Fundamental Analysis

Financial Ratio Analysis (Part 3) – Poonit Rathore

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Financial Ratio Analysis (Part 3) - Poonit Rathore
Financial Ratio Analysis (Part 3) – Poonit Rathore

11.1 The Valuation Ratio

Finding the value of something is called the valuation of that thing. When the price of a share is calculated in the stock market, it is called the valuation of the share. Before investing in any business, it is seen what should be its valuation. _ any business Its valuation is also seen to buy. _ _ _ Sometimes it is considered a better investment in a simple business at a low valuation rather than buying a very good business at a very high valuation.

The valuation ratio tells us how the market is viewing the price of any stock. _ _ Means how much he is valuing it. From this, we get to know which is the good stock to invest in. _ This ratio tells us that this stock is at this price _ What kind of benefit can we get from buying? Like all other ratios, it should be compared with the ratios of other companies.

Valuation ratios usually compare a specific portion of a business to its share price. We will look at these 3 valuation ratios here

  1. Price to Sales Ratio (Price to Sales – P/S ratio)
  2. Price to Book Value Ratio (Price to Book Value – P/BV Ratio)
  3. Price to Earnings Ratio (Price to Earnings – P/E Ratio)

We will again use Amara Raja Batteries Limited as an example and look at all these three ratios. In this example, the share price of Amara Raja Battery is of great importance. Here I will take the share price as on 28 October 2014 which is ₹661.

We also need to know the total number of outstanding shares of ARBL to arrive at this ratio. We worked out the number of outstanding shares of stock in Chapter 6. This number was 17,08,12,500 i.e. 17.08 crores.

Price to sales ratio (P/S ratio)

Many times investors pay more attention to the sales of the company than the earnings of the company when choosing a company for their investment. Because sometimes it also happens that there has been a decrease in the earnings of the company due to some specific reason. Sometimes there is a decrease in the profit or earnings of the company due to someone’s accounting decision, such as due to a large payment or any other reason. In such a situation, it is better for the investor to focus on the sale of the company. Under this ratio, the ratio between the sales of the company and the price of the shares of the company is seen. There is a formula to extract the price-to-sales ratio.

Price to sales ratio = Current share price / Sales per share

Now let us calculate the Price to Sales Ratio for ARBL. For this, we have to first find the denominator. 

Sales per share = Net income / Total number of shares

According to the balance sheet of ARBL

Total income = 3482 crores

Total number of shares = 17.08 crore

Sales per share = 3482/ 17.081

= Rs 203.86

This shows that the company is selling at Rs.203.86 per share.

Price to Sales Ratio = 661 / 203.86

= 3.24x or 3.24 times

The price-to-sales ratio of 3.24 indicates that the share price is trading at 3.24 times for every rupee of sales. The higher the price-to-sales ratio, the higher will be the valuation of the company. We will know whether this stock is expensive or cheap by comparing it with the price-to-sales ratio of other companies in the industry.

Let us understand with an example how we decide to invest in a company by comparing the price-to-sales ratio. Suppose two companies A and B sell the same type of product in the market. Suppose the income of both companies is Rs.1000. Company A earns Rs.250 as PAT while Company B’s PAT is Rs.150. This clearly means that the profit margin of Company A is 25% while that of Company B is 15%. It also means that the sales of Company A are more important than the sales of Company B. Therefore, the price-to-sales ratio of company A is high and its valuation is also high because company A is earning more profit for every rupee of sales.

If you ever feel that the share price of a company is looking higher from the point of view of its price-to-sales ratio, then definitely check the profit or profit margin of the company.

Price to book value ratio (P/BV ratio)

 Before understanding the price-to-book value ratio, we need to know what is book value.

Suppose a company has to be closed down and it has to sell all its assets. The book value of the company is considered to be the minimum amount that the company would get on selling all the assets.

In simple language, the amount of money left with the company after selling everything and meeting its liabilities is considered as its book value. If the book value of the company is Rs 200 crores, it means that the money that the company got on selling everything and from that the company has fulfilled all its liabilities, then this is the remaining amount. Book value is usually expressed in terms of per share. If the book value of a company is Rs 60 per share, it means that every shareholder of the company should expect Rs 60 if the company is sold. The formula to calculate book value is:

Book Value (BV) = Share Capital + Reserves (after removing Revaluation Reserves) / Total Number of Shares 

Now let’s extract it for ARBL:

From the Balance Sheet of ARBL, we know the:

Share capital = Rs 17.1 crore

Reserves = Rs 1345.6 crore

Revaluation Reserves = 0

Number of shares = Rs 17.081 crore

Book value per share = [17.1+1345.6-0] /17.081

= Rs 79.8 per share

This means that if ARBL were to sell everything it owns and after paying off the debt, every shareholder of the company should expect to get Rs 79.8 per share. If we divide the current share price of the company by the book value of the company, then we will get the price to book value, which shows the number of times the shares of the company are selling at their book value. The higher the price to book value, the more expensive the company’s shares are considered.

Now let us calculate the price to book value for ARBL:

The share price of ARBL = Rs.661 per share

Book Value (BV) of ARBL = 79.8

Price to Book Value (P/BV) = 661/79.8

=8.3 times

This means that ARBL shares are selling at 8.3 times their book value.

A high price to book value means that the company’s shares are expensive relative to their book value, and a low price to book value means that the company’s shares are trading cheap relative to their book value.

Price to Earning Ratio (P/E ratio)

The Price to Earnings ratio is probably the most popular financial ratio. Everyone wants to know the Price to Earnings ratio of the company. It is also called the superstar of financial ratios.

The current share price of the company is divided by its EPS i.e. Earning per share to calculate the Price to Earnings ratio. Before moving ahead, let us first know what is EPS. 

If the profit of the company is divided on the basis of per share, then the figure which will be obtained is called the EPS of the company. For example, suppose the company has 1000 shares and the company earns a profit of Rs.200000. Now the EPS of this company will be Earning Per Share

200,000 /1000

=200 per share  

EPS tells us how much profit the company is making per share. The higher the EPS of the company, the better it is for the shareholders. If you divide the current share price of the company by the EPS of the company, you will get the P/E ratio. This ratio shows the premium the market players are willing to pay on the share price of the company in comparison to its profits. For example, a P/E ratio of 15 means that market participants are willing to pay 15 times the company’s earnings per share. The higher the P/E ratio of the company, the more expensive the stock.

Let’s calculate the P/E ratio of ARBL: 

From the Annual Report of ARBL, we know: 

PAT = Rs 367 crore 

Total number of shares = 17.081 crore

EPS = PAT / Total number of shares

= 367 / 17.081

= Rs 21.49

The current share price of ARBL = Rs.661  

Hence P/E ratio = 661 / 21.49

= 30.76

This means that the market players are ready to buy shares by paying Rs 30.76 for every share of profit that ARBL is earning. Now suppose that the share price becomes Rs.750 while the EPS remains the same at Rs.21.49. Now the new P/E will be:

= 750 / 21.49

= 34.9 

What do you think would have happened if the EPS had remained at 21.49 per share and the P/E of the stock had gone up?

The P/E went up because the share price went up. We know that the share price increases when the expectations from the company increase. 

Remember that a company’s profits are used as the denominator when calculating the P/E ratio. Keep these things in mind when looking at P/E ratios:

  1. The P/E ratio tells us how expensive or cheap a stock is getting. Never buy shares at very high valuations. Personally, I never buy stocks with P/E ratios above 25 or 30, irrespective of the company or sector.
  2. Earnings are always in the form of denominators while calculating the P/E ratio and the company can manipulate the earnings accordingly.
  3. Note that the company is not changing its accounting policy frequently, if it is doing so, it means it is trying to distort its earnings. 
  4. Also, keep an eye on the depreciation of the company. Sometimes companies show more earnings by showing less depreciation. 
  5. If the company’s earnings are increasing but its cash flow and sales are not increasing, then it means that something is wrong somewhere.

11.2 – Valuation of the Index

Like shares, stock market indices like BSE Sensex and CNX Nifty 50 also have their own valuations. Which you can measure with things like P/E, P/B, and Dividend Yield Ratio. Usually, stock exchanges declare the valuation of their indices on a daily basis. The valuation of the index tells us whether the market is currently expensive or cheap. To arrive at the P/E ratio of CNX Nifty 50, the National Stock Exchange adds the market capitalization of the 50 stocks included in its index and divides it by the earnings of all 50 companies. By looking at the P/E ratio of the index, we get to know how the market players are viewing the market at the moment. Take a look at the P/E ratio chart of Nifty 50:

* Source- Creytheon

Looking at the above chart, we come to know a few important things:

  1. The highest valuation of the index was 28 times which came in early 2008. After this, there was a sharp decline in the market.
  2. After this fall, the market valuation was almost 11 times what it was in late 2008 and early 2009. This was the lowest valuation of the Indian stock market in the recent past. 
  3. Generally, the P/E ratio of the Indian stock market index is between 16 to 20 times i.e. 18 times on average. 
  4. It was trading 22 times in 2014, which is above average P/E.

 Based on this we can draw some conclusions.

  1. We should be careful while investing in the stock market with a P/E ratio above 22.
  2. The best time to invest in the stock market is when the valuations are around 16.

The best way to know the P/E ratio of an index is to visit the website of the National Stock Exchange (NSE) where it is reported on a daily basis.

On NSE home page click on Product > click on Index > click on Historical Data > P/E, P/B & Div > search

(NSE’s home page click on Products > Indices > Historical Data > P/E, P/B & Div > Search)

Enter your current date as the search field and you will see the most recent P/E valuations. Remember that NSE updates this every day at 6:00 PM. See a picture of the search result:  

Here you will see that the stock market is trading around its highest P/E. We need to be more careful before investing at this level.

Main points of this chapter

  1. Valuation generally means finding out the worth of something.
  2. We may need data from both the P&L statement and the balance sheet to arrive at the valuation ratio. 
  3. The price-to-sales ratio compares the company’s share price to the company’s sales per share.
    1. Sales per share mean the total sales figure of the company divided by the number of shares.
  4. The sales of a company with a higher profit margin are more important than those of a company with a lower profit margin. 
  5. Book value means that if a company has gone bankrupt and has met its liabilities, then how much money is left with it? 
  6. Book value is usually expressed in terms of per share.
  7. The price-to-book value ratio tells how many times the company’s shares are selling at their book value. 
  8. EPS measures a company’s earnings on a per-share basis. 
  9. The P/E ratio indicates the price per share market players are willing to pay for the company’s profits. 
  10. While looking at the P/E ratio, one should keep an eye on the possibility of a change in profits.
  11. The valuation of the stock market index can also be measured by P/E, P/B, or dividend yield ratio. 
  12. One should be careful while investing when the index is at a valuation of more than 22 times.
  13. 16 times the valuation of the index is very good to invest. 
  14. NSE puts the valuation of the index on its website every day.

Poonit Rathore

My name is Poonit Rathore. I am a Blogger, Content-writer, and Freelancer. Currently, I am pursuing my CMA final from ICAI. I live in India.

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