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Analysing Stocks-Financial Ratios

When we think of investing in direct equity, we must know the basis for the same. Some common financial ratios have been described below so that you find it easy to comprehend them better.

Following are some important financial ratios that analysts attach great importance, while investing:

Earnings per Share (EPS)

This ratio indicates the post tax profits earned per share. The higher the EPS, the better it is. This ratio enables the investors to actually quantify the income earned by a share and to determine whether it is reasonably priced.

Price Earnings Ratio (P/E Ratio)

This ratio depicts the relation between the market price of the share and the earnings per share. Whether a particular company’s P/E ratio is on the higher or lower side may be understood with reference to the all-industry average, and also with reference to the specific industry average.

The P/E ratios of well established and financially sound companies are high. The P/E ratio would be high as long as the investing public has faith in the company’s ability to grow. It will fall as soon as this confidence in the earning capacity of the company falls.

Book to Market Ratio

This ratio is used to identify undervalued stocks by comparing the book value of a firm to its market value. The market value is nothing but the market capitalization of a share and its book value is the firm’s historical cost. The stock is undervalued if the ratio is above 1 and undervalued if it is less than 1.

Book Value per Share

This ratio indicates the asset-backing available for each share. The higher the book value per share, the better it is for the company.

Book Value per Share = Shareholder’s funds/ No. of Equity Shares

Return on Net Worth

This indicates the post-tax return on the shareholder’s funds. The higher the better it is.

Return on Net Worth = Earnings available to Equity Shareholders/ Shareholder’s Funds

Debt-Equity Ratio

Debt (i.e., loans) is measured as a multiple of equity or net worth (i.e., shareholders’ funds). The lower the ratio, the better it is.

Debt / Equity Ratio = Loans / Shareholder’s Funds

While these are the more common ratios, there are several other financial ratios as well that can be studied for a more intricate analysis of a stock.

Equity investors are not as interested in a historical P/E ratio as in a projected ratio. The current market price of the share has to be assessed with respect to the projected P/E ratio for the current year, not based on the past year’s data.

The above defined ratios are only a few to mention. There are many more of such ratios. These ratios should be chosen based on the purpose of the analysis being carried out. Any inference about the stock / company / industry drawn on the basis of one or two ratios would be incomplete and not well balanced. It is pertinent that all the ratios must be studied in conjunction for a wholesome analysis.

These ratios have been developed to measure the financial health of the company and hence the stock. Finally, these are mere tools that have been developed to ease the analysis process. The utility of any tool depends primarily on the manner and skill with which it is used
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