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

or

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.

Hope you ind this information useful. If so, you can subscribe to our regular updates in you email by clicking here.
sources:

1. http://stocks.about.com/od/evaluatingstocks/a/Fundanatools1.htm
2. http://wealth.moneycontrol.com/yourstartupkit/equity-investing/8-key-ratios-while-buying-stocks-/14152/0

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Earnings Per Share (EPS)

It has been quite a few days that I posted here. I was actually not able to decide where to start.After due diligence, I decided to start with the most basic of the fundamental tools: THE EPS a.k.a. Earnings per Share.


Why is EPS so Important

While evaluating two companies, one needs to compare the companies on a common basis. We can't compare them on the basis of their market price as that changes daily and also doesn't represent the total worth of a company. Consider company A having only 100 shares of Rs 10000 each and company B with 10000 shares of Rs 1000 each. Obviously, Company B is the bigger one in size!

Similarly, comparing the earnings of one company to another really doesn’t make any sense, if you think about it. Using the raw numbers ignores the fact that the two companies undoubtedly have a different number of outstanding shares. For example, companies A and B both earn Rs 100, but company A has 10 shares outstanding, while company B has 50 shares outstanding.

EPS comes for your help here! In the above example, Company A has an EPS of 10 as compared to 2 for Company B, making Company A as more profitable for the stock holder. So, you should go buy Company A with an EPS of 10, right? Maybe, but not just on the basis of its EPS. The EPS is helpful in comparing one company to another, assuming they are in the same industry, but it doesn’t tell you whether it’s a good stock to buy or what the market thinks of it. For that information, we need to look at some ratios (My next Post). Today, we would only concentrate on EPS.

Definition

The portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability.

Calculated as:

There are 3 kinds of EPS:

• Trailing EPS – last year’s numbers and the only actual EPS
• Current EPS – this year’s numbers, which are still projections
• Forward EPS – future numbers, which are obviously projections

Diluted EPS


expands on basic EPS by including the shares of convertibles or warrants outstanding in the outstanding shares number. This is because all of these can be converted into shares at a particular date. This reduces the EPS value making the stock look more expensive.


In most cases, the diluted earnings-per-share figure is far more accurate estimation of the total earnings per share and receive special attention when valuing a company.


Hope this helps. Do let us know your feedback through comments. If you liked this post and want to receive regular updates, you can subscribe via email.

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Evaluating Shares

We will try to understand few of the key methods to find out if a company is worth investing or not. With the number of companies in the market today, it is really tough to figure out which is worth investing. This is a time consuming exercise but if followed, it can provide rich dividends.

There are mainly 2 ways of selecting stocks.

1. Fundamental Analysis - This is to know how good is a company and to invest in it for a long term. Fundamental analysis maintains that markets may misprice a security in the short run but that the "correct" price will eventually be reached. Profits can be made by trading the mispriced security and then waiting for the market to recognize its "mistake" and reprice the security.
2. Technical Analysis - This follows the price variations of a stock and lets you know if the stock has any short term gains. Technical analysis maintains that all information is reflected already in the stock price. Trends 'are your friend' and sentiment changes predate and predict trend changes. Investors' emotional responses to price movements lead to recognizable price chart patterns. Technical analysis does not care what the 'value' of a stock is. Their price predictions are only extrapolations from historical price patterns.

We will discuss about the Fundamental Analysis today.

Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When analyzing a stock, futures contract, or currency using fundamental analysis there are two basic approaches one can use; bottom up analysis and top down analysis. The term is used to distinguish such analysis from other types of investment analysis, such as quantitative analysis and technical analysis.

Fundamental analysis is performed on historical and present data, but with the goal of making financial forecasts. There are several possible objectives:

• to conduct a company stock valuation and predict its probable price evolution, 
• to make a projection on its business performance, 
• to evaluate its management and make internal business decisions, 
• to calculate its credit risk. 

Even if you don’t plan to do in-depth fundamental analysis yourself, it will help you follow stocks more closely if you understand the key ratios and terms. The main idea behind Fundamental Analysis is Earnings of a company. 

Earnings are profits. It may be complicated to calculate, but that’s what buying a company is about. Increasing earnings generally leads to a higher stock price and, in some cases, a regular dividend.

When earnings fall short, the market may hammer the stock. Every quarter, companies report earnings. Analysts follow major companies closely and if they fall short of projected earnings, sound the alarm.

But only earnings are not enough to know if the company is worth investing. There are a number of fundamental analysis tools (read financial ratios), that we would discuss in the next few posts.

Keep checking this space for updates!

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What is Face value and book value?

Past few posts we have been metioning this word (face value) a lot. So, what is face value? How is it different from the market value of the share? Why do we need this? How does it matter to me as a share holder? We will try to answer some of these in this post.

Face Value

By the definition of it, Face value is the value of a coin, stamp or paper money, as printed on the coin, stamp or bill itself by the minting authority. While the face value usually refers to the true value of the coin, stamp or bill in question (as with circulation coins) it can sometimes be largely symbolic, as is often the case with bullion coins. For example, a one troy ounce (31 g) American Gold Eagle bullion coin was worth and used to sell for about $670 USD at current market prices (as of July 17, 2006) and yet had a face value of only $50 USD.

For a share this is decided by the company issuing it, at the time of initial offering .It is mentioned on the face of share, Bond certificate or other financial instrument. Face value has nothing to do with market value of the share. Market value of shares changes depending on several conditions. Face value changes only when splitting takes place.

Let me use an example. Suppose,  you want to start a Company with the Capital of Rs. 1,00,000. Now, to arrange this money you take help from  friends and relatives. In exchange, you issue shares of your company, it can be 100 shares, each of the Face Value of Rs. 1,000; or 1,000 shares of Rs. 100 each any such value.

Now let us bring in other value, the Book Value.

Book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value is its total assets minus intangible assets and liabilities

Suppose your company grows 10 times in a given period of time, and it is worth Rs. 10,00,000. The price of the share of your Company will also grow 10 times, i.e. the book value of a share of the face value of Rs. 10 will become Rs. 100. In case of a loss on the other hand, if your company is  worth only Rs. 10,000, the book value of the share of face value Rs. 10 will become Re.1 only. The Shares are first valued on their Book Value and then by the future prospects or risks involved. If the future prospects are good, I will buy a share (issued by you for Rs. 10 FV, now at Rs. 100 BV) for Rs. 120 or Rs 280 (market value). This will depend on the Market, at what price the holder of the share in your company, is willing to sell. And, suppose, your Company is making losses, I will not buy the share of FV Rs. 10, now available at Re. 1, even if the holder agrees to sell at Re. 0.40. And that is the reason why the shares of different companies sell at different prices.

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Did your company just Split Shares?

Thought to do a separate post on share splits after getting a lot of comments/questions on this. see comments at http://taxingsalaried.blogspot.com/2009/10/what-is-bonus-share.html.So here is a humble try to explain what a share split is.




What is a share split


When a company splits its shares, it agrees to issue additional shares to the existing share holders, but it doesn't intend to issue new shares like in a Follow-on Public Offer. The shares would come from the existing shares only and hence the face-value of the existing shares would be reduced. For example, if a stock has a face value of Rs 10, a two-for-one stock split will mean that there will be twice the number of shares as before with a face value of Rs 5 each for the new share. So if an investor owns 100 shares, he will have 200 shares after the split. In case of a five-for-one split, there will be five times the number of shares and the investor will own 500 shares for every 100 shares.


Fair enough, but how is this different from a bonus share


As discussed in the other post, in case of a bonus share, the current market price of the share decreases and the face value remains constant, where as in case of share split, both change. 


These 2 are inherently different in terms of accounting. A bonus reduces a company's reserves, converts it into equity capital and then issues additional shares from it. In absolute rupee terms, the equity capital (number of share multiplied by the face value) rises after a bonus. After a 1:1 bonus, the equity capital will double.
In a split, the absolute rupee capital is maintained at the same level and the reserves remain as before.


Merits of such an action

• To make the share price affordable for more people to buy them in open market.
• Increase in liquidity. It is now more readily available in the market to be traded.

What does it change


Practically nothing! A share split or a bonus changes nothing on the fundamentals of the company. It is much like cutting a 12 inches pizza into 8 pieces instead of 4. But investors love stock splits and bonuses. Empirical studies in the US do suggest that stock splits improve prices in most cases as investor sentiment improves. Bonus issues in India have also provided returns to investors.


Analysts do feel that both bonus and stock split indicate the management's conviction to sustain a higher profit growth to service the higher number of shares.

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Dividend Explained...

To carry on what we started with "what is a bonus share?", let's discuss dividends today.

Definition of Dividend

That part of the earnings of a corporation that is distributed to its shareholders; usually paid quarterly. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be paid to the shareholders as a dividend. Many corporations retain a portion of their earnings and pay the remainder as a dividend.

What's in it for me (WIIFM)?

When a company offers a dividend to its stock holders, it is taking money that could be reinvested into the company, and distributing it to shareholders as a benefit of investing in the company. Receiving a dividend is good for investors, because they get a guaranteed return on their investment in the form of the money from the dividend. A stock that returns a dividend is good as an income investment or a long term growth investment. This is because these stocks tend to remain stable, and offer a tangible monetary benefit to investors.

Dividends are usually settled on a cash basis, as a payment from the company to the shareholder. They can take other forms, such as store credits (common among retail consumers' cooperatives) and shares in the company (either newly-created shares or existing shares bought in the market.) Further, many public companies offer dividend reinvestment plans, which automatically use the cash dividend to purchase additional shares for the shareholder.

How does it work?

Dividend generally comprise of 3 factors:

• Amount - the money that you are getting as dividend from a company. This is generally represented as a percentage of the face value of the share of the company. For example, Hawkins Cooker recently offered a dividend of 200% i.e. Rs 20 per share (face value being Rs 10).
  
• Consistency - How often does a company offer dividends. As dividends are not guaranteed. It depends on the company if it wants to declare a dividend or wants to use the profits for some other purposes. A company that offers dividends consistently along with business growth is usually better as it is able to strike a balance between growth and share holder value.
  
• Timing - This is when would the dividend come into effect. Usually termed as Record Date, this is when all the shares held by any one would be considered for dividend. The point to note is, the shares should be with you before this date. One day after this date the share is termed as ex-dividend.

The other side of the coin

High dividends is not always a sign of good management. A company that needs to reinvest should not pay out all of its accounting profits in dividends. This will cause the productive capacity of the company to diminish and the company to eventually fall into bankruptcy. This actually is a technique of "corporate vultures". They buy a large controlling position in a fine company and purposefully pay far more dividends than they should. This causes the competitive position and productive capacity of the company to falter. This all takes a long time to happen and the company can rest on its laurels for a while. It takes outside analysts a long time to figure all this out. Accounting rules offer lots of scope to obscure what's going on The company is usually able to borrow money to pay dividends for quite a while before the market refuses to offer more credit. Then the inevitable day of reckoning eventually comes, but the "vulture" has already picked the bones clean before the death throes arrive.

The moral of the story is that it "pays dividends" to analyze the dividend record and dividend policy of a company.

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What is a Bonus Share

Reliance Industries has declared a Bonus issue of 1:1. WoW!!! But what does it mean? How does it affect me? Should I purchase RIL shares now?

We will try to get answers to these questions today.

What is a Bonus?

Free shares of stock given to current shareholders, based upon the number of shares that a shareholder owns. While this stock action increases the number of shares owned, it does not increase the total value. This is due to the fact that since the total number of shares increases, the ratio of number of shares held to number of shares outstanding remains constant.

Where did this bonus come from?

Bonus shares are issued by cashing in on the free reserves of the company. 

A company builds up its cash reserve by retaining part of its profit over the years (the part that is not used over the years to expand the capacity, pay the dividend etc.). After a while, this reserve increases, and the company wanting to issue bonus shares converts part of the reserve into capital.

So, the existing investor gets some free shares and the company's profit as well remains in-tact.

Affect of Bonus issue

A bonus issue adds to the total number of shares in the market.

Taking the case of RIL, the company has about 1,642.5 million shares outstanding. Now, with a bonus issue of 1:1, there will be another 1,642.5 million shares added. So now, there will be 3285 million shares.

This is referred to as a dilution in equity.

Now the earnings of the company will have to be divided by that many more shares.

Earnings Per Share = Net Profit/ Number of Shares

Since the profits remain the same but the number of shares has increased, the EPS will decline.

Theoretically, the stock price should also decrease proportionately to the number of new shares. But, in reality, it may not happen.

That's because:

1. The stock is now more liquid. Now that there are so many more shares, it is easier to buy and sell.
2. A bonus issue is a signal that the company is in a position to service its larger equity. That means, the management would not have given these shares if it were not confident of being able to increase its profits and distribute dividends on all these shares in the future.

When does it take effect?

When a bonus issue is announced, the company also announces a record date for the issue. The record date is the date on which the bonus takes effect, and shareholders on that date are entitled to the bonus.

After the announcement of the bonus but before the record date, the shares are referred to as cum-bonus. After the record date, when the bonus has been given effect, the shares become ex-bonus.

Then how is this different from a share split?

In case of bonus shares the value of the share decreases proportionate to the number of bonus shares issued. For example, if the company issues bonus shares in ratio of 1:1 and the price of share is 900 , after bonus issue, the corresponding value of the share gets Rs. 450. Genreally company issues this in place of giving dividends. The market captalization doesn't get affected,  becuase if shares double,  the prices is halved.

In case of a split,  the face value of share decreases. Generally the face value of share is 10 Rs. but face value can be higher as well. So, if face value is Rs 10, then the  company can split the share in ratio of 10:1. Now the person holding 100 shares of rs 10 now will hold 1000 shares of Rs 1 each. now shares can be traded more frequently and this will in turn increase the liquidity of the share.

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RIL announces 1:1 bonus issue

Mukesh Ambani group firm Reliance Industries (RIL) today said it will issue one bonus share for every share held in the company.

The board of directors of the company at its meeting held today, recommended issuance of bonus shares in the ratio of one equity share of Rs 10 each for each share held, RIL said in a filing to the Bombay Stock Exchange (BSE).

The issue of bonus shares is subject to the shareholders' approval, it added.

The board has also declared a dividend of Rs 13 per fully paid-up equity share of Rs 10 of the company to the shareholders, the company said.

Shares of RIL today closed down 1.57 per cent at Rs 2,099 on the Bombay Stock Exchange.

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