What are the Important Ratios you must know before Investing?
What are the Important Ratios you must know before Investing?
What makes it hard for people like us to invest in the stock market is our upbringing. Let us tell you why! We have always been taught that the stock market is speculation. Investing in a speculative space like the stock market is nothing short of gambling. You must be looking for a line where we denounce their theory! For a change, they are right - but partially. If you are investing your hard-earned money into some company whose fundamentals do not show much promise is kind of proving our predecessors right.
But, what if we tell a few important pointers that will help you finalize a handful of stocks that would secure your financial future? Well then! Without any further ado, let us dive into those pointers that will help us make the right decision regarding investing in the stock market.
1). Price to Earnings Ratio (P/E Ratio)
The Price to Earnings ratio or P/E Ratio roughly translates to “a share price of a company to its earnings per share”. In mathematical terms, the P/E ratio is the outcome of the market value of each share of a company divided by its per share earnings. The P/E ratio is a very useful indicator to assess the relative value of a company’s shares. Given below are some important pointers regarding the P/E ratio that must be considered while selecting this indicator to assess an investment opportunity:
- A high P/E ratio denotes the stock of a company is overpriced and vice-versa.
- P/E ratio should not be the only indicator to evaluate the performance of a company’s stocks.
- A high P/E ratio also indicates that the company’s earnings are expected to grow rapidly.
- It is sensitive to calculate the past P/E ratio of a company before investing.
- P/E ratio can be manipulated by the companies through debt.
2). EBITDA Margin
EBITDA stands for “Earnings Before Interest, Taxes, Depreciation and Amortization”. The EBITDA margin is used to calculate the profitability of a company from its operations. An increasing EBITDA margin is a positive indicator that reflects the ability of a company to control its operating cost effectively. If a company has a high EBITDA margin that means the operating expenses of the company are not eating too much into its revenue.
Formula to calculate EBITDA margin:
EBITDA Margin = (Earnings before tax and interest + Amortization + Depreciation) ➗ (the total revenue of the company) X 100
Eg: The total revenue of company “A” is INR 1000. The total EBITDA of the company is INR 500. Putting the given values in the aforementioned formula, we find out the EBITDA margin is 50%.
Given below are some important points regarding the EBITDA margin that must be taken into consideration before using this indicator to help invest in a company:
- Smaller companies have better EBITDA margins compared to the larger entities
- EBITDA margin does not take into account the debt of companies which can be misused by the companies to create a false perception about their financial performances
- EBITDA margin should not be used to assess the financial performance of high-debt companies
3). Debt to Equity Ratio (D/E Ratio)
The Debt-to-equity ratio is again an important parameter that investors must use to assess how much the company depends on the money borrowed from its lenders? A low D/E ratio is indicative of the fact that the company will not face issues while raising funds in the future. A high debt-to-equity ratio means the company might suffer greatly during the hard times.
Even though a low D/E ratio is considered better for a business, experts suggest that this parameter, if seen in isolation, can give a false image to investors. Ideally, one must not invest in those companies that have a debt-to-equity ratio of not more than 2:1.
4). Return on Capital Employed (ROCE)
Return on Capital Employed or ROCE is one of the important parameters or ratios of companies that investors should look at before investing. In layman's terms, ROCE is defined as “the profit percentage earned by a company with respect to the capital invested”. So, ROCE is the profit amount earned by a company from the capital invested. Both the equity and debt components are considered in this parameter.
The formula to calculate the “Return on Capital Employed” has been given below:
ROCE = Earnings before Interest and Tax ➗ (Total assets - Current liabilities)
Over the years, ROCE has been an important performance indicator for investors. This indicator is used to assess the financial performance of a company before making an investment decision.
5). Return on Equity (RoE)
The reason we are fretting so much over important ratios is that we want to find out those parameters that will help us get a “Return on our Investments”. In this context, “return on equity” or RoE is a major ratio that helps investors calculate how much return on their investment they would get.
This parameter is also an important factor in gauging the profitability of a company and how efficient is the company in generating this profit. RoE can be calculated by dividing the net income of a company by the equity being currently held by the shareholders.
A high RoE suggests that the company is making consistent profits efficiently. However, many experts have also pointed out that companies with higher debts can also exhibit a good RoE. So, this indicator must not be looked at in isolation as a high D/E ratio can artificially pump the return on equity.
6). Current Ratio
Is a company capable of paying off its short-term debts? Does the company have enough cash assets or assets that can be easily converted into cash within a year to pay off its liabilities within a year? Questions like these are very important while looking for a good company to be invested in for a longer period of time. Questions like these can be answered with the help of an important indicator called “Current Ratio”.
It is defined as the “ability of a company to liquidate its current assets to pay off its short-term debts (ones that have to be paid off within a year or less). Companies with a good current ratio enjoy the confidence of investors as it reflects their ability to hold on to their revenue-generating assets. Again, the current ratio in isolation does not provide a complete picture of long-term solvency and short-term liquidity.
The formula to calculate the current ratio of a company is given below
Current Ratio = Current Assets ➗ Current Liabilities
7). Asset Turnover Ratio (ATR)
Asset Turnover Ration (ATR) or Total Asset Turnover Ratio is a measure of a company’s efficiency to produce revenue using its assets. It is a very important metric for investors who want to understand the effectiveness of companies to generate sales with the help of their assets.
A high ATR signifies the efficiency of a company in producing revenue from its current assets and vice-versa. While assessing this key ratio to select good stocks for long-term investment, the investors must also consider the sector in which the company is functioning.
For example, the ATR of real estate companies is usually low due to low sales volume even though their asset bases are huge. The exact opposite is visible in the ATR of companies that are into retail.
While a complete fundamental Analysis study of a firm is required, these ratios can assist you to analyse the financial position of companies. It's also vital to keep in mind that these ratios inherently are dynamic. Therefore, it is very significant to calculate them again after every 6 months or after the announcement of quarterly financial results. It is always advisable to learn the skills first and then implement them to avoid any major loss.
And, if you want to understand these ratios in detail then, StockDaddy is one of the prestigious platforms where you can learn everything about the stock market.
1). Which is the most important ratio to look at while investing in a stock?
Ans: Although the ratios mentioned above are all important metrics to be considered before investing in a stock, one of the most important ratios is Return on Equity (RoE) as it helps investors to calculate the approximate return their investment would generate.
2). Why is it important to analyze the financial ratio of a company before investing?
Ans: The financial ratio analysis of a company is very important before making investment decisions because this key parameter reflects the performance of the organization or company.
3). Which is the best financial ratio to track small businesses?
Ans: Return on equity, operating profit margin, net profit margin, gross profit margin, cash ratio etc are the best financial ratios to track small businesses.
4). Which is the best ratio to value a stock?
Ans: The best ratio that can be used to value a good stock is the Price-to-Earnings ratio or P/E ratio. There can be, however, different ways of looking at the P/E ratio to assess the value of a stock. Value investors usually prefer stocks with lower P/E ratios and it is the exact opposite for growth investors - who choose stocks with higher P/E ratios.