Investment – Understanding basic Ratios (part 1)

 

Any investment that allows us to beat inflation and earn an interest or income over and above it is a good investment in the most basic sense. Of course, there are many other factors to consider. Many investors are risk averse and consider Fixed Deposit as the most appropriate avenue to park their corpus. However, investment in the equity segment, if done considering time horizon, risk and reward ratio and fundamentals, can allow us to earn a higher return without having to worry about inflation or capital erosion.

In this article, we will try to understand some basic ratios that should be considered before investing in stocks. Looking at a single ratio alone will not help us fetch any relevant information, it is important to consider various calculations together to make a rational decision.

 1.       Earnings Per Share

This is very simple to calculate. When I was preparing for my Certified Financial Planning Certification, our sir had taught us a simple way to remember the formula.

                           EPS = PAFESH ÷ WANOSH

Where,  PAFESH = Profit available  for Equity shareholders

WANOS = Weighted average number of outstanding shares

 

Outstanding shares are the issued shares, these are held by institutional investors, retail investors and the officers and insiders of the company.

Calculation of EPS is significant in understanding the profitability and performance of the company. It is calculated by diving the Net income of the company by total number of shares, thus, it helps in understanding how much the company is earning for each share of the company. Here, Preferred Dividend is not included in the net income calculation since the ratio is primarily for common share holders.

The higher the EPS, the better it is.

2.       Price – Earning Ratio

The most commonly used ratio is Price to Earning Ratio. PE ratio helps us in understanding how much the investors are ready to pay in order to earn Re. 1 in earnings of the company.

                        P-E Ratio = MPS ÷ EPS

 Where, MPS = Market Price per share

 EPS= Earnings Per Share

As the formula is given, PE ratio is calculated by taking price of the shares and dividing it with the EPS. Market price is the price at which the share is currently trading in the market. In the simplest of terms, it helps us understand what cost we have to bear in order to gain Re. 1.  Higher PE ratio indicates higher cost of investment for every Re.1 return. However, looking solely at PE ratio without context doesn’t really provide a fair picture. Information regarding the industry benchmark, PE ratio of competitor companies, market in general, the investor’s interpretation and market performance.

3.       Price to Book Ratio

                      P/B ratio = MPS ÷ BVPS

Where, MPS= Market price per share

BVPS= Book value per share

 

Price to Book Value ratio, commonly known as P/B ratio, reflects what the price of the share is as per the prevailing market price compared to the book value of the share. Book value is calculated by dividing the Net worth of the company to Total number of outstanding shares. This data is easily available and can be collected from the financial statements. P/B ratio helps us understand how the market participants value the share. Many investors also consider this ratio to understand if the shares are over-valued, under-valued, or at par.

4.       Dividend Yield

        Dividend Yield = DPS ÷ MPS

Where, MPS= Market price per share

DPS = Dividend per share

 

Many investors prefer value stocks and for them this ratio is quite significant.  This helps in understanding how much the company is paying out of its profits to its shareholders. As we know, we earn through capital appreciation as well as dividend. Here, only the dividend aspect is taken into account. This ratio gives us a percentage as to how much dividend the company is paying as compared to the prevailing market price of the share.

Many investors consider a high Dividend Yield attractive while some believe it many come at a cost of potential growth of the company.

—-End of part 1 —–

Disclaimer: Don’t act on tips!! It is your hard-earned money, always make a rational decision rather than acting on a tip or hearsay. Study the fundamentals and the financial statement, make an informed decision.