The Stock market glitters with possibility, but it can also feel like a confusing maze for beginners. Fear not! This article equips you with the tools to navigate with confidence. We will crack open the secret language of finance by exploring essential financial ratios.

These ratios are like X-rays for stocks, revealing the company’s financial health, value, and growth potential. Whether you’re a seasoned stock enthusiast or just starting your investment journey, mastering these ratios is crucial for making investment decisions.
So grab your metaphorical magnifying glass, and let’s unlock the secrets to spotting strong companies and building a successful investment portfolio.

The ratios are as follows:

      1. EARNING PER SHARE (EPS):

• Definition: Earnings Per Share (EPS) is a fundamental financial metric that quantifies a company’s profitability on a per-share basis. It essentially measures how much net income (profit) a company generates for each outstanding share of common stock.
• Formula: EPS = NET INCOME-PREFERENCE DIVIDEND / AVERAGE OUTSTANDING SHARES OF THE COMPANY                                                      

• Importance:

1. Higher EPS indicates greater profitability and often leads to higher stock prices.
2. EPS is a critical metric for assuming a company’s profitability on a per-share basis.

• Example: Suppose Company F has a net income of Rs.15 Cr and 5 Crores of common stock outstanding. The EPS would be:

      EPS = Net income / Average outstanding shares = Rs.15 Crores / 5 Crores = Rs.3           

This means Company F has an EPS of Rs.3, indicating that each share earns Rs.3 during the specific period.

      2. PRICE TO EARNING RATIO (P/E) RATIO:

• Definition: The Price-to-Earnings Ratio (P/E Ratio) is a cornerstone metric in stock valuation, acting as a bridge between a company’s current market price and its profitability. It essentially tells you how much an investor is willing to pay for each rupee of a company’s earnings.
• Formula: P/E RATIO = MARKET VALUE PER SHARE / EARNING PER SHARE                                                          

• Importance:

1. A High P/E Ratio might indicate that a stock is overvalued or investors are expecting high growth rates in future.
2. A Low P/E ratio might suggest that the stock is undervalued or the company is facing challenges.

• Example: Coffee Cravings and P/E Ratios: A Tasty Example

       let’s take a look at two Indian coffee shop chains:

• Coffee shop A: This high-end chain offers a trendy atmosphere and boasts premium coffee blends. Their stock price sits at ₹100 per share, and their EPS (Earnings per Share) is ₹5 per share. This translates to a P/E Ratio of 20 (100 / 5).
• Coffee shop B: This popular chain focuses on value and convenience, with a grab-and-go approach. Their cafes are known for their quick service and no-frills ambience. Their stock price is ₹20 per share, and their EPS is also ₹2 per share. This results in a P/E Ratio of 10 (20 / 2).

     So, Coffee Shop A appears more highly valued by the market. Investors are willing to pay a higher premium             (₹20 per share) for each rupee of earnings compared to Coffee Shop B (₹10 per share). This could be due to factors like brand recognition, perceived higher-quality products, or the potential for future growth.

    3.  PRICE TO BOOK RATIO (P/B) RATIO:

• Definition: It compares a company’s current market value to its book value, essentially asking: “Is the market valuing the company more (or less) than the net value of its assets?”
• Formula: P/B RATIO = MARKET VALUE PER SHARE / BOOK VALUE PER SHARE                                                     

• Importance:

1.  Identifying Undervalued Companies: A low P/B Ratio (less than 1) suggests the market might be undervaluing the company. This could be an opportunity to invest in a potentially undervalued stock. For example, a company with a strong track record and solid financials but a low P/B due to temporary headwinds could be a good investment opportunity.

 2. Evaluating Growth Potential: A high P/B Ratio (greater than 1) can indicate the market believes the company’s future earnings potential justifies a higher valuation than its book value.

• Example: Suppose Company B has a market price of Rs.40 per share and a book value of Rs.50 per share. Then the P/B ratio will be:

       P/B Ratio = Market value per share / Book value per share  = Rs.40 / Rs.50= 0.8                         

     This means the stock is trading at 80% of its book value, suggesting it might be undervalued. Investors might see this as an opportunity, especially if the company’s fundamentals are strong.

4.  DEBT TO EQUITY (D/E) RATIO:

• Definition: The D/E ratio indicates the relative proportion of shareholder’s equity and debt used to finance a company’s assets.
• Formula: D/E RATIO= TOTAL LIABILITIES / SHAREHOLDERS EQUITY                                               

• Importance:

1. A High D/E Ratio may signify that a company is heavily financed by debt, which could be risky during the economic downturn.
2. A Lower D/E Ratio generally suggests a more financially stable company.

• Example: Imagine two fast-food chains: ” Perfect Burgers” and “Bun Burgers.” Both serve delicious burgers, but their financial strategies differ significantly.

    Perfect Burgers: This family-owned business prioritizes financial stability and has minimal debt. They have total equity (owner’s investment and retained earnings) of ₹100 crore and total debt of only ₹10crore.                         This translates to a Debt-to-Equity Ratio of 0.1 (10 / 100).

    Bun Burgers: This aggressive chain, fuelled by venture capital, has grown rapidly through debt financing. They have a total equity of ₹50 crore but a hefty debt burden of ₹150 crore. This results in a Debt-to-equity Ratio of        3  (150 / 50).

Perfect Burgers appears financially more stable (ratio of 0.1) compared to Bun Burgers (ratio of 3).

5.  RETURN ON EQUITY (ROE):

• Definition: The Return on Equity (ROE) is a key financial ratio that measures a company’s profitability relative to the shareholder equity it has accumulated. In simpler terms, it tells you how much net income (profit) a company generates for each rupee of shareholder investment.
• Formula: ROE = NET INCOME / SHAREHOLDERS EQUITY                      

• Importance: ROE (Return on Equity) is crucial for investors. It reveals how effectively a company uses shareholder investment to generate profit.

1. High ROE: A company is squeezing good returns from shareholder money, often indicating strong management and profitability.
2.  Low ROE: The company might be struggling to turn a profit on shareholder investment.

• Example:  Let’s analyze Company D’s financial health using the Return on Equity (ROE) ratio. ROE indicates how effectively a company utilizes shareholder investment to generate profits.

     Consider the following scenario of Company D:

    Net Income: ₹5 Crore

   Shareholder’s Equity: ₹25    Crore

    Calculation of ROE:

    ROE = (Net Income / Shareholder’s Equity) * 100

   ROE = (₹5 Crore / ₹25 Crore) * 100 = 20%

  Interpretation: Company D’s ROE of 20% signifies that it generates a return of ₹20 for every ₹100 of shareholder equity. This indicates the efficient use of shareholder capital to produce profits. In Simpler terms,        the company is effectively converting shareholder investment into earnings.

6. CURRENT RATIO:

• Definition: The current ratio is a liquidity ratio used to assess a company’s short-term ability to meet its financial obligations. It essentially compares a company’s current assets (those that can be converted into cash within one year) to its current liabilities (debts that need to be settled within one year).
• Formula: CURRENT RATIO = CURRENT ASSETS / CURRENT LIABILITIES                                                  

• Importance:

1. High Current Ratio (> 1): Signals strong short-term financial health, indicating sufficient resources to cover upcoming obligations.
2.  Low Current Ratio (< 1): Raises concerns about a company’s liquidity, potentially leading to difficulty meeting short-term debts.

• Example:

Let’s assess Company E’s short-term financial health using the current ratio.

 Consider the following scenario of Company D:

Current Assets: ₹10 Crore

Current Liabilities: ₹5 Crore

Current Ratio Calculation:

Current Ratio = Current Assets / Current Liabilities

Current Ratio = ₹10 Crore / ₹5 Crore = 2

Interpretation: Company E’s current ratio of 2 signifies that it has ₹2 of current assets for every ₹1 of current liabilities. This indicates strong liquidity. In simpler terms, the company has sufficient readily available resources to cover its upcoming financial obligations, suggesting a lower risk of default and greater financial flexibility in the short term.

•  DIVIDEND YIELD: 
• Definition: Dividend yield is a financial ratio that tells you how much a company pays out in dividends relative to its current stock price. It essentially expresses the annual dividend payment as a percentage of the share price.
• Formula: DIVIDEND YIELD = ANNUAL DIVIDEND PER SHARE / PRICE PER SHARE                                          

• Importance: A Higher Dividend Yield: Generally indicates a higher percentage of the share price being paid out as dividends. This can be attractive to income investors seeking regular cash flow from their investments.

    A Lower Dividend Yield: This may suggest the company is reinvesting a larger portion of its profits back into the business for future growth, or it might not be profitable enough to distribute substantial dividends.

   Example: Imagine you’re considering investing in Pizza Limited. (PZZA), a popular pizza chain. You’re interested in both receiving some income from your investment and potentially seeing the stock price rise over time. Here’s how dividend yield can help you:

       Current Stock Price: ₹100 per share

       Annual Dividend per Share: ₹5

       Calculating Dividend Yield: Dividend Yield = (Annual Dividend per Share / Share Price) x 100

        Dividend Yield for PZZA = (₹5 / ₹100) x 100 = 5%

 Interpreting the Result: By investing in PZZA, you would receive ₹5 for every ₹100 share you own, translating to a 5% annual return on your investment just from dividends. This might be appealing if you seek regular income.

Conclusion: Understanding financial ratios is the cornerstone of successful stock market participation. These ratios serve as a compass, guiding investors through the complexities of a company’s financial landscape. By analyzing metrics like profitability (ROE), liquidity (current ratio), valuation (P/E ratio), and debt levels (debt-to-equity ratio), investors gain invaluable insights into a company’s financial health, its potential for future growth, and its true worth relative to its market price.

As the legendary investor Benjamin Graham once said, “The intelligent investor does not aim to beat the market; his aim is to not be beaten by it.” By equipping themselves with the knowledge of financial ratios, beginners can make more informed investment decisions, navigate potential risks with greater awareness, and ultimately increase their chances of achieving long-term financial success.

To understand more on the topic as well as to start investments please feel free to contact us:

Phone: +91-9324609115

E-mail: team@richvikwealth.in

The article is authored by Mr. Kaustubh Parmar from Team RichVik.