What
are the important indicators to look out for in order to recognize a
profitable portfolio?
When you are
investing in stock, you should perform a careful analysis of financial data to
explore the company's true worth. You can do this by examining and evaluating
the company's financial statements. This is time-consuming and cumbersome and
you are expected to have sound knowledge of the measurement bases used in the
financial statements.
To overcome this
problem, you can use different financial ratios that depict the performance and
health of the company. Ratios are not all in all but they may give indications
about the performance and health of the company with no loss of time.
Among them some of
the most important indicators to look out for in order to recognize a
profitable portfolio are as follows:
1.
Earnings Per Share (EPS)
2.
Price to Earnings Ratio (P/E Ratio)
3.
Price to Earnings to Growth Ratio
(PE/G Ratio)
4.
Price to Book Value Ratio (P/B Ratio)
5.
Dividend Payout Ratio (DP Ratio)
6.
Dividend
Yield
7.
Debt
to Equity Ratio (DE Ratio)
8.
Return
on Equity (ROE)
9.
EV
to EBITDA
10.
Interest
Coverage Ratio
11.
Current
Ratio
12.
Asset
Turnover Ratio
1.
Earnings Per
Share (EPS)
It
refers to the amount that each share would get if all profits of the company
are distributed among every shareholder. The Earnings Available to Equity
Shareholders (EASH) when divided by the total number of outstanding shares gives
the figure of EPS.
What
indication is given by EPS?
It
indicates the performance of the company as compared to other companies.
The
companies with steady and consistent growth in EPS will outperform companies
with volatile EPS.
2. Price to Earnings Ratio (P/E Ratio)
This ratio depicts the relationship
between the earnings of the company and its market price. The market price of a
share of a company when divided by earning per share gives the figure of P/E
ratio.
What indication is
given by the PE ratio?
It indicates
-whether a
company's market price of a share is high or low as compared to EPS. Or
-High PE ratio
indicates the company is overvalued by the market and a low PE ratio indicates
the opposite.
-A company
with a low PE ratio has greater potential for rising.
3. Price to Earnings to
Growth Ratio (PE/G Ratio)
It gives you a better idea of
the PE ratio. This ratio shows the relationship between the market price of a
share, EPS, and the company's growth rate. The PE ratio divided by the company's projected
growth in earnings gives the figure of the PE/G ratio.
What
indication is given by the PE/G ratio?
-It indicates
whether or not your stock would be a good value. -The lower number indicates
that you have to pay less to get in the company's expected earnings growth
rate.
-High PEG
ratio (more than 1) indicates that the company is growing fast
-High PEG ratio
(more than 1) also indicates that the company may be overvalued.
-PEG ratio of
1 indicates the company is reasonably valued.
4. Price to Book Value
Ratio (P/B Ratio)
This compares the market value
of the company with the company's book value. The company's book value is the
value of the company as per the recent listed financial statements. The current
market price per share when divided by the book value per share gives the
figure of P/B Ratio.
It is useful in valuing the
company whose assets are mostly liquid e.g. Banks and Financial Institutions.
What
indication is given by the P/B ratio?
-The lower P/B ratio indicates
that you are paying less for more book value and in the case of higher, it
indicates that you are paying more for lower book value.
-If the P/B ratio is less than 1
the stock is undervalued and if the P/B ratio is more than 1 the stock is
overvalued.
5.
Dividend
Payout Ratio (DP Ratio)
This measures what amount is
paid to the investors in comparison to the capital appreciation of the stock.
Annual dividend per share divided by EPS gives the figure of DP ratio.
What
indication is given by the DP ratio?
It indicates how profitable the
company is. Cash dividend indicates the company is able to generate handsome
cash flows.
Mature companies pay a higher
dividend than growing companies because growing companies reinvest the cash
generated through profit. So, it also indicates the maturity of the companies
and their future growth.
6.
Dividend Yield:
This measures
the rate of earning your stock has generated on the company's stock price.
Annual dividend per share when divided by the market price per share gives the
figure of dividend yield. It is expressed in %.
What indication is given by Dividend
Yield?
It indicates how much cash your
stock is generating for your money invested at the current market price.
7.
Debt to Equity
Ratio (DE Ratio):
It measures how much debt is
used in the business in comparison to the promoter's own fund. The amount of
debt and preference share capital when divided by the equity share capital and reserve
and surplus gives the figure of DE ratio.
What
indication is given by DE Ratio?
-Low DE ratio indicates that the company has a lot of scope of expansion due to more fundraising options
-High DE ratio indicates high
leverage, a high risk of credit default. It also signals the company has invested
in high NPV projects.
-If the company's profitability
is higher than interest cost, the debt will increase shareholders' wealth if
otherwise then deplete shareholders' wealth.
8.
EV to EBITDA
It is similar to the PE ratio and
is used in takeover valuation as debt is included in the EV. EV is the market
cap plus debt minus cash. EBDTA is the earnings before interest, tax,
depreciation, and amortization.
This ratio is used to value
companies that have taken more debt. Hence, this ratio is better than the PE ratio.
What
indication is given by EV to EBITDA?
-A lower ratio indicates that the company is undervalued and a higher indicates that the company is overvalued.
-This ratio is higher when the
industry is growing at a fast pace and low when the industry is growing slowly.
9.
Return on
Equity (ROE)
It measures the return that
shareholders get from the business and overall earnings. It helps to compare
the profitability of the companies in the same industry. Net income divided by
the shareholders' equity gives the figure of return on equity. It is expressed
in %.
What
indication is given by the ROE?
-ROE of 15-20% is considered
good.
-High-growth companies have
high ROE.
-When the company is highly
levered it may high ROE. This should be carefully noted because the major part of the capital that generates returns is accounted for by debt.
10.
Interest
Coverage Ratio
It measures how well the
company can serve the interest on the debt. EBIT or EBITDA divided by the interest
gives the figure of interest coverage ratio.
What
indication is given by Interest Coverage Ratio?
-It indicates how solvent a
business is.
-It indicates the number of
interest payments the business can service solely from business operations.
11.
Current Ratio
It measures the company's liquidity
position. It shows how well the company is equipped to meet short-term
obligations from short-term assets. The current assets divided by the current
liabilities give the figure of the current ratio.
What
indication is given by the Current Ratio?
-A current ratio of greater
than one indicates that the company has sufficient cash to meet its shorter-term
obligations.
-A current ratio of less indicates
some concern over working capital issues.
12.
Asset Turnover
Ratio
It measures how efficiently the
management is using assets to generate revenue. The figure of sales divided by
total assets gives the figure of asset turnover.
What
indication is given by Asset Turnover Ratio?
-It indicates that the company
is generating more revenue per rupee spent on the asset.
Be
Aware:
Financial ratios are not all in
all. They are only indicators. They give relative values. Indicators can help
you assess the value of a stock and its growth potential. But there are many
other factors that affect stock prices that can't be easily predicted or
measured.
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