When an investor in the stock market sees the dreaded downward red arrow against his stock on the news ticker, somewhere a panic button gets pushed. Such a situation is not only unsettling, but temporarily depressing as well.
As the risk is pretty high in the share market, one has to make use of the tools available to gauge the potential of a company. Having said that,the question remains: which stock is good for you? There isn't any one right answer to that, but you should certainly identify which stock is bad for you. We break down the process of identifying a stock’s worth for you.
How to read the P.E. ratio
The PE ratio is the Price-Earnings ratio, one the most popular and common yardsticks used to spot “good” stocks. It’s arrived at by dividing its current market value by its earnings per share (EPS). The present market value of a share is readily available in the public domain and the EPS is earnings in relation to number of outstanding shares. For example: if a company clocks a profit of Rs 100 crore in the first quarter and it has Rs 50 crore outstanding shares, then the EPS would be Rs 2.
Let’s assume two companies ‘X’ and ‘Y’ have PE ratios of 20 and 10 respectively. What does this imply? In case of ‘X’, it shows that it is an over-priced stock and its price is prone to crash. So it's better to buy shares of 'Y' as the PE is lower as the market prices have not gone up to expose the earning capacity of the company. So it is always ideal to buy the shares of a company with a lower PE ratio but with good earnings potential. The downside of the PE ratio is that it could be used only to compare firms in the same sector.
Dividend Payout ratio
Dividend payout ratio is the parameter that would guide the investor in picking stocks. Basically, the ratio can be arrived at by dividing total dividend by reported net income and multiplying it by 100. For example, if the dividend for the fiscal is Rs 1,000 and the net income is Rs 10,000, the dividend payout ratio is 10 per cent. The ratio shows the portion of income given away as dividend to the shareholders.
A stable dividend payout ratio is much better than a high or low ratio. A high ratio means that the company is paying more to the investor as dividend and retaining less for operations and future growth. On the other hand, a low ratio implies less dividend and that could be discouraging for the investor. If the ratio of a company has been dipping consistently for the past five years, it shows poor operating performance and it is better not to invest in this company.
So, it is important to draw a middle path. For instance, a company that has a payout ratio of 10 per cent for the past five years would in all probability be maintaining the momentum in the future too.
Price-to-Book Value ratio
The Price-To-Book Value (PBV) ratio compares the price of a share with the company’s book value. The book value is calculated by deducting liabilities from the assets as shown in the balance sheet. In other words it is the total value of company assets available to the shareholders if the company is liquidated. For example, the PBV ratio will be 3.33 for a company with a share price of Rs100 and book value per share of Rs 30.
A lower PBV means that the stocks are attractively priced. The PBV is a good parameter while evaluating the stocks of the banks but doesn’t work as well with companies in the pharma and IT sectors as they have intangible assets, which are not factored into calculation.
Debt-to-Equity ratio
As the name suggests, the ratio denotes the debt content in the company’s assets. The ratio is arrived at by dividing long-term debt by shareholder equity as stated in the balance sheets.
For example, a company that has a long-term debt of Rs 500 crore and a shareholder equity of Rs 250 crore will have a Debt-to-Equity ratio of 2.
A high debt-equity ratio (above 15) reflects lurking risk and it is better not to put money in those stocks. A higher ratio shows that the company doesn’t have a strong asset base. It also points to the fact that excessive debt brings in more interest outflow and this can eat into the profits. You can try to invest in shares with less debt-equity ratio, ideally in the range of 0.6 to 2.
Current ratio
What happens if you don’t have money to pay your electricity bills? The fallout is obvious: you will be in the dark the next day. There is a similar implication for companies that don’t have a healthy current ratio. This ratio shows that a firm has adequate current assets to cover its short-term financial obligations. The ratio is arrived at dividing the total current assets by current liabilities.
Assume, company ‘D’ has total current assets to the tune of Rs 100 crore and liabilities of Rs 50 crore, then the current ratio will be 2.
If the current ratio is between 1 and 2, it’s considered to be good and the shares of these companies could be bought. The higher the ratio, more the liquidity and that doesn’t augur well. This means that the firm is not investing the excess cash. At the same time if the ratio is less than 1, it means that the company is not able to meet its short term obligations.
There are hundreds of stocks to choose from and the chances of going wrong while investing is pretty high. If an investor doesn’t take the investment decision judiciously, he may burn his fingers. So,when it comes to the stock market, the credo should be to take calculated risk with gusto.
(The writer is the CEO of Bankbazaar.com)
