Financial ratios you should know: PE, EPS, and more

Being a value investor requires thorough research. Understanding whether a company is undervalued or overvalued, what its potential is, how it is spending its money, and how the company can help you grow your money is where the art of investing lies. This is where we come across financial ratios. They prove to be invaluable tools to interpret a company’s financial health while assessing its growth potential.

In this blog, we will talk about four of the most important financial ratios – Price-to-Earnings (P/E), Earnings per Share (EPS), Return on Equity (ROE), and Debt-to-Equity (D/E). Understanding these ratios will help you become a more informed investor. Remember, investing involves inherent risks, and this information is for educational purposes only; consult a qualified financial advisor before making any investment decisions.

Price-to-Earnings (P/E) Ratio

The P/E ratio, perhaps the most widely used stock valuation metric, compares a company's current share price to its earnings per share (EPS). It essentially reveals how much investors are willing to pay for each rupee of the company's earnings.

Formula: P/E Ratio = Current Share Price / Earnings per Share (EPS)

Interpretation:

• High P/E: Typically indicates investor expectation of high future growth, but also suggests a potentially higher risk. Compare the P/E ratio to industry peers and historical values to assess its relative attractiveness.
• Low P/E: This might imply undervalued stocks, but could also signal concerns about future growth potential. Investigate the reasons behind a low P/E before investing.

Earnings per Share (EPS)

EPS represents the portion of a company's profit allocated to each outstanding share. It reflects the company's profitability relative to its share count.

Formula: EPS = Net Income / Outstanding Shares

Interpretation:

• Rising EPS: Generally indicates improved profitability, potentially attracting investors. However, analyse EPS growth alongside revenue growth to ensure it's not solely due to cost-cutting measures.
• Declining EPS: This might signal profitability concerns, but consider external factors like industry-wide downturns before drawing conclusions.

Return on Equity (ROE)

ROE reveals how efficiently a company utilises its shareholders' equity to generate profits. It measures the percentage return on the company's net income relative to its shareholder equity.

Formula: ROE = Net Income / Shareholder Equity

Interpretation:

• High ROE: Generally indicates efficient use of shareholder funds and potentially higher profitability. But compare it to industry peers to assess its relative performance.
• Low ROE: This might suggest inefficient operations or low profitability. Investigate the reasons behind a low ROE to understand its implications.

Debt-to-Equity (D/E) Ratio

The D/E ratio gauges a company's financial leverage, indicating the proportion of debt used to finance its operations compared to its shareholder equity.

Formula: D/E Ratio = Total Debt / Total Equity

Interpretation:

• High D/E: Implies higher financial risk, as the company relies heavily on debt. Evaluate the company's debt servicing ability and future cash flow projections before investing.
• Low D/E: Suggests conservative financial management and lower risk, but might also limit growth potential due to less access to capital.

Beyond the Ratios

Remember, these ratios are just starting points. A holistic analysis requires considering:

• Industry Comparisons: Benchmark ratios against industry averages to understand the company's relative performance.
• Historical Trends: Analyse trends in these ratios over time to identify improvement or deterioration in the company's financial health.
• Company-Specific Factors: Consider qualitative factors like management quality, competitive landscape, and future growth prospects before drawing conclusions.

Conclusion

Financial ratios offer valuable insights if you wish to invest in stocks. However, they should not be used in isolation. Investment decisions inevitably involve inherent risks. Consulting a finance expert is always recommended. Conduct your own research before investing in any instrument.