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Making Sense of Ratios March 3, 2010
In this article, we shall explain what certain financial ratios mean and how investors can use these ratios for making the right investment decisions.
Author : iFAST Research Team


Untitled Document

If one follows finance-related news, it is not uncommon to come across market ratios in the various commentaries. Some of the commonly used ratios by market experts are:

  • Earnings Per Share (EPS)
  • Price-to-Earnings (P/E)
  • Price-to-Book (P/B)
  • Return on Equity (ROE)
  • Price-to-Sales (P/S)

The table here shall give you a brief perspective how each of the ratio can signify the valuation of a stock.

Financial Ratio

Ideal value

Scenario

EPS

 

Higher the better

For 2 companies in the same industry and trading at the same price, the one with a higher EPS will be deemed more attractive to investors.

P/E

 

Lower the better

For 2 companies in the same industry and trading at the same price, the one with a lower P/E will be deemed more attractive to investors.

P/B

 

Lower the better

For 2 companies in the same industry and trading at the same price, the one with a lower P/B will be deemed more attractive to investors.

ROE

 

 

Higher the better

For 2 companies in the same industry and trading at the same price, the one with a higher ROE will be deemed more attractive to investors.

P/S

 

Lower the better

For 2 companies in the same industry and trading at the same price, the one with a lower P/B will be deemed more attractive to investors.

Read on for more!

Earnings Per Share

EPS stands for earnings per share. It is calculated by dividing a company’s net income by the outstanding number of shares. In layman’s terms, it indicates to a stockholder how much his share has earned for the year.

Intuitively, the higher the EPS, the more valuable the share becomes. However, it is precisely because this ratio is so simple to understand that it is also one of the most manipulated ratios.

To make the EPS ratio look good, companies can manipulate it in the following ways:

  • Big bath method – the company accumulates foreseeable future losses into one quarter to create a temporary depressed EPS situation. As the future losses have already been expensed off, the future quarters’ earnings improve. An investor may be tricked into believing that an average business is doing very well on looking at the EPS in those future quarters.
  • Normalizing method – this method is used by companies to create an impression of a steady increase in the EPS over the years. To create this effect, the company can normalise its earnings. Normalizing is a process where a company purposely manipulates its revenue and expense recognition in a way to show a steady rising trend in its earnings. As such, EPS will no longer then be an accurate measure of the company’s performance especially for business in cyclical industries. For cyclical industries, it is expected that earnings will vary very much with the boom and bust cycle. However, by using the normalising method, some companies can smoothen those sharp variations in the earnings.

The EPS ratio is commonly used in conjunction with the P/E ratio, which will be explored in the next section.

Price-to-Earnings

P/E stands for price-to-earning ratio. It is calculated by dividing the market price per share by the earnings per share (EPS). Simply put, the P/E ratio is the price multiple of earnings i.e., it is the price that you are paying in order to gain the said amount of earning. P/E ratio is one of the most important ratios that market participants look at to evaluate whether a stock is overvalued or undervalued.

Let’s elaborate with a simple example.

Assuming the general banking industry in India is trading at a P/E of 20 and ICICI bank is trading at a P/E of 15, it could mean that the stock is undervalued relative to its peers.

Generally, when the P/E ratio of a stock is low relative to the industry, it may mean that the stock is undervalued and that presents a buying opportunity. However, it is noted that some stocks that trade at low P/E might have fundamental problems in the business and that actually justifies its low P/E. Hence, an investor must be prudent enough to look through the stock’s financial statements to evaluate the stock’s fundamentals.

Price-to-Book

P/B stands for price-to-book ratio. The P/B ratio is an indication of how much shareholders are paying for the net assets of a company, and as with PE ratios, the lower the ratio, the better. A P/B ratio of 1X signifies that the current price of the share is exactly what the company is worth if all its assets were stripped off and sold in drastic circumstances.

Famous proponents of value investing – Benjamin Graham and Warren Buffett use P/B ratios extensively to spot undervalued stocks with respect to their intrinsic value. Graham’s famous concept of margin of safety advises investors not to buy stocks that trade at higher P/B than 1.5X.
It is actually quite rare to find stocks trading at P/B below 1 and if an investor can find such stocks, it could be an attractive investment options for investors.

The P/B ratio refers to the excess of the market price or the price paid for the share over its book value. It is calculated by dividing the market price per share by the book value per share.

Before we explain how this ratio is useful, let us understand book value better. Book value per share (also commonly known as Net Tangible Asset) is calculated in the following way:

Book value per share = (Total asset – Total liability)/Total outstanding number of shares

Return on Equity

ROE stands for Return on Equity. It is calculated by dividing the company’s net income by the total amount of shareholder’s equity. ROE literally tells an investor how much return you would have earned from the investment in the company.

As per the definition, the higher the ROE is, the more attractive the shares become. However, you need to be aware that ROE can be affected by the company’s financial leverage. A company that takes on more debts is able to boost the ROE figure. However, this very act that improves ROE also increases the business risk of the company. Hence, an investor should be comfortable with the company’s existing debt levels before making the investment decision.

Price-to-Sales

P/S stands for price-to-sales ratio. It is calculated by dividing the market price per share by the revenue generated per share. It tells the investor the price he is paying for a unit dollar of sales generated.

This ratio is commonly used when the company you are evaluating is making temporary losses. A company with negative earnings makes the P/E ratio meaningless; hence the P/S ratio provides an alternative valuation measure. This ratio is also simple to understand and not so easy to manipulate compared to the P/E ratio.

Similar to the P/E and P/B ratio, a company that is trading at a low P/S ratio may prove to be an attractive investment option.

However, the main criticism against using this ratio for evaluating companies is that P/S totally neglects the cost management aspect of the company. Most of the time when a company makes losses, it is due to overspending (labour costs, rental costs…etc). By focusing solely on the P/S ratio, it is easy to neglect the overall profitability of the company.

Conclusion

Based on what has been discussed, an investor needs to use a number of ratios and in-depth research to properly evaluate the attractiveness on a stock. By following this process of understanding and evaluating the ratios, an investor can come to an informed buy or sell decision.

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iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


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