Ratio Analysis Techniques to use while picking stocks

We are sure that you hopped onto this article only because it will help you make wiser decisions while building your basket of stocks, and most definitely this article won't disappoint you.

Putting your hard earned money into the equity market is a difficult financial decision due to the risks involved in it, but as you know risk hai toh ishq hai, and on that note today you will learn various ratios and how to understand and implement it the next time you are on a stock shopping spree!

There are a plethora of methods through which stocks can be analysed and stock picking has been an art very few have mastered. Each investor will have their very own philosophy to make the best possible decision. A lot of these numbers are time-consuming and cumbersome to understand therefore the ratio analysis will make your life easier by having a quick check on any company’s financial health. This, like all methods, is not a foolproof method but is recommended by many stock market pundits.

So, let's get started…

P/E ratio (Price to Earning’s ratio)

Price to Earning’s ratio or more popularly known as “PE ratio” is mostly used to evaluate a stable company. So, basically a P/E ratio talks about the fraction of the current share price to the earnings per share. Don't worry, we will give you an example for you to understand, but for now, you can register that a higher P/E ratio is a clear indication that investors are ready to pay more for that stock.

Umm... Let's analyse Company X who has had an earning of Rs. 10,000. Also, it has 1000 outstanding shares (trading in the market).

This means that Company X’s earning per share is Rs. 10.

Let's continue and check the current market price of X, and what we find that it's trading at Rs 500. Now we can calculate the P/E ratio.

P/E Ratio = 500/10 = 50.

You might be wondering what is 50, right? In layman’s terms, it suggests that the market is willing to pay Rs. 50 for each Rs 1 of the company’s earnings.

Comparing the stock’s P/E ratio with a stock operating in another sector is a wrong practice as then you won't be comparing it with the industry averages and will end up analysing the stocks incorrectly.

The next one under our scanner is the Return On Equity of a company...

RoE ratio (Return on Equity ratio)

The RoE is a profitability ratio that measures the capability of a company to churn out money from its investor’s money. In layman’s terms, it is the ratio that indicates how much profit each rupee of common shareholders’ equity generates. This is a very crucial factor when it comes to checking how capable a company is to use its money most efficiently.

We know you understand it better with an example, so here it is…

Going by the textbook formula,

RoE = Net Income / Shareholder’s Equity

Let's make you the promoter of a company and assume that your equity contribution to the company is Rs. 500

NOW, if the company can make Rs. 300 in income then by the formula, the RoE will stand at 60 % (or 300/500). 

If you invest the same amount (Rs. 500) in another company, and if this company can earn Rs. 400 from your investment of Rs. 500 then its RoE will be at 80 %.

And of course, the company generating better RoE is considered better, but this can’t be a standalone measure, because the company whose RoE is higher might also mean that they are overly dependent on debt financing. Another point to keep in mind while looking at this ratio is the same as the one discussed in the P/E ratio, i.e. you need to understand and compare this ratio with the industry peers.

As we have spoken about debt, the ratio that comes to our mind is the Debt-to-equity ratio...

D/E ratio (Debt to Equity ratio)

Corporate finance is a poignant area of study for investors, and also an important metric when it comes to measuring the degree of financial leverage. To ease up the definition, it is a reflection of the shareholder’s equity to cover all outstanding debts if the company starts its downward slide.

But, if the company is financing their activities by debt extensively then they most often find it difficult to pay it back. You should also know that debt attracts interest and this has a straight impact on the P&L statements.

As simple as it gets, a higher D/E ratio means higher usage of debt and vice - versa.

D/E is simply a ratio of the total liabilities by the total shareholder’s equity.

All the information you would want to have about the D/E ratio can be found in the balance sheet of the company.

A company’s fundamental analysis is a perfect way to get a bird’s eye view of the company’s financials, but you should remember that these ratios are very dynamic and keep changing. Therefore, we recommend investors deploy their logic and understand the company’s multiples every quarter.

Until next time…

Happy Investing! :)

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