Wise stock selection entails using some ratios to help you figure out the mettle of your investment. Its better to keep in mind that a single financial ratio can never determine the true value of a stock. It is advisable to use a combination of ratios to get the bigger picture on the canvas about the financials of a company, its earnings and the value of its stock. Here is some of the frequently used ratio analysis for stock selection.
Price to Earnings Ratio or P/E Ratio
P/E ratio helps investors to understand the market value of a stock compared to the company’s earnings. Its purpose is to gives an idea about the growth potential of the stock.
P/E Ratio = Current Market Price / Earnings Per Share
A high P/E ratio usually indicates that stock’s price is high relative to its earnings and possibly overvalued. As opposed, a low P/E indicates that the current stock price is low relative to earnings.
If there are two companies A – with a P/E of 50 and B – with a P/E of 30. Then other things being same, B is considered to be a better buy as the market price has not gone up to reveal the growth potential of the company.
“All intelligent investing is value investing – acquiring more that you are paying for. You must value the business in order to value the stock.”
– Charlie Munger
However, earnings of a company can be hard to predict as they are based on past performance and expectations of the financial analyst. Both can give uncertain results. Also, the P/E ratio doesn’t factor in earnings growth. Interpretation of P/E ratio is heavily dependent on comparison of the company with its contemporaries in the relevant industry. P/E ratio is also not neutral to major announcements in relation to the growth of the company. It can be pushed up or down by any issues faced by the company.
Earnings Per Share or EPS
Earnings per share are calculated by dividing a company’s net income by its number of shares outstanding. An increasing EPS is considered to be a good omen as a strong growth suggests a successful stock which will give a good performance in the future too. However, it’s important to realize that companies can boost their EPS figures through stock buybacks that reduce the number of outstanding shares.
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Price-to-Book Value or P/B Ratio
The P/B ratio measures whether a stock is over or undervalued by comparing the net assets of a company to the price of all the outstanding shares. This ratio shows the difference between the market value and the book value of a stock. The market value is the price investors are willing to pay for the stock based on expected future earnings. The book value, on the other hand, is derived from a company’s assets and is a more conservative measure of a company’s worth. Value investors often prefer companies with a market value less than its book value. Hoping that the market perception turns out to be wrong.
Debt to Equity Ratio
The debt equity ratio shows the proportion of equity to debt that a company is using to finance its assets. When a company is using a lower amount of debt for financing it will have a low debt equity ratio. If the ratio is high, it means that the company is financing more from debt relative to equity. Due to this it can pose a risk to the company as too much debt is not preferred. The debt-to-equity ratio can vary from industry to industry and depending on the type some companies have higher ratios than companies in other industries.
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Free Cash Flow
Free cash flow is the left-over cash of the company after it has paid off its operating expenses and capital expenditures. It shows the efficiency of a company at generating cash and is considered as an important indicator in determining whether a company has sufficient cash to reward shareholders through dividends and share buybacks. Free cash flow can be an early indicator to value investors that earnings may increase in the future. When a company’s share price is low and free cash flow is on the rise, the earnings and share value of the company could soon be heading in the upward direction.
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