In the stock market, "ratio" refers to financial parameters that help understand the financial position and performance of a company. These ratios are important for investors and analysts as they are used to evaluate a company's performance. Let's understand some of the key ratios:
What is the P/E Ratio?
Definition: The P/E Ratio, or Price-to-Earnings Ratio, is an important financial metric that shows the ratio between the market price of a company's stock and its Earnings Per Share (EPS). It is considered an indicator of how much premium investors are willing to pay for a company's stock price compared to its profits.
How is the P/E Ratio calculated?
To calculate the P/E Ratio, a company's market price per share is divided by its earnings per share.
Formula:
Importance of P/E Ratio:
P/E Ratio helps investors understand whether a company's stock is expensive or cheap.
High P/E Ratio: If a company's P/E Ratio is high, it means that investors are paying a premium for the company's stock in anticipation of its future growth. It can also mean that the company's price is being overvalued.
Low P/E Ratio: If a company's P/E Ratio is low, it means that the stock may be undervalued, or investors are sceptical about the company's future growth.
Example:
Suppose, the current share price of a company is ₹ 100 and its earnings per share (EPS) is ₹ 10.
P/E Ratio:
This means that investors are willing to pay 10 times the price for the company's earnings per share of ₹ 1.
Uses of P/E Ratio:
P/E Ratio is used to understand the valuation of a company. However, it should always be analyzed in conjunction with other financial metrics and factors, as the P/E Ratio may vary in different industries and sectors.
Types of P/E Ratio:
- Trailing P/E Ratio: It is based on the EPS of the last 12 months.
- Forward P/E Ratio: It is based on the estimated EPS of the next 12 months.
Conclusion:
P/E Ratio is an important financial metric that shows the relationship between a company's stock price and its profits. Investors need to understand that the P/E Ratio should be viewed in conjunction with other metrics and industry standards to make the right investment decisions.
What is the Price-to-Book Ratio (P/B Ratio)?
The P/B Ratio shows the ratio between the price of a company's stock and its book value. It is used to understand whether a company's stock is undervalued or overvalued. In simple terms, it tells us how much the market is pricing a company's stock compared to its net assets.
How is the Price-to-Book Ratio calculated?
To calculate the P/B Ratio, the market price of a company's per share is divided by its per-share book value.
Formula:
Importance: This ratio shows how much investors are willing to pay for a company's book value. A low P/B ratio may mean that the stock is undervalued.
What is Book Value?
Book value is the value that remains on a company's balance sheet after subtracting total liabilities from its total assets. It represents the company's shareholders' equity.
Understand with an example:
Suppose the market price of a company's stock is ₹ 100 and its book value per share is ₹ 50.
The formula to calculate the book value is as follows:
Assumption: Suppose a company has these financial details:
Total Assets: ₹ 100
Total Liabilities: ₹ 50
That is, the book value of the company is ₹ 50
Example:
The share price of ABC Ltd. is ₹ 100 and its book value per share is ₹ 50.
P/B Ratio:
This means that investors are paying 2 times more price for the stock of this company than its book value.
Importance of P/B Ratio:
- P/B Ratio < 1: If the P/B Ratio is less than 1, it shows that the company's stock may be undervalued. That is, the market is selling the stock at a lower price than its net assets.
- P/B Ratio = 1: If the P/B Ratio is 1, it means that the market price and book value of the stock are the same.
- P/B Ratio > 1: If the P/B Ratio is more than 1, it means that the stock may be overvalued. That is, investors are paying more than the company's net assets.
Where to use P/B Ratio?
The use of the P/B Ratio is more important for companies whose assets have a high value, such as banking, financial companies, and real estate companies. It is not as effective for companies like tech companies because the book value of their assets is low.
Conclusion:
The P/B Ratio is an important financial metric that helps investors understand whether the price of a stock is high or low compared to its net assets. However, the right decision should be taken only after combining it with other financial metrics like P/E Ratio and debt-to-equity Ratio.
What is the Dividend Yield Ratio?
Definition: The Dividend Yield Ratio is a financial metric that shows how much percentage the dividend on a company's stock is compared to its market price. It is considered important for investors, as it helps them understand how much return they are getting on their investment, especially in the form of dividends.
How is the Dividend Yield Ratio calculated?
To calculate Dividend Yield Ratio, a company's dividend per share is divided by its share's market price and then multiplied by 100.
Formula:
Importance of Dividend Yield Ratio:
Dividend Yield Ratio tells investors how much return they are getting on their investment in the form of dividends.
High Dividend Yield means that the company is paying more dividends to its shareholders, which can be a positive signal.
A low Dividend Yield may indicate that the company is not focusing much on dividends and is probably reinvesting its profits for growth.
Example:
ABC Ltd. pays a dividend of ₹ 5 per share every year and its share price is ₹ 100.
Dividend Yield:
This means that investors are getting a return of 5% on their investment in the form of dividends.
Use of Dividend Yield Ratio:
Dividend Yield Ratio is mainly used by investors who are interested in investing in dividend-paying companies. This ratio is especially important for investors who are looking for a stable and regular income source, such as post-retirement investors.
Conclusion:
Dividend Yield Ratio is an important financial metric that helps investors understand how much return they are getting on their investment in the form of dividends. It can be analyzed in conjunction with other metrics such as Price-to-Earnings Ratio (P/E Ratio) and Return on Equity (ROE) to get a holistic view of a company’s profitability and the value of the investment.
What is the EV/EBITDA Ratio?
Definition: EV/EBITDA Ratio is an important financial metric used to analyze a company’s valuation and its operational performance. EV stands for Enterprise Value and EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. This ratio is used by investors and analysts to understand a company’s valuation, especially when comparing companies with different capital structures.
How is the EV/EBITDA Ratio Calculated?
To calculate the EV/EBITDA ratio, a company’s Enterprise Value is divided by its EBITDA.
Formula:
What is Enterprise Value (EV)?
Enterprise Value represents the overall value of a company. It is calculated as follows:
Importance: This ratio is used to assess the valuation of a company and can be compared with other players in the industry.
What is EBITDA?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It shows the operational performance of the company and shows how much profit the company is earning without any interest, tax, depreciation, and amortization.
Importance of EV/EBITDA Ratio:
Lower EV/EBITDA Ratio: If the EV/EBITDA Ratio of a company is low, it means that the company may be undervalued, i.e. it may be a good investment option.
Higher EV/EBITDA Ratio: If the EV/EBITDA Ratio of a company is high, it means that the company may be overvalued, i.e. investors should invest in it with caution.
Understand with an example:
ABC Ltd. has a market capitalization of ₹500 crore, it has a debt of ₹100 crore, and it has a cash amount of ₹50 crore. The EBITDA of the company is ₹50 crore.
EV/EBITDA Ratio:
Meaning: It means that the valuation of the company is 11 times its EBITDA.
Use of EV/EBITDA Ratio:
The EV/EBITDA Ratio is used to analyze the valuation of a company. This ratio is particularly useful for financial analysts and investors as it helps in accurately evaluating the performance of a company irrespective of its capital structure.
Limitations of EV/EBITDA Ratio:
This ratio only measures the operational performance of a company and does not reflect the net income or overall profitability of the company.
It does not take into account other aspects of the capital structure such as the cost of debt.
Conclusion:
The EV/EBITDA Ratio is an important metric that is useful for analyzing the valuation and operational performance of a company. Investors need to combine this ratio with other financial metrics such as P/E Ratio, Debt-to-Equity Ratio, etc. to make a complete analysis and make the right investment decision.
What is Return on Equity (ROE)?
Definition: Return on Equity (ROE) is a financial metric that shows the ratio between a company's net income and investors' equity. It is used to understand how much profit a company is earning on its investors' investment. It is considered very important for investors as it is an indication of the company's profitability and efficiency.
How is Return on Equity (ROE) calculated?
To calculate ROE, a company's net income is divided by its investors' equity.
Formula:
Importance of ROE:
ROE tells investors how much return a company is earning on the money they invest. A high ROE means that the company is using its investors' money in a better way. However, a very high ROE can also mean that the company has taken on too much debt.
Example:
ABC Ltd. has a net profit of ₹50 crore and shareholders' equity of ₹200 crore.
ROE:
Meaning: This means that the company is earning a return of 25% on its investors' money.
Where to use ROE?
ROE can be used to measure the profitability of any type of company. However, one should be cautious when comparing ROE across industries, as some industries generally have higher ROE while others have lower ones.
Conclusion:
Return on Equity (ROE) is an important financial indicator that measures a company's profitability and its value to investors. Investors need to analyze ROE in conjunction with other metrics such as Debt-to-Equity Ratio and Return on Assets (ROA) to make informed investment decisions.
What is Quick Ratio?
The Quick Ratio, also known as the Acid-Test Ratio, is a financial metric that measures how quickly a company's cash and cash-equivalent assets (such as marketable securities, and accounts receivables) can cover its short-term liabilities. It is used to assess a company's short-term financial situation.
How is the Quick Ratio calculated?
To calculate the Quick Ratio, a company's quick assets are divided by its current liabilities. Quick assets include cash, marketable securities, and accounts receivables, while inventory is not included because it can take longer to convert into cash.
Formula:
Importance of Quick Ratio:
Quick Ratio indicates whether a company has enough cash or cash equivalent assets to pay all its current liabilities immediately.
A Quick Ratio greater than 1 means that the company's financial position is strong and it can easily pay its short-term liabilities. On the other hand, a Quick Ratio of less than 1 indicates that the company does not have enough cash or cash-equivalent assets.
Example:
ABC Ltd. has current assets of ₹150 crores, including an inventory of ₹50 crore, and its current liabilities are ₹100 crore.
Quick Ratio:
Meaning: It means that the company can meet its current liabilities immediately.
Use of Quick Ratio:
Quick Ratio is used to analyze the short-term financial situation of a company, especially when investors and creditors want to know how quickly the company can pay its short-term liabilities. Quick Ratio is best used when it is analyzed with other financial ratios and metrics to get an accurate idea of the company's overall financial situation.
Conclusion:
Quick Ratio is an important metric that measures the short-term financial situation of a company. It is important to analyze this ratio to ensure that the company has enough cash or cash equivalent assets to pay its short-term liabilities. By analyzing Quick Ratio in combination with other ratios and metrics, the strengths and weaknesses of the company can be fully ascertained.
What is the Current Ratio?
Current Ratio is an important financial metric used to measure a company's short-term liquidity. This metric indicates how many current assets a company has available to pay its short-term liabilities. It is also called the liquidity ratio, and it is important for investors and creditors because it shows the company's financial situation.
How is the Current Ratio calculated?
To find the current ratio, a company's current assets are divided by its current liabilities.
Formula:
Importance of Current Ratio:
High Current Ratio: If a company's Current Ratio is greater than 1, it means that the company has enough current assets to pay its short-term liabilities. It shows the company's strong financial position.
Low Current Ratio: If the Current Ratio is less than 1, it means that the company does not have enough current assets to pay its short-term liabilities. This may indicate a weak financial situation and the company may have difficulty in repaying short-term debt.
Understand with an example:
Suppose a company has current assets of ₹150 crores and its current liabilities are ₹100 crores.
Correct Ratio:
Use of Current Ratio:
The current Ratio is used to analyze the short-term financial health of a company. This metric is especially used by creditors who want to know whether the company can meet its short-term obligations on time or not.
Limitations of Current Ratio:
- The current Ratio only shows the availability of current assets to cover short-term liabilities but does not tell how fast the assets can be converted into cash.
- In some industries, the normal value of the Current Ratio may vary, so it is important to compare it with industry standards.
Conclusion:
The Current Ratio is an important liquidity metric that reflects a company's short-term financial position. Investors and creditors need to understand that the Current Ratio should be considered in conjunction with other metrics such as the Quick Ratio and Debt-to-Equity Ratio to perform a complete analysis of a company's financial stability.
With these examples, you can understand how these ratios help evaluate a company's financial health and investment capacity.
These ratios play an important role in evaluating a company's financial performance and help investors make informed decisions. By using these ratios correctly, you can make a good assessment of a company's financial position.