments, accounts payable (creditors), provisions for payments of taxes, dividends. In simple terms, if a company has the interest payment due of Rs.150 crore in the next month, the possibility of the company can get the money from day to day operations.

If the current ratio is 1 or less than one, it implies that the company will face the difficulty on the short term debt obligations and may dent company’s growth path. It will lead company to sell it’s assets to pay the outstanding debt. The good ratio is 1.5 and above. But, the ration would be differ from the each sector. Also, the high ratio doesn’t mean the company is in good position. It may not be using the excess cash effectively.

The following formula is used for calculating the current ratio:

Asset Turnover Ratio

Asset Turnover Ratio is much useful to check the sales generated from the each rupee spent on the business. This ratio would be very high if the company has the very low profit margins and will be less if the company has the very high profit margins. For example, the oil companies ratio would be much higher because the profit margin is very low and volume of the business if high. We can not take any firm decision on using this ratio, it will be depend on the industry. If the ratio is higher, it is more efficient.

The following formula is used for calculating the asset turnover ratio:

Return on Capital Employed Ratio

If the ratio is higher, it is better. The ratio used for finding the efficiency of company’s investments to generate the profits. The increase in the ratio must be because of the reduction in the expenses, not because of the reduction in the capital in the company. This ratio has to be used with other ratios to take any investment decision.

The following formula is used for calculating the return on capital employed ratio:

Summary

The above are the few important financial ratios used from finding the current status of the company. If you are the beginner, it is not wise to take any expensive decision only looking into the ratios. Do your home work by studying the financial statements of the company and understand why the ratios are moved and compare the different ratios. Because the same ratio can have different significance for different industry. If you have any thoughts, please post it in the comments section. Subscribe to our future articles here.