Important Ratios for Evaluation

Till now we have understood financial statements for evaluating a company. If you have not read that post, you can read it here. In this post, we are going to look at something derived from these financial statements that help us filter companies at a glance. These are known as Financial ratios.

Have you ever wondered how investors filter companies from a sea of companies in the market? The answer to this is the financial ratios.

What are Financial Ratios?

So before starting let’s understand what are these financial ratios. Financial ratios are ratios derived from the company’s financial statements. These ratios help the investor in filtering or evaluating the company. Investors can set up filters using these Financial Ratios to filter out companies that suit the investor’s investing philosophy and risk appetite. We will get a clearer understanding of this as we progress further in knowing these ratios.

Financial Ratios

Let’s see some of the most commonly used Ratios to understand what they stand for, and understand the terms from which these ratios derive their value.

ROCE (Return on Capital Employed)

ROCE stands for Return on Capital Employed. As the name declares this ratio measures a company’s profitability relative to the total capital it employs. It considers both equity and debt financing.

The formula for ROCE is: ROCE = Operating profit/Capital Employed

Here Operating Profit is the profit before interest and taxes and Capital Employed includes long-term debt, equity, and other non-current liabilities. Kindly note that Operating profit is different from EBITDA as it considers depreciation and amortization in its calculation.

A higher ROCE indicates better capital efficiency. Companies often compare their ROCE to industry averages to assess performance. Keep in mind that different industries may have varying benchmarks for what constitutes a good ROCE. So to summarize in points ROCE is used for the following:

Assessing efficiency: it measures how effectively a company utilizes its capital to generate profits. A higher ROCE suggests better efficiency in deploying resources.
Comparing companies: Investors can compare ROCE across companies within the same industry. A company with a consistently higher ROCE may be more attractive for investment.
Long-Term Performance: ROCE reflects a company’s long-term performance. Stable or improving ROCE over time indicates sustainable profitability.
Risk Management: A declining ROCE may signal operational challenges or poor capital allocation. investors can use it as an early warning sign.

While ROCE helps investors with a lot of insights there are some limitations of ROCE as well which are described below:

Industry variability: Different industries have varying benchmarks for what constitutes a good ROCE. Comparing ROCE across sectors may not provide accurate insights.
Capital structure ignored: ROCE treats equity and debt equally. however, companies with high debt may have artificially inflated ROCE due to financial leverage.
Short-Term Focus: ROCE reflects long-term performance. Short-term fluctuations may not fully capture a company’s fundamentals.
Quality of Earnings: ROCE relies on reported earnings, which can be manipulated. Investors should consider the quality of earnings and accounting practices.
Unused Cash Reserve: Companies with substantial unused cash tend to have lower ROCE. This metric doesn’t account for the impact of cash holdings on the company’s profitability.

Remember that while ROCE is valuable, it is essential to consider other financial metrics and industry-specific factors, when making investment decisions. Investors can select a particular ROCE value, for example, a value of 15% for filtering out companies in the same sector.

ROE

ROE stands for Return on Equity. This ratio measures a company’s profitability relative to its shareholder’s equity. ROE is calculated by dividing net income by the average shareholder’s equity. It represents how efficiently a company utilizes shareholders’ funds to generate profits.

In formula terms it can be represented as follows:

ROE = Net Income/ Average Shareholders’ Equity

A higher ROE indicates better efficiency in converting equity financing into profits. Just like ROCE, ROE varies across industries and sectors. So Significance of ROE:

Profitability assessment: ROE measures how efficiently a company uses shareholders’ equity to generate profits. A higher ROE indicates better profitability.
Comparing Companies: Investors can compare ROE across companies within the same industry. A consistently high ROE may signal a well-managed company.
Growth Potential: Increasing ROE suggests growth potential. However, consider other factors like debt levels and industry norms.
Shareholder Value: ROE directly impacts shareholder value. Companies with strong ROE tend to create value for investors.

While ROE is a good indicator it has its limitations as described below:

Variability: Different industries have varying benchmarks for what constitutes a good ROE. Comparing ROE across sectors may not provide accurate insights.
Oversimplification: ROE oversimplifies a company’s financial health. While it offers a view of profitability, it ignores other critical factors such as organizational growth potential and market potential.
Quality of Earnings: ROE relies on reported earnings, which can be manipulated. Investors should consider the quality of earnings and accounting practices

All in all, ROE is a good ratio but it should be used with other ratios to develop a better understanding of the company.

ROI

ROI stands for Return on Investment. This ratio is used to evaluate the efficiency or profitability of an investment. It helps compare the effectiveness of different investments.

The formula of ROI is:

ROI = (Current Value of Investment – Cost of Investment)/ Cost of Investment

The current value of the investment is the proceeds obtained from selling the investment. The cost of investment is the initial investment cost. A positive ROI indicates a worthwhile investment, while a negative ROI implies a net loss.

We can summarize the significance of ROI for an investor under the following points:

Performance Assessment: ROI helps evaluate the effectiveness of an investment. A positive ROI indicates profitability, while a negative ROI suggests losses.
Comparison Tool: It allows investors to compare different investments. Higher ROI implies better returns relative to the initial cost.
Decision making: ROI guides investment decisions. Investors prioritize projects or assets with higher ROI.
Risk-Adjusted Returns: By considering risk, ROI helps assess whether an investment compensates for the associated risks.

As with everything else, this ratio has its own limitations as described:

Data Quality: ROI relies on accurate data. If data is flawed or incomplete, the resulting ROI may mislead decision-makers.
Temporal Factors: ROI doesn’t consider the time value of money. Future cash flows are worth less than present ones, but ROI treats them equally.
Intrinsic Value: ROI focuses on financial returns but overlooks non-financial factors like brand reputation or employee satisfaction.
Risk Ignorance: It doesn’t account for risk. High ROI doesn’t guarantee low risk, and vice versa.
Complex Scenarios: ROI works well for straightforward investments but struggles with multifaceted scenarios involving multiple factors.

ROI is a concept that people use in everyday life apart from evaluating companies.

Free Cash Flow

Free Cash Flow (FCF) represents the cash that a company generates after accounting for cash outflows to support operations and maintain its capital assets.

It is calculated by:

FCF = Operating Cash Flow – Capital Expenditure

Here Operating Cash Flow is the cash generated from core business operations and Capital Expenditure (CapEx) is the spending on equipment, technology, and real estate.

So what is the importance of FCF?

The importance of FCF can summarized in the below points:

Measure Profitability: Unlike net income, FCF excludes non-cash expenses and interest payments.
Reveal trends: Changes in working capital (eg. accounts payable, receivable, inventory) impact FCF.
Assesses Health: A positive FCF indicates financial strength, but analyzing the trend of this is essential to see if the company is moving in the right direction. Consistent positive FCF indicates financial stability and operational efficiency.
Investment Decisions: FCF helps assess a company’s ability to invest in growth opportunities. Positive FCF allows for capital expenditures, acquisitions, dividend payments, share buybacks, or debt reduction.
Valuation: Investors use FCF to value a company. It provides a clearer picture of cash available to shareholders than net income.

Limitations of FCF:

Accounting Practices: Different accounting methods can impact the calculation of FCF, and making comparisons between companies is challenging.
Non-recurring Items: Extraordinary events, such as one-time gains or losses, can distort FCF figures.

Therefore investors need to own framework where they include FCF for evaluating companies. FCF in most cases doesn’t come in handy to filter companies but instead helps support the future stability of the company according to me.

P/S ratio

Price to Sales ratio is a valuation metric that compares a company’s stock price to its revenues. It indicates the value that financial markets assign to each dollar of a company’s sales or revenues. It indicates how much investors are willing to pay per dollar of a company’s sales.

Here’s how it is calculated:

P/S ratio = Market Value per Share/ Sales per Share

Here Market Value per Share (MVS) represents the current stock price, which you can find by searching the stock symbol on any major finance website or Exchange. Sales per Share (SPS) is calculated by dividing a company’s total sales by the number of outstanding shares.

Keep in mind that the P/S ratio doesn’t consider whether the company generates profits or will ever make profits. it’s most relevant when comparing companies within the same sector. A low ratio might suggest undervaluation, while a significantly above-average ratio could indicate overvaluation. A higher ratio suggests higher growth expectations or optimism about future earnings.

While the P/S ratio considers revenues, the P/E ratio focuses on profits.

So to summarize the significance of P/S ratio in points:

Assessing Valuation: The P/S ratio helps evaluate whether a stock is overvalued or undervalued. A low P/S ratio might indicate an undervalued stock, while a high ratio could suggest overvaluation. however, it’s essential to compare P/S ratios within the same industry or sector for meaningful insights.
Focus on Revenues: Unlike the price-to-earnings (P/E) ratio, which considers profits, the P/S ratio focuses solely on revenues. It is particularly relevant for companies with volatile earnings or those in growth phases. Investors interested in top-line performance use this metric.
Industry Comparisons: Comparing a company’s P/S ratio to its peers provides context. Industries with different business models may have varying typical P/S ratios. For instance, technology companies often have higher P/S ratios due to growth expectations.

The limitations of P/S ratio can be summarized as below:

Profit Ignored: P/S doesn’t consider profitability or earnings. A company with high revenues but low profits may appear attractive based on P/S but might not be sustainable.
Variability: Revenues can fluctuate due to seasonality, economic cycles, or one-time events. P/S doesn’t account for this volatility.
Industry Difference: Different industries have varying typical P/S ratios. Comparing across sectors may not provide accurate insights.
Debt and Expenses: It ignores debt levels, operating expenses, and other financial aspects.

Use P/S along with other metrics for a comprehensive analysis.

Asset Turnover

It measures how efficiently a company uses its assets to generate revenue. It’s a key indicator of operational efficiency.

Here’s the formula:

Asset Turnover Ratio = Revenue/ Average Total Assets

Here Revenue is Total Sales. Average Total Assets is the average value of a company’s assets during the year.

A higher asset turnover ratio implies better performance, as it means the company generates more revenue per dollar of assets. Keep in mind that ratios can vary across different industries. In simpler terms, it reveals how many dollars of revenue a company generates for each dollar invested in its assets.

The significance of Asset Turnover can be summarized in the following points:

Operational Efficiency: A higher asset turnover ratio indicates effective asset utilization. Efficiently using assets means the company generates more sales per unit of investment, leading to improved profitability.
Comparisons: Investors use asset turnover to compare similar companies within the same sector. It helps assess whether a company’s asset utilization is better or worse than its peers.
Profitability Link: Asset turnover directly relates to a company’s operational efficiency and overall profitability. Companies with higher ratios tend to perform better in terms of revenue generation.

The limitations can be summarized in the below points:

Ignores profit margins: Asset turnover focuses solely on revenue generation it doesn’t consider profit margins or net income. A high asset turnover may not necessarily lead to profitability if margins are thin.
Industry Variability: Different industries have varying asset turnover norms. Comparing asset turnover across sectors may not provide accurate conclusions.
Quality of Assets: The ratio treats all assets equally. It doesn’t differentiate between productive assets (eg. machinery) and non-productive ones (eg. excess inventory)
Seasonality and Cyclical Trends: Asset turnover can fluctuate due to seasonal demand or economic cycles. Short-term variations may not reflect long-term efficiency.

Thus Asset turnover can be used after filtering the company in a particular sector to select a company out of 2 or more companies.

P/E ratio

P/E stands for Price to Earnings. It measures a company’s share price relative to its earnings per share (EPS). It’s often called the price-to-earnings multiple and helps assess the relative value of a company’s stock.

The P/E ratio is calculated as follows:

P/E ratio = Market Value per Share/ Earnings per Share

A high P/E ratio could mean that a company’s stock is overvalued or that investors expect high growth rates. Companies with no earnings or those losing money don’t have a P/E ratio because there’s nothing to put in the denominator.

There are two types of PE ratios:

Trailing PE: Based on past 12 months earnings (TTM)
Forward PE: Uses earnings guidance for future expectations.

Compare PE ratios within the same industry or track a single company’s performance over time.

The significance of the P/E ratio can be summarized below:

Valuation Assessment: It helps to determine whether a stock is overvalued, undervalued, or fairly priced. A high PE may indicate optimism about future earnings, while a low P/E could signal undervaluation.
Comparisons: Investors compare a company’s PE to its peers or historical averages. it provides context for evaluating relative attractiveness.
Growth Expectations: A high P/E suggests growth expectations, especially for companies in high-growth sectors. Conversely, low P/E may indicate slower growth or risk.

The Limitations of the P/E ratio can be summarized below:

Earnings quality ignored: I consider reported earnings, but not their quality. Companies can manipulate earnings through accounting practices. Assess earnings sustainability and consistency.
Cyclical Businesses: It may mislead cyclical industries (eg. commodities). High P/E during a boom might be temporary.
Comparing across sectors: Different sectors have varying typical P/E norms. Comparing P/E across unrelated industries can be misleading.
Future Growth Uncertainty: High P/E assumes sustained growth which might go wrong. Considering the factors such as industry trends, and competitive advantage is also important.

P/B ratio

The Price to Book ratio compares a company’s stock price to its book value per share. Book value represents the net assets ( total assets minus liabilities) of the company. It also indicates whether a stock is trading above or below its intrinsic value. It’s relevant for industries with significant tangible assets (eg. banking, real estate).

P/B ratio = Market Price per Share/ Book Value per Share

Market Price per Share is the current stock price. Book Value per Share is the total assets minus intangible assets and liabilities divided by outstanding shares.

The significance of the P/B ratio can be summarized below:

It helps identify undervalued stocks.
Ratios below 1 are often considered solid investments by value investors.

The Limitations of the P/B ratio can be summarized below:

Ignores Intangibles: P/B only considers tangible assets. it ignores intangibles like brand value, patents, and intellectual property.
Industry Differences: P/B norms vary across sectors. Comparing P/B ratios across unrelated industries can be misleading.
Market Sentiment: P/B doesn’t account for investors’ sentiment or growth prospects.
Book Value accuracy: Book value may not reflect true market value due to historical cost accounting.

The P/B ratio can be used as a filtering entity by investors.

Debt to Equity ratio

It evaluates how much debt a company uses relative to its equity.

Debt/ Equity = Total Liabilities/ Total Shareholders’ Equity

Its significance can be summarized as below:

The D/E ratio assesses a company’s reliance on debt financing. It gives insights into a company’s financial structure.
A higher ratio indicates more risk, while a low one suggests underutilization of debt for expansion.
Investors often focus on long-term debt to better understand risk.

The Limitations can be summarized as below:

Industry Variability: Different industries have varying typical D/E norms. Comparing D/E ratios across unrelated sectors can be misleading.
Risk Perception: A high D/E ratio indicates more debt and potential financial risk. However, it doesn’t consider the company’s ability to service debt.
Business Lifecycle: Young companies may have higher D/E ratios due to startup costs. mature companies may maintain lower ratios

The verdict is high debt companies are at a higher risk as compared to low-debt companies. However, some industries require companies to have high debt. So a judicious call should be taken.

PEG ratio

The Price Earnings to Growth ratio considers both P/E and expected earnings growth. it helps assess valuation while accounting for growth prospects.

The PEG ratio is calculated by dividing a stock’s price-to-earnings (P/E) ratio by its earnings growth rate for a specified period as described below.

PEG ratio = (Price/EPS)/ EPS Growth

Price /EPS is the PE ratio and EPS growth is the expected earnings growth rate (usually one to three years).

The Limitations of the PEG ratio are summarized below:

Earnings Growth Assumptions: PEG relies on projected earnings growth rates. If growth assumptions are inaccurate, the PEG ratio may mislead.
Industry Variability: Different sectors have varying typical PEG norms. Comparing PEG ratios across unrelated industries can be misleading.
Market Sentiment and Risk: PEG doesn’t account for market sentiment or risk factors. High Growth expectations may not materialize.

The significance of the PEG ratio is summarized below:

Assessing valuation: PEG combines the P/E ratio (price per share/earnings per share) with expected earnings growth. A lower PEG suggests relative undervaluation. Aim for a PEG below 1 for potentially attractive stocks.
Growth consideration: PEG accounts for growth expectations. It helps evaluate whether a stock’s valuation aligns with its growth potential.

PEG provides a more complete picture than the standard P/E ratio. A lower PEG suggests undervaluation relative to growth expectations. Aim for a PEG below 1 for potentially attractive stocks

Enterprise Value to EBITDA (EV/EBITDA)

EV/EBITDA considers a company’s enterprise value (market cap + debt – cash) relative to its EBITDA (earnings before interest, taxes, appreciation, and amortization). it accounts for debt and cash, providing a more comprehensive view of valuation. It is commonly used for assessing acquisition targets or comparing companies in capital-intensive sectors.

It measures how many times EBITDA (a proxy for operating cash flow) an investor would have to pay to acquire the entire business.

The significance of the ratio is summarized below:

It helps to compare the entire value of a company to its annual EBITDA.
A lower ratio suggests a potentially undervalued company, while a higher ratio indicates a potentially overvalued company.
It’s useful for transnational comparison and identifying attractive takeover candidates in mergers and acquisitions.

The limitations of the ratio are summarized below:

Earnings quality is Ignored: EBITDA excludes certain expenses. it doesn’t account for interest payments, taxes, or non-operating items. Assess the quality of earnings beyond EBITDA.
Industry Variability: Different sectors have varying typical EV/EBITDA norms. Comparing ratios across unrelated industries can be misleading.
Debt and Capital Structure: EV includes debt, which affects the ratio. high debt level may distort the valuation.

Some of the ratios can be used to filter stocks while others are used to compare stocks post-filtration. Remember an investor has to develop his own philosophy incorporating the ratios which he/she feels important to evaluate companies matching their risk-apetite.

This is all for this post. Tell me your thoughts in the comments. Don’t forget to follow my Facebook and Instagram Page for regular updates. See you all in the next post. Till then keep learning.