Wednesday, December 9, 2009

4 Key Ratios for Fundamental Analysis of stocks

Hi Friends,

It has been quite a few days that I last wrote about the Fundamental Analysis (see EPS). I was pretty busy with the regular work and couldn't devote time to this blog.

Today, I have decided to give a shot at other important financial ratios that should be considered while buying/selling stocks. I have decided to put 4 of them in a single post as against my original wish to devote a separate post for each one. This is to avoid people waiting for my posts to get the basic knowledge when I'm not getting time to update the website.

The ratios that we will discuss today will be:

  1. Price-to-Earnings Ratio (PE)
  2. Projected Earnings Growth (PEG)
  3. Price-to-Sales Ratio (PS)
  4. Price-to-Book ratio (PB)

Price-to-Earnings Ratio (PE)

This is the ratio of the current stock price to the Earnings of the company. This is one of the most popular ratios discussed around the market.

P/E = Stock Price/Earnings Per Share

This value gives you an idea of how much the market ready to pay for every Rupee that the company in question earns per outstanding share in the market. A high PE thus means that the company is overpriced, but it also means that market in general is willing to take more risks on this company as it thinks that this is a good company with bright future.

A lower P/E on the other hand may mean that the company doesn't have the market's confidence and hence is trading at a relatively lower price. This may also mean that the company is being overlooked by market players right now and could be a real asset when it gets market's eye.

I myself don't have an answer of what is a right PE ratio, it generally depends on how much are you willing to pay for a company. I generally treat a PE of under 12 to be fairly valued company.

Projected Earnings Growth (PEG)

This is another ratio that you can use to check the future earnings growth of the company. PEG is used to calculate the inbuilt worth of the share. To derive the ratio, you have to associate the P/E ratio with the expected growth rate of the company. It assumes that higher the growth rate of the company, higher the P/E ratio of the company’s shares. Vice versa also holds true.

PEG = (P/E)/Expected EPS growth rate

For example, a stock with a P/E of 30 and projected earning growth next year of 15% would have a PEG of 2 (30 / 15 = 2). The lower the number the less you pay for each unit of future earnings growth. So even if a stock has a high P/E, but high projected earning growth may be a good value. In general, a PEG lesser than 0.5 is a lucrative investment opportunity. However if the PEG exceeds 1.5, it is time to sell.

Price-to-Sales Ratio (PS)

The above 2 were the ratios where the company has earnings history. What if the company you are looking at is new and has no earnings  history? You can use P/S to measure such a share. It looks at the current stock price relative to the total sales per share. You calculate the P/S by dividing the market cap of the stock by the total revenues of the company.

You can also calculate the P/S by dividing the current stock price by the sales per share.

P/S = Market Cap / Revenues
P/S = Stock Price / Sales Price Per Share

Much like P/E, the P/S number reflects the value placed on sales by the market. The lower the P/S, the better the value, at least that’s the conventional wisdom. However, this is definitely not a number you want to use in isolation. When dealing with a young company, there are many questions to answer and the P/S supplies just one answer.

Price-to-Book ratio (PB)
You calculate the P/B by taking the current price per share and dividing by the book value per share.

P/B = Share Price / Book Value Per Share

Like the P/E, the lower the P/B, the better the value. The Book Value per Share is calculated as follows:

Book Value per Share = Shareholders' funds/Total quantity of equity shares issued

Shareholders' funds = Total assets (equity capital to the company's reserves) - Total liabilities (money owed to creditors)

Value investors would use a low P/B is stock screens, for instance, to identify potential candidates.

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