Is Ratio Analysis Important for Stock Investment?

Is Ratio Analysis Important for Stock Investment?
by Nikita Bhoota 04/02/2021

Stock investing requires careful study of financial data to find out the company's true value. This is generally done by studying the company's profit and loss account, balance sheet and cash flow statement. However, this can be time-consuming. An easier way to check a company's performance is to do ratio analysis. Ratio analysis is a good way to run a fast check on a company's health.

"Ratio analysis not only helps in knowing how the company has been performing but also makes it easy to compare companies in the same industry and make a wise investment decision. 

Let’s discuss some of the ratios in detail that one should look at before investing in a stock.

P/E Ratio
The price-to-earnings, or P/E, the ratio shows how much equity investors are paying for each rupee of earnings. It shows if the stock is overvalued or undervalued. 
One can know the ideal P/E ratio by comparing the current P/E with the company's historical P/E, the average industry P/E and the market P/E. For example, a company with a P/E of 10 may look expensive when compared to its historical P/E, but may be a good buy if the industry P/E is 15 and the market average is 18.

Price-to-Book Value
The price-to-book value (P/BV) ratio is used to compare a company's market price to its book value. A P/BV ratio of less than one shows the stock is undervalued (value of assets on the company's books is higher than the value the market is assigning to the company). It indicates a company's inherent value and is useful in valuing companies whose assets are mostly liquid, for example, banks and financial institutions.

Debt-to-Equity Ratio
It shows how much debt is involved in the business vis-a-vis promoters' capital (equity). A low figure is usually considered better. However, it is industry-specific, with capital intensive industries such as automobiles and manufacturing the ratio can be higher than others.

Operating Profit Margin (OPM)
It measures the proportion of revenue that is left after meeting variable costs such as raw materials and wages. It is calculated by dividing operating profit by net sales. The higher the margin, the better it is for investors. While analysing a company, one must see whether its OPM has been rising over a period. Investors should also compare OPMs of other companies in the same industry.

Enterprise value (EV) by EBITDA is often used to value a company. EV is market capitalisation plus debt minus cash. It gives a much more accurate takeover valuation because it includes debt. EBITDA is earnings before interest, tax, depreciation and amortisation.

This ratio is used to value companies that have taken a lot of debt. A lower ratio indicates that a company is undervalued. However, it is important to note that the ratio is high for fast-growing industries and low for industries that are growing slowly.

Price/Earnings Growth Ratio
The PEG ratio is used to know the relationship between the price of a stock, earnings per share (EPS) and the company's growth. Generally, a company that is growing fast has a higher P/E ratio. This may give an impression that the company is overvalued. Thus, P/E ratio divided by the estimated growth rate shows if the high P/E ratio is justified by the expected future growth rate. The result can be compared with that of peers with different growth rates.

A PEG ratio of one indicates that the stock is valued reasonably. A figure of less than one indicates that the stock may be undervalued.

Return On Equity
Return on equity (ROE) measures the return that shareholders get from the business and overall earnings. It helps investors compare profitability of companies in the same industry. ROE is net income divided by shareholder equity.

"ROE of 15-20% is generally considered good, though high-growth companies should have a higher ROE. The main benefit comes when earnings are reinvested to generate a still higher ROE, which in turn produces a higher growth rate. 

Interest Coverage Ratio
It is earnings before interest and tax, or EBIT, divided by interest expense. It indicates how solvent a business is and gives an idea about the number of interest payments the business can service solely from operations.

Current Ratio
This shows the liquidity position, that is, how equipped is the company in meeting its short-term obligations with short-term assets. A higher figure signals that the company's day-to-day operations will not get affected by working capital issues. A current ratio of less than one is a matter of concern. The ratio can be calculated by dividing current assets with current liabilities. 

Asset Turnover Ratio
It shows how efficiently the management is using assets to generate revenue. The higher the ratio, the better it is, as it indicates that the company is generating more revenue per rupee spent on the asset. However, the comparison should be made between companies in the same industry. This is because the ratio may vary from industry to industry. 

Dividend Yield
It is the dividend per share divided by the share price. A higher figure signals that the company is doing well. But one must be cautious of penny stocks (that lack quality but have high dividend yields) and companies benefiting from one-time gains or excess unused cash which they may use to declare special dividends. Similarly, a low dividend yield may not always mean that it is a bad investment as companies (particularly at nascent or growth stages) may choose to reinvest all their earnings so that shareholders earn good returns in the long term.

While ratio analysis helps in assessing factors such as profitability, efficiency and risk, added factors such as macro-economic situation, management quality and industry outlook should also be studied in detail while selecting a stock for investment.