In this blog, we aim to discuss the key parameters and figures you should look for while scouting for a stock for investment purposes.
I believe developing a simple and easy-to-use set of criteria for evaluating stocks can make the stock selection task less stressful.
A decade ago, investors used to face problems such as low information availability. However, in the current day with rising transparency and the requirement to comply with governance laws, the company has started to share incremental information with investors.
This has empowered investors to make an informed decision about stock selection. Additionally, many organizations offer database services that can be put to use while evaluating a company.
While we have the information available, the primary challenge lies in selecting the right set of data and inferring meaningful output from the information.
The following steps can be used by an investor that can make the selection process simplified. Subsequently, we shall also cover the key numbers that an investor should consider before zeroing down on stocks.
While picking stocks, it is important you look at the fundamental value of shares. The fundamental value is generally assessed by earnings, operating margins, and cash flow. These factors collectively provide a complete picture of a company’s current and expected financial health.
It is essential that you evaluate every business segment of a company. You should look out for the usage of the physical asset for generating revenue for each of the products. The ratio between income and asset base indicates efficiency.
The capital structure refers to the availability of capital. The company avails money either in the form of equity or in the form of debt. A conservative company tends to use debt at a controlled level. This ensures that the maximum returns are generated for equity holders. Also, the risk appetite for such companies remains within a controllable limit.
An investor is interested in understanding the earnings potential of a company. Before investing, it is essential that you know where the company is headed. Thus, you should look out for earnings growth and sustainability.
Let us now talk about the ratios that you should evaluate before investing.
Ratio analysis is crucial while making an investment decision. It helps in knowing about the operations of a company and also helps to compare companies in the same industry to zero in on the best investment option.
Following are the key ratios that you should look at before investing in stock –
The P/E ratio also known as the Price-to-Earnings ratio shows how much an investor is willing to pay for every rupee of earnings. The ratio indicates how the market is valuing the company – overvalued or undervalued.
You should compare a company’s current P/E ratio with historical P/E, industry P/E, and market P/E to understand the valuation of the stock. For example –
A stock trading at 5x P/E currently may be considered undervalued if the industry P/E is 8x and the market P/E is 10x.
Generally, a stock with a low P/E may have a greater potential for rising. However, please note that you should use the P/E ratio in combination with other financial ratios for informed decision-making.
The P/B ratio or the Price-to-Book Value ratio is used to compare a company’s book value with its current market price.
For our novice readers – book value is the value that remains when a company liquidates its assets and repays all its liabilities.
Generally, a P/BV ratio of less than one shows the stock is undervalued (the value of assets on the company’s books is more 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 instance, banks and financial institutions.
The ratio shows the leverage level in a company. It indicates how much debt is involved in every unit of equity. A Low D/E ratio is considered good as it depicts sizeable scope for growth. But the ratio should not be used in isolation. The ratio is industry-specific.
For example, some of the sectors such as oil and gas, automobile, etc. are capital intensive and thus may possess comparatively higher D/E than other sectors. Thus, a company should be compared with the industry average to understand its risk-taking ability.
The operating profit margin indicates operational efficiency and pricing power. The ratio is computed by –
Operating profit / Net sales
A higher operating profit margin is considered good as it suggests a company’s efficiency in procuring raw materials at a lower price.
It also indicates a company’s pricing power and its ability to command a premium in the market. An investor should use the operating profit margin with the industry average to understand a company’s position regarding operational efficiency in the industry.
Enterprise value (EV) by EBITDA is generally used with a P/E ratio.
It is used to value a company. EV here is the market capitalization of the company plus any debt the company may have minus the cash balance. This gives a complete picture of a company’s valuation as it includes debt also.
The primary benefit of using the metric is that if any company is significantly leveraged, the parameter provides a clear picture. EBITDA in the formula is Earnings before interest, tax, depreciation, and amortization which is nothing but the operating profit margin. A lower ratio indicates that the company is undervalued.
The PEG ratio depicts the relationship between the price of a stock, earnings per share (EPS), and the company’s growth.
A fast-growing company has a higher P/E ratio which may give the impression that the company is overvalued. But when divided by the future growth rate, it shows if the P/E is justified or not. Generally, a figure less than one indicates that the stock may be undervalued.
Return on equity (ROE) measures the return that shareholders get from a business. ROE highlights the capability of the management of a company. It is arrived at by dividing the net income by the shareholder’s equity.
Typically, ROE of 15-20% is considered good.
Interest coverage is the earnings before interest and tax (EBIT) divided by interest expense. This ratio indicates how solvent a company is and provides a fair picture of the number of interest payments the business can service from business operations. This ratio is primarily used to understand the risk involved in a company.
The current ratio is current assets divided by current liabilities.
The ratio shows the liquidity position of a company. It indicates how many short-term assets a company has to meet its short-term obligations. A higher ratio means that the company’s day-to-day operations are not likely to get impacted by working capital issues. A ratio of less than one is a matter of concern.
Current assets include inventories, receivables, cash, and cash equivalents. Current liabilities include payables and the current maturities of any long-term loan. This ratio is primarily used to understand the risk involved in a company and also indicates the efficiency of operations.
The asset turnover ratio shows how efficiently the management of a company is using its assets (fixed and current) to generate revenue. For example, assume a machine can produce products worth Rs 100 when operated at full capacity. If the management can use the tool multiple times in a year in a cost-effective manner and generate Rs 150, it indicates that the machine is used efficiently.
Thus, the higher the ratio, the better it is. This indicates that the company is generating more revenue per rupee spent on the asset. While using the ratio, you should compare the company’s ratio with the industry average as in some capital-intensive sectors such as power and telecommunication; the ratio is generally low. So having the right benchmark is essential.
Dividend Yield is the dividend per share divided by the market price of the share. A higher figure indicates that the company is doing well. But remember to have a holistic view while using this ratio. In penny stocks, the company may declare special dividends due to any one-off gain. This pushes the dividend yield. But the sustainability of dividends is also essential.
Moving on, we saw that financial ratios help in assessing factors such as profitability, efficiency, and risk. But before investing, an investor should also marry the macro-economic situation, management quality, and industry outlook with the micro factors before arriving at any decision.
For an investor, the bible is the annual report. Also, conference calls, investors’ presentations, and quarterly reports are also critical to assessing a company from the investment angle.
While the above points are helpful in selecting a stock but these parameters won’t tell you if the stock is right for your portfolio. Thus, you should try answering the following questions –
Is the company’s sector consistent with your asset allocation? If yes you may consider adding the stock to your portfolio even if the stock has a high-risk, high-return combination. However, it should be done only if you have a long-term investment horizon.
To conclude, picking winning stocks with consistency is difficult if not impossible. That is why you have portfolios, asset allocation, diversification, etc. as an integral part of portfolio management. And at the heart of the overall scheme is prudent selection and review of data when selecting stocks.