Many investors will suggest you go through the fundamentals of a company before picking any stocks. This means that you are required to check the financial records of a company which tells you that the stocks are worth investing in or not.
To be frank, not everyone is a finance expert to know everything about a company’s fundamental elements.
Financial Ratios to Study When Investing in Stocks
Here, I am going to share with you the 5 financial ratios you should study before investing in stocks:
1) Price to Earnings Ratio (P/E)
This is one of the crucial financial ratios investors have been using for a long time. P/E ratio is defined as the ratio of the current share price to the earning of the company per share. The ratio helps investors to determine whether the stock is undervalued or overvalued in the market.
For instance, if the company has overall earnings of Rs 1000 and has shares of 100 currently trading in the market. Therefore, it's earning per share is Rs 10. This means that you are paying Rs 10 to the company and in return, you get Rs 1 from the company’s earnings which is not good.
The Ideal Price to Earnings Ratio you can Invest in:
To be honest, there is no ideal price to identify P/E ratio of any stock. You cannot determine the exact P/E ratio as every industry has a different benchmark. If we compare the P/E ratio of two FMCG companies, let's say Hindustan Lever and Britannia, we will get to know that HUL is overvalued as compared to Britannia as the P/E of HUL is greater than 70 while the P/E ratio of Britannia is nearly 50.
The P/E ratio of JK Paper is 4 and if you compare this P/E ratio with HUL and Britannia, you will get an incorrect picture as the industries are very different. Hence it is suggested to know the industry benchmarks while analyzing the P/E of a company.
2) Return On Equity Ratio
Return on equity depicts the rate of return on the stock of a company. It’s a way to know about the company’s return on stock investment. Return on equity ratio is defined as Net income to total shareholder’s equity. This is an important ratio as it helps investors to determine how well a company shares its profit with its shareholders.
For instance, if investors contributed Rs 100 in equity and the total equity of the company is Rs 100. With this equity, if a company generates Rs 20 then ROE is 20%. On the other hand, if another company with the same equity generates an income of Rs 40, then the ROE of that company will be 40%. The company that generates better ROE is considered as good to invest in.
Return on Equity is defined as Net income/ Average Stockholder’s equity.
3) Price To Book (P/B) Ratio
Price to Book Ratio is calculated as Price per share divided by Book value per share. The ratio simply depicts the comparison of a company’s market capitalization to its book value.
Price to Book ratio gives investors an idea of how much shareholders willing to pay for the net asset of a company. Generally, a low P/B ratio is considered good. Do remember that the ratio should be compared within the same industry. For example, the P/B ratio of a manufacturing company should be compared with the P/B ratio of another manufacturing company.
4) Dividend Yield Ratio
The dividend yield ratio is calculated as the amount of dividend a company pays to its shareholders over the years to its current stock market price. For example, if the share price of a company is Rs 100 and it gives a dividend of Rs 10 then the dividend yield ratio will be 10%.
To get deeper into this, let's assume that an investor purchases a stock at a price of Rs 100. A year later, the stock price is still constant, i.e Rs 100. Is this a good investment? Of course not. You receive a zero per cent return from that company.
5) Debt to Equity Ratio
Needless to say, the Debt to Equity ratio depicts the amount of debt and equity of a company. This gives investors a clear idea of how much the company running on borrowed capital and owned funds.
Debt to Equity Ratio is defined as total liabilities/total shareholder equity.
Ideally, it is suggested to invest in a company which gives you high ROE for at least 3 years.
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