Financial statements such as the Balance Sheet, Profit & Loss A/c and the Cash Flow Statement tell you about the health of the company. However on their own one can’t make an informed decision of investment. For example if a Balance Sheet shows 1000 crore as debt of the company, is it too high? Similarly if the shares of a company are selling at Rs 20 is it very cheap? To answer the questions above one has to look at the numbers in relation to another number. This relation is called as Ratio.
All the data will still come from financial statements but the ratios present the data in such a way that investors get a better picture which helps them plan their investment. The number of ratios can be many but not all are equally important. We will look at some of the important ratios which will help us understand a company’s finances better and make right decision.
Earnings per Share
Earnings means profits after taxes. Before you buy a share, this is the first figure that you need to check. An increase in earnings every year is a sign that the company in question is prima facie a good candidate for further analysis. Increasing earnings generally leads to a higher stock price. Most of the high earning companies also pay regular dividend to its shareholders. Analysing earnings is the first most important step for investors because they give an indication of the company’s expected future dividends and its potential for growth and capital appreciation.
The basic measurement of earnings is “earnings per share” or EPS. This measurement divides the earnings by the number of outstanding shares. For example, if a company earned Rs 150 crore in the year and had 75 crore shares outstanding, the EPS would be Rs 2 (150 / 75).
Why is EPS Important??
The reason you reduce earnings to a per share basis is to compare it with another company. For example – Two companies A and B has earned a profit of 150 crore each. Which one would you prefer? Both seem to be ok with you, right? However, if I say that company A has 75 crore shares outstanding and company B has 100 crore shares outstanding, which one would you prefer? Your answer lies in the EPS figure.
Company A has an EPS of 2 (150/75) whereas company B has an EPS of just 1.5 (150/100). So you prefer the company A that pays you more profit per share.
Price Earnings Ratio
The price-to-earnings ratio, or simply P/E ratio, is an often used metric in stock valuation. The P/E ratio is obtained by dividing the price per share by the earnings per share. Using the P/E ratio, we can compare the relative earning power of the companies regardless of their size or stock price. For example on the surface, a Rs 50 stock may seem more expensive than an Rs 20 stock, but if the Rs 50 stock has an EPS of Rs 5 while the Rs 20 has an EPS of Re 1, using the P/E ratio, you will be able to see that the Rs 20 stock is twice as expensive as the Rs 50 stock.
What is a good P/E ratio?
There may be no such thing as a good price-to-earnings ratio. When P/E is high, one can either say it’s too expensive or argue that growth prospects are good. On the other hand, when P/E is low, one can say that it is a value play or that the company’s future is not too bright.
What I have suggested through my article is just the tip of the iceberg, and shall continue to throw more light in the future. As Peter Lynch puts it “Know what you own, and know why you own it.”
