What comes to your mind when I say, Sachin Tendulkar? Maybe you think about 34,347 runs in International Cricket, 663 international matches, a century of centuries, or a batting average of almost 50. These numbers are good as standalone figures. But, when you compare them with the other successful batsmen, you will understand that these numbers are monumental.
Similarly, when you want to analyze a stock, comparing the numbers to other companies in the same industry gives you an idea of whether your stock is overvalued or undervalued. It also shows you the possible future performance of the company and how it will affect the stock price. This article aims to simplify the art of comparing stocks.
In the 21st century, as an investor, you have multiple options for investing. Even if you prefer to invest in equity, there are many investment options within every sector. Gone are the days of monopoly. There are many market players within the same industry. This has increased competition, which has made the management become more proactive. In such a scenario, comparing stocks within the same industry can help you make the right investment choice.
Looking at mere numbers is not enough. While analyzing a cricketer’s performance, you see his technique as well as past performance. You have to analyze all the factors like injuries, current form, age, fitness, etc.
In the same way, there are two methods to analyze a stock.
Let’s take a deeper look at these concepts.
Ratio analysis talks about calculating the major ratios that make up the fundamentals of the stock for you. These include ratios like Return on Equity (ROE), Price to Earnings Ratio (P/E), Debt to Equity Ratio (D/E), leverage, etc.
Once you calculate these ratios for the stock, you can compare them with the ratios of other stocks belonging to the same industry.
A company might look good from the surface, but there can be secrets that are hidden in the depths of management that can destroy your hard-earned money. We have seen stocks like Satyam Computers and Yes Bank crashing due to poor management.
To avoid this, you should check the following points when comparing them with other stocks:
It is tricky to understand the concepts and calculate the ratios, especially for investors from a non-commerce background. These ratios are readily available on several websites. You can find the ratios for the stocks and the industry averages. You only have to interpret them and compare them with other stocks. Here are the key ratios that you should compare, along with their interpretations:
Book value is the value of assets in a company’s balance sheet. Price is the market price of the stock. P/B ratio shows how many times the book value are the investors willing to pay for one share.
Higher than the peers: The stock is too expensive or enjoys a certain degree of monopoly.
Lower than the peers: The stock is underpriced, or investors do not trust the management’s decisions.
Net profit after tax per share is called Earnings per Share (EPS). P/E ratio shows how many times the earnings are the investors willing to pay for one share.
Higher than the peers: The stock is too expensive, or investors anticipate higher growth in future profits.
Lower than the peers: The stock is underpriced, or inventors are doubtful about future earning prospects.
Debt refers to the loans taken by a business from banks and financial institutions. Equity is the money invested by shareholders. Debt doesn’t carry any voting rights and is less costly. This makes the business achieve higher profits.
Hence, businesses prefer to take more debt. Ideally, a D/E ratio of 2:1 is acceptable, but it can vary from industry to industry.
Higher than the peers: Investing in the company is too risky because it has to pay a significant part of the income to the lenders. Paying back your loans on time is a statutory liability. If the company incurs a loss, the shareholder’s wealth is eroded to pay the loans.
Lower than the peers: Investing in the company is less risky as the probability of loan default is minimal.
Return on Equity represents the Net Income as a percentage of the book value of Equity Share Capital. Suppose your company earns a Net Profit of Rs. 1,00,000/- and the Share Capital is Rs. 10,00,000/-. Then,
ROE = 10% [(1,00,000 / 10,00,000) x 100]
Higher than the peers: It means that the company is using its capital efficiently. The company is generating higher returns with less capital.
Lower than the peers: It means that the company is not using its capital efficiently.
This ratio shows the number of times income can cover the interest cost. The formula is,
EBIT (Earnings before Interest and Tax) / Interest Expense
Higher than the peers: The company can pay the interest costs easily from its profits.
Lower than the peers: The company may face difficulty in bearing interest costs.
Where can I find details about the key ratios of all companies?
Online websites keep track of these key ratios in real-time.
Do I need to be a commerce graduate to perform ratio analysis?
No. The calculation of key ratios is the tricky part that is done by online websites. You only need to see the correct interpretation of the ratios and compare them with other stocks of the same industry.