Important Financial Ratios Every Investor Should Know - Part 1

There are many important factors and ratios that need to be focused while investing in any stocks. 

And today we are going to learn about the some important ratios which are widely used to analyse the stocks

1. P/E Ratio - Price to Earning Ratio

As in formula says it is the ratio of the current share price to the earning of the company per share. Now you may be thinking that what is this Earning per share - EPS.

let us understand EPS with an example, Company A has an overall earning of  Rs. 10,00,000 and there are 2,000 shares in market. 

Then,

EPS = 10,00,000/2,000 = 500

And further if the company A's shares are trading at Rs. 10,000 presently then P/E ratio will be

P/E Ratio = 10,000/500 = 20

In very simple language P/E ratio says in above condiation is that you are paying Rs. 20 to earn Rs. 1 from the Company.

2. ROE Ratio - Return On Equity Ratio

As the formula says ROE is a measure of the rate of return on the stock of a company. In other words, it tells investors how good the company is in generating returns on stock investments.

Let's understand ROE with an example

Company - A as a net income of Rs.10,00,000 and share holders equity is Rs. 1,00,000 and assume dividends are Zero. then ROE will be 10. it means company is generating 10% ROE on equity. The company which generates good ROE then the company is good.

Like the P/E ratios, the RoE ratios can vary according to sectors and industries. Hence, it is important to understand the industry average too and you should not look at RoE as a standalone factor.

3. P/B Ratio Price To Book Ratio

The price to book ratio is a simple comparison of a company’s market value (market capitalization) to its book value. It compares the company’s stock price to its book value per share.

first let’s look at what book value is

The easy way to understand book value is to think that if a company stops doing all business, pays off its loans, and sells its assets, what will be the value of the company. Here is an example:

Let’s say that the value of a company is Rs.1000. It decides to shut down the company and receives Rs.1000. Out of this, it has to pay Rs.400 as loan repayment. Also, the company has some assets that fetch it Rs.200. Therefore,

The total book value of the company = 1000 – 400 + 200 = Rs.800

Next, let’s say that the total number of outstanding shares was 100. Therefore, the book value of the company per share = 800/100 = Rs.8

Now,

P/B ratio = Market price of a share/Book value per share

Let’s say that the market price of a share of the company is Rs.80. Therefore,

P/B ratio = 80/8 = 10

If a company has a low P/B ratio, then it is said to be undervalued and a high P/B ratio is overvalued. It is an excellent way to identify companies whose stock prices have sky-rocketed without any asset base.

However, as is the case with the other ratios mentioned above, you should not make a decision about the strength of a company by looking at its P/B ratio alone. In the current markets, with panic selling being the theme, many fundamentally weak stocks will have a low P/B ratio (even less than 1)