It’s a very common dilemma for first time stock buyers. You want to invest in ‘safe’ stocks yet have no idea about the process involved.
Understand the parameters so that you can make the best choice and go ahead with your investments in Stocks buying. To help you understand the intricate art of choosing the best stocks to invest in, here are eight key ratios.
Plough back/reserves: Every year, a company divides its net profit (profit left after subtracting various expenses including taxes) in two portions: plough back and dividends. While dividends are handed out to the shareholders, plough back is kept by the company for its future use and is included in its reserves.
Plough back is essential because besides boosting the company’s reserves, it is a source of funds for the company’s expansion plans. Hence if you are looking for a company with good growth prospects, check its plough back figures.
Reserves are also known as shareholders’ funds, since they belong to the shareholders. If a company’s reserves are twice its equity capital it can then reward its shareholders with a generous bonus. Also any increase in reserves will push the share price of your share.
Book value per share: This ratio shows the worth of each share of a company as per the company’s accounting books. It is calculated as:
Book Value per share = Shareholders’ funds / Total quantity of equity shares issued
Shareholders’ funds can be computed by subtracting the total liabilities (money owed to creditors) of the company from its total assets. It can also be calculated by adding the equity capital to the company’s reserves.
Book value is an old record that uses the original purchase prices of the assets. However it doesn’t show the present market price of the company’s assets. As a result, this ratio has a restricted use when it comes to estimating the market price of the shares, but can give you an estimate of the minimum price of the company’s shares. It will also help you judge if the share price is overpriced or under-priced.
Earnings per share (EPS): One of the most popular investment ratios, it can be computed as:
Earnings per Share (EPS) = Profit Post Tax / Total quantity of equity shares issued
This ratio computes the company’s earnings on a per share basis. E.g. you own 100 shares of ABC Co., each having a face value of Rs 10.
Assume the earnings per share is Rs 10 and the dividend declared is 30 per cent, or Rs 3 per share. This implies that on every share of ABC Co, you earn Rs. 6 each year, but you actually get Rs 3 via dividend. The balance of Rs 4 per share goes into the plough back (retained earnings). Had you purchased these shares at par, it implies a return of 60 per cent.
This example shows that instead of looking at the dividends received from to company as the base of investment returns, always look at earnings per share, as it is the actual indicator of the returns earned by your shares.
Price earnings ratio (P/E): This ratio highlights the connection between the market price of a share and its EPS.
Price/Earnings Ratio (P/E) = Price of the share / Earnings per share
It shows the degree to which earnings of a share are protected by its price. E.g. if the P/E is 40, it means the share price is 40 times its earnings. So if the company’s EPS is constant, it will need about 40 years to make up for the purchase price of the share, after taking into account the dividends and the capital appreciation. Hence low P/E means you will recover your money quickly.