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. Should you trust your broker? Or should you trust the markets analysts. And at the end of the day you are left confused by the myriad of opinions and advices that are thrown at you.
Instead, why not understand the parameters yourself
P/E ratio shows what the market thinks about the earnings potential and future business forecast of a company. Companies with high P/E ratios are the darlings of the investors and thus enjoy a higher market rating.
In order to use the P/E ratio properly take into account the future earnings and growth projections of the company. If the current P/E ratio is low, as against the future prospects of a company, then the shares make an attractive investment option.
But if the company is saddled with losses and falling sales stay away from it, despite the low P/E ratio.
Dividend & yield: Dividend is the portion of the profit that is distributed amongst shareholders. Companies offering high dividends normally don’t have much of growth to talk about.
This is because the plough back required to finance future development is insufficient. Similarly, those companies in high growth sector don’t give any dividend. Instead here they give sharp capital appreciation, which ultimately will lead to higher dividends.
So it makes much more sense to invest for capital appreciation instead of dividends. Rather it makes more sense to invest for yield, which is nothing but the association between the dividends and the market price of the shares. Yield (dividend yield) can be calculated as:
Yield = (Dividend per share / market price of a share) x 100
Yield shows the returns in percentage that you can expect via dividends earned by your investment at the current market price. It is more useful than simply focusing on the dividends.
Return on capital employed (ROCE): ROCE is the ratio that is calculated as:
ROCE: Operating profit / capital employed (net value + debt)
To get operating profit, add old taxes paid, depreciation, special one-off expenses, and special one-off income and miscellaneous income to get the net profit. The operating profit is a far better indicator of the profits earned by the company instead of the net profit.
Hence this ratio is the better indicator of the general performance of the company and the company’s operational efficiency. It is one of the most useful ratios to compare amongst the companies.
Return on net worth (RONW): RONW is calculated as
RONW = Net Profit / Net Worth
This ratio gives you an idea of the returns generated by investing in the company. While ROCE is an effective measure to get a general overview of the profitability of the company’s business operations, RONW lets you gauge the returns you can earn on your investment.
When used along with ROCE, you get an overview of the company’s competence, financial standing and its capacity to generate returns on shareholders’ finances and capital employed.
PEG ratio: PEG is an essential and extensively used ratio for calculating the inbuilt worth of a share. It helps you decide whether the share is under-priced, totally priced or overpriced.
To derive the ratio, you have to associate the P/E ratio with the expected growth rate of the company. It assumes that higher the growth rate of the company, higher the P/E ratio of the company’s shares. Vice versa also holds true.
PEG = P/E / expected growth rate of the EPS of the company
If PEG is lesser than 0.5 it is a lucrative investment opportunity. However if the PEG exceeds 1.5 it is time to sell.
These are some of the most critical ratios that must be considered when purchasing a share.