Stock Market for Beginners: Must know Financial Ratios Before Investing in a Stock | CA Aleena Rais

Summary

In this informative video, Chartered Accountant Aleena Rais enlightens viewers on six crucial financial ratios for evaluating a company's performance. She explains Earnings per Share (EPS), Price to Earnings (P/E), Debt to Equity, Return on Equity (ROE), Price to Book (P/B), and Current Ratio, detailing their significance and how they can guide investment decisions. Aleena emphasizes the importance of comparing these ratios with industry standards and competitors for a comprehensive understanding of a company's financial health and potential for growth.

Takeaways

• 📈 Earnings Per Share (EPS) is a profitability ratio that measures a company's earnings per share and should show steady growth for a viable investment.
• 💰 The Price-to-Earnings (P/E) ratio indicates whether a share is expensive or cheap by comparing the share price to the EPS, with a high P/E suggesting investor confidence and potential for growth.
• 🏦 The Debt-to-Equity ratio represents the proportion of debt to equity in a company's financial structure, with an ideal balance being around 1:1 to 1.7.
• 🧘‍♂️ Return on Equity (ROE) shows the profit delivered to shareholders as a percentage, highlighting a company's efficiency in using its resources.
• 📚 The Price-to-Book (P/B) ratio compares a firm's market value to its book value, helping to determine if a company's shares are over or undervalued.
• 🔄 ROE and P/B ratios should be considered together; a discrepancy between the two can signal potential issues with a company's profitability or valuation.
• 🤔 Investors should compare financial ratios with industry averages and competitors to assess a company's performance and investment potential.
• 💡 EPS is essential for calculating the P/E ratio and provides insight into a company's profitability and investor sentiment.
• 💼 Equity shareholders are the actual owners of a company and receive dividends only when the company is profitable, unlike preference shareholders with fixed returns.
• 💡 The Current Ratio measures a company's short-term liquidity and ability to pay off current liabilities, with a range of 1.5 to 2 considered appropriate.
• 📊 Financial ratios are interconnected and should be analyzed collectively to form a comprehensive understanding of a company's financial health and investment potential.

Q & A

What is the main topic of the video presented by Aleena Rais?

The main topic of the video is the explanation of 6 key financial ratios that investors should consider when investing in stocks.

What does EPS stand for and what does it represent?

EPS stands for Earnings Per Share, and it represents the earnings of a company attributable to each share held by equity shareholders, excluding the effects of extraordinary items.

Why is it important to compare a company's EPS with its competitors?

Comparing a company's EPS with its competitors helps to determine if the investment in the company is profitable or not, as it provides a relative measure of the company's profitability.

What is the formula for calculating the P/E ratio?

The P/E ratio is calculated by dividing the market price of one share by the EPS (Earnings Per Share) of the company.

How does a high P/E ratio reflect on a company's stock?

A high P/E ratio indicates that the company's stock is expensive or overvalued, but it also reflects investor confidence in the company's future growth and performance.

What does the Debt-Equity ratio measure?

The Debt-Equity ratio measures the proportion of debt (outsider's money) to equity (shareholder's money) in a company's financial structure.

Why is a rising Debt-Equity ratio considered a negative indicator for a company?

A rising Debt-Equity ratio indicates that the company is increasingly relying on debt to finance its operations, which could lead to financial instability and bankruptcy if the company is unable to repay its loans.

What is the difference between EPS and ROE?

EPS (Earnings Per Share) is the profit per share and is calculated on a per-share basis, while ROE (Return on Equity) is the percentage of profit relative to the total equity, showing how efficiently a company uses its equity to generate profit.

What does the Price to Book value ratio indicate about a company's stock valuation?

The Price to Book value ratio indicates whether a company's stock is overvalued or undervalued by comparing its market value to its book value per share.

How is the Current Ratio useful for assessing a company's short-term financial health?

The Current Ratio, calculated by dividing current assets by current liabilities, is useful for assessing a company's ability to pay off its short-term debts and meet its immediate financial obligations.

What should an investor consider when evaluating a company's financial ratios?

An investor should consider the company's ratios in comparison to industry averages and competitors, as well as the overall trend and stability of these ratios over time, to make informed investment decisions.

Outlines

00:00

📈 Introduction to Stock Investment Ratios

In this introductory segment, Jagdeep Singh welcomes viewers to Groww Originals, a platform for insightful investment sessions. Aleena Rais, a top Chartered Accountant and finance tutor, is introduced to discuss six key financial ratios for evaluating a company's performance. Aleena begins with a personal introduction, outlining her experience in finance and tutoring, before diving into the first ratio, Earnings Per Share (EPS), which measures a company's profitability per share after excluding non-recurring items. She emphasizes the importance of steady EPS growth and comparing it with industry standards and competitors to assess investment viability.

05:12

💰 Understanding the Price-Earnings Ratio

Aleena explains the Price-Earnings (P/E) ratio, which indicates whether a company's shares are overvalued or undervalued. The P/E ratio is calculated by dividing the market price per share by the Earnings Per Share (EPS). A high P/E ratio suggests investor confidence in the company's future growth, despite a higher share price relative to earnings. Conversely, a low P/E ratio may indicate undervaluation. Aleena advises comparing the P/E ratio with industry averages and competitors to make informed investment decisions, highlighting the importance of investor sentiment and company reputation.

10:19

🏦 The Debt-Equity Ratio: Leverage and Financial Stability

The Debt-Equity ratio is explored as a measure of a company's financial leverage, comparing the money borrowed (debt) to the money invested by shareholders (equity). Aleena discusses the ideal 1:1 ratio and the implications of deviations from this benchmark. A high debt-equity ratio may signal financial risk due to excessive borrowing, while a low ratio could indicate poor creditworthiness or diluted shareholder returns due to an increasing number of shares. Aleena emphasizes the need to maintain a sustainable debt-equity ratio and compare it with industry standards to assess a company's financial health.

15:30

🔄 Return on Equity: Gauging Shareholder Returns

Return on Equity (ROE) is introduced as a percentage measure of the profit a company delivers to its shareholders relative to the total equity. Aleena illustrates the concept using a comparison between two companies with the same profit but different equity share capital, highlighting how ROE can affect investment decisions. A higher ROE indicates a company's efficiency in using shareholder resources to generate profit. Aleena advises investors to consider ROE alongside other financial ratios for a comprehensive understanding of a company's performance.

20:37

📊 Price to Book Value Ratio: Assessing Share Valuation

Aleena discusses the Price to Book Value (P/B) ratio, which compares a firm's market value to its book value per share. The P/B ratio is calculated by dividing the company's market value by the net assets per share. A high P/B ratio may suggest the company's shares are overvalued, while a low ratio could indicate undervaluation. Aleena explains the importance of comparing the P/B ratio with industry averages and competitors, and also warns of potential red flags when the P/B ratio moves in opposition to the Return on Equity (ROE), indicating a disconnect between profitability and market valuation.

💼 Current Ratio: Measuring Short-Term Liquidity

The Current Ratio is presented as a measure of a company's ability to meet its short-term liabilities with its current assets. Aleena explains that an ideal current ratio ranges between 1.5 and 2, indicating that the company has sufficient liquid assets to cover its short-term debts. She notes that while the current ratio is important for assessing a company's immediate financial health, it should not be the sole determinant for investment decisions, as it does not account for long-term financial stability. Aleena encourages investors to consider the current ratio alongside other financial metrics for a well-rounded evaluation.

Keywords

💡Earnings per Share (EPS)

EPS is a financial metric that represents the portion of a company's profit allocated to each outstanding share of common stock. It is calculated by dividing the company's net income minus any preferred dividends by the number of common shares outstanding. In the video, EPS is introduced as a profitability ratio that indicates the earnings of a company on a per-share basis, which is crucial for investors to evaluate the financial performance of a company. For instance, a steady growth in EPS is considered a positive sign for potential investors.

💡Price-Earnings Ratio (P/E Ratio)

The P/E Ratio is a valuation ratio of a company's current share price compared to its per-share earnings. It is calculated as market value per share divided by earnings per share (EPS). This ratio is used by investors to determine whether a company's stock is overvalued or undervalued. In the video, a high P/E ratio indicates strong investor sentiment and confidence in the company's future growth, while a low P/E ratio might suggest that the stock is undervalued.

💡Debt-Equity Ratio

The Debt-Equity Ratio is a financial leverage ratio that measures a company's financial structure by comparing its total debt to its total equity. It is calculated as total liabilities divided by total shareholders' equity. This ratio helps investors understand how much debt a company is using to finance its assets compared to the equity provided by shareholders. In the video, a sustainable debt-equity ratio around 1:1 to 1.7:1 is suggested as appropriate, indicating a balance between debt and equity financing.

💡Return on Equity (ROE)

ROE is a profitability ratio that measures the amount of net income returned as a percentage of shareholders' equity. It is calculated by dividing a company's net income by the total amount of its shareholders' equity. ROE reflects the efficiency with which a company generates profit from its equity investments. In the video, ROE is used to compare the profitability of different companies and is highlighted as an important metric for investors to consider.

💡Price to Book Value Ratio (P/B Ratio)

The P/B Ratio is a valuation ratio calculated as a company's market value divided by its book value per share. It indicates whether a company's shares are overvalued or undervalued. In the video, the P/B ratio is discussed in the context of understanding a company's market value relative to its net assets, and it is suggested to be read in conjunction with ROE for a more comprehensive analysis.

💡Current Ratio

The Current Ratio is a liquidity ratio that measures a company's ability to pay short-term obligations. It is calculated by dividing current assets by current liabilities. A current ratio of 1.5 to 2 is generally considered acceptable, indicating that the company has enough short-term assets to cover its short-term liabilities. In the video, the current ratio is emphasized as an important metric for assessing a company's short-term financial health.

💡Profitability

Profitability refers to a company's ability to generate income (profit) from its business operations. It is a key aspect that investors consider when evaluating a company's financial performance. In the video, profitability is discussed in the context of EPS and ROE, which are both profitability ratios that provide insights into a company's earning capacity and efficiency in using its equity.

💡Leverage

Leverage, in financial terms, refers to the use of borrowed money to increase the potential return of an investment. It is associated with the risk of loss as well. In the video, leverage is discussed in relation to the Debt-Equity Ratio, which indicates the proportion of debt used by a company to finance its assets, reflecting the company's financial risk and potential for return on investment.

💡Turnover

Turnover in finance refers to the rate at which investments are bought and sold by an investor or the rate at which a company's assets are converted into cash. While not explicitly defined in the video, the concept of turnover is implicitly tied to the discussion of ratios that measure a company's efficiency in using its assets and managing its finances.

💡Equity Shareholders

Equity shareholders are the owners of a company who hold common stock and have voting rights. They are entitled to receive dividends if the company is profitable. In the video, the distinction between equity and preference shareholders is made, highlighting that equity shareholders are the actual owners of the company and their returns are tied to the company's performance.

💡Comparison with Competitors and Industry Average

Throughout the video, the importance of comparing a company's financial ratios with those of its competitors and the industry average is emphasized. This comparative analysis helps investors understand a company's relative performance and standing in the market. It provides a benchmark to evaluate whether a company's financial metrics are in line with industry standards or if they present a unique opportunity or risk.

Highlights

Introduction to Groww Originals and the purpose of insightful sessions for intelligent investing.

Aleena Rais, a top Chartered Accountant and finance tutor, discusses six key financial ratios for stock investment.

Explanation of Earnings Per Share (EPS) as a measure of company profitability for equity shareholders.

Importance of steady EPS growth and its comparison with industry peers for investment evaluation.

The Price-to-Earnings (P/E) ratio as an indicator of a stock's valuation relative to its earnings.

High P/E ratios reflecting investor confidence and expectations of future growth.

Debt-Equity ratio analysis to understand the financial leverage and risk of a company.

The ideal Debt-Equity ratio and its implications on a company's financial health.

Return on Equity (ROE) as a measure of how efficiently a company uses shareholder equity to generate profit.

Difference between EPS and ROE in evaluating a company's performance and profitability.

Price to Book value ratio as an indicator of whether a company's shares are over or undervalued.

Interpretation of the P/B ratio in conjunction with ROE for a comprehensive company valuation.

Current Ratio as a measure of a company's short-term liquidity to meet its liabilities.

The significance of a Current Ratio between 1.5 and 2 for assessing a company's solvency.

The importance of considering multiple financial ratios for long-term investment decisions.

Invitation for viewers to share their thoughts, favorite ratios, and topics for future videos.

Closing remarks and a reminder to engage with the community for further investment insights.

Transcripts

Hey friends! I, Jagdeep Singh, welcome you to Groww originals.

As you know that in Groww originals, we bring guests for insightful sessions. These sessions can help you in becoming an intelligent investor.

Following this, we have brought Aleena, who will talk about the 6 ratios that need attention while investing in a stock. Aleena is among the top ten CA tutors in the country.

Let's quickly move to Aleena, who will talk about the 6 ratios that need attention while investing in a stock.

Hello, everyone! My name is Aleena Rais. Today I will be talking about 6 ratios and their importance for knowing a company's performance.

It is highly essential to know that every ratio talks about different aspects like profitability, leverage, turnover, etc. Separate kinds of categories are there for different ratios.

Let's get into the first one that I have for you. Before we get into that, let me tell you about myself.

I am a Chartered Accountant, and I have been a part of this industry for a long time. I also worked for finance roles, and now I am a tutor.

So let's speedily start today's video with the first ratio- EPS. Earnings per Share(EPS) depicts the earning of a company on a share.

This ratio is calculated for equity shareholders. I assume that you know the difference between equity and preference shareholders.

If you don't know this, then let me give you a brief idea of this. Equity shareholders are the company's actual owners. While Preference shareholders have a fixed return every year.

Hence their dividend is payable by the company every year. Equity shareholders receive a dividend when there is a profit made by the company.

Otherwise, they are not paid dividends. EPS talks about the earnings of the company. The earning obtained after deducting extraordinary items from net income. These items are non-recurring gains or losses.

For instance, the sale of a building. The company does not run a business of selling buildings. The sale of a building is a non-recurring event.

The profits/losses of such items are subtracted/added to the net income.

This nullifies its effect. EPS is a profitability ratio. It is important to look into the quality of the EPS ratio to be steady. A company having fluctuations in EPS isn't a viable investment option.

The steady growth of EPS is quite important. Guessing this in absolutes is difficult. If I say the EPS of a company is 12, then this does not tell anything significant.

Hence the EPS of a company is compared with its fellow competitors. On comparison of the EPS with the fellow competitors, one knows whether an investment in the company is profitable or not.

This gives you an idea of investing in the company. EPS can be studied through comparison with competitors and industry average.

EPS is specifically used for calculating another ratio, which is the P/E ratio. It tells about an important characteristic of the company.

You calculate EPS and use it for another ratio. This is also an advantage of EPS.

I will now brief you about the calculation part. It is Net income+/- extraordinary items divided by weighted average common stock of the company.

You make the division from the outstanding shares. This shows you the profit for one share out of the total earnings of the company.

This is a simple formula. The calculation is done by finding Net income from P&L A/c and outstanding shares from the Balance sheet.

The next ratio is the P/E ratio, which is called the price-earning ratio. This informs whether the share is expensive or cheap.

I will elaborate on this. Its formula is the share price divided by EPS. In other words, the market price of one share is divided by the EPS of the company's share.

Let's say the P/E ratio is 3/2. This means that the share's market price is Rs.3, while the earning on one share is Rs.2.

This means that investors get Rs.2 as compared to the amount raised of Rs.3. You might be wondering that this share is expensive.

Nobody will like to do this. If your P/E ratio is high, it means that your share is expensive/overvalued.

If the P/E ratio is less, it means that the share is cheap. This shows that the company's share is undervalued.

This means that the company receives less from investors at the time of purchase than its earnings on the share.

Let's assume that the P/E ratio is 1/2. This means that the share value is Rs.1, and the company's earnings are Rs.2. Here you might feel that buying a low P/E ratio share is beneficial.

However, the opposite of this happens. If the P/E ratio is high, it speaks of great investor sentiments and the company's past overall performance.

It tells us that based on the company’s past performance, the reputation and the goodwill of the company have automatically risen. Even though the share is expensive, people still wish to buy it.

Here, the investors hope that the company will show growth and witness an increase in the future share value. This will then lead to an increase in their stock holding value.

P/E ratio shows the trust of the buyer in a company. The high the P/E ratio, the higher is the buyer's trust.

Hence a high P/E ratio is favorable for a company. This is one thing that must be clear to you.

Now let's learn how to study a P/E ratio. Just like the EPS ratio, the P/E ratio is also understood in comparison to the company's industry average.

If you want to study the P/E ratio of a company, then using the industry average is considered appropriate. Also, if you have enough time, you can compare it with the company's fellow competitors.

You might have understood this thing. Now, let's move to another ratio. The next ratio is the debt-equity ratio.

The formula for it is Debt/Equity. It talks about outsiders and insiders' money. Outsiders are the stakeholders that give loans to the company.

Debt is the long term borrowing of the company. While Equity is the shareholder's money invested in the business.

Interest and dividend are payable on debt and equity, respectively. This is the difference between the two.

A dividend is not a mandatory payment, while the interest paid on debt is surely one.

Post the formula, let's try to understand this ratio further. We will try to decipher the meaning of the Debt-equity ratio. I will take up an example of this.

Suppose that the debt-equity ratio of a company is 2:1. This means that Rs.2 is invested in the form of a loan, while Rs.1 for equity.

Let's comprehend the meaning of this. The ideal debt-equity ratio is 1:1. This means that Rs.1 is invested in the form of a loan, and Rs.1 for equity.

This is an ideal ratio. But you will never get to see an ideal ratio. Some fluctuations will surely be there.

There are some essential things to understand over here. The first thing is that a rising trend of Debt-Equity ratio means that the company is increasing its borrowing repeatedly. This is a dangerous situation.

This is a perplexing situation, as the recoverability of the loan is not known. The company might get bankrupt in the future if it is not able to settle its loans.

A rising debt-equity ratio is a negative indicator. It should not rise quite frequently. This must be clear to you.

Now let's move to another point. Both high and low Debt-Equity ratio is unfavorable.

A high debt-equity ratio means that there is an enormous burden on the company. This will act as a hindrance to obtaining future loans.

This is the issue with a high debt-equity ratio. A low debt-equity ratio is also unfavorable. It means that the company is not able to raise money from outsiders due to low creditworthiness.

Even if the company is taking up loans, the shareholder's base is increasing. The company earnings will automatically be divided into numerous people, which will decrease the earnings of shareholders.

The company will not be able to benefit from its increasing profits. Debt is quite cheap as compared to Equity.

This means that the company is not able to take benefit from increasing profits and financial leverage. This means that the company is not able to raise cheap loans from the market.

The company is raising high money, which is equity. As a consequence of this debt-equity ratio is low. The company is not raising money from outside but is increasing its shareholders.

Instead of a high or low debt-equity ratio, a sustainable one around 1 and 1.7 would be appropriate for a company. I won't give you any absolute numbers.

You need to compare it with competitors and industry. This will give an idea of the company's debt-equity ratio and its performance.

The debt-equity ratio discusses the money raised by the company and its danger of going bankrupt in the future in case of high debt.

The next ratio is Return on Equity. It shows the profit earned and delivered by the company to its shareholders. Now you might be wondering the difference between EPS and ROE.

Under EPS, the basis for calculation is per share, while in the case of ROE, it is total shares. ROE is in percentage terms, while EPS is in absolute numbers.

But both are connected to each other. Let's first understand ROE.

The formula for ROE is the total profit of a company divided by the company's total equity.

Let's take the example of two companies. Profit figures solely cannot tell whether a company is performing well or not.

You can comprehend a company's performance when the distribution among the shareholders is known.

Suppose that company A and B earn Rs.10 crores of profit. Can we find the amount earned by the shareholders? No.

We can find this when we know the number of people investing in the company or equity share capital. Let the equity share capital of company A and company B be Rs.100 crores and Rs.1000 crores, respectively.

The profits of both of the companies were equal at Rs.10 crores. But the equity share capital of company A and company B is Rs.100 crores and Rs.1000 crores, respectively.

This means that the same Rs.10 crores are distributed to many people in company B compared to company A.

Now you tell me where you will like to invest? Obviously, you will want to be a part of company A.

How did you determine this? Divide 10 by 100 and multiply it with 100; you will get the percentage. Whenever you want to calculate a percentage, multiply by 100.

This is what I did. 10 divided by 100 multiplied by 100 gives 10%.

Now let's come to company B. 10/1000 multiplied by 100 gives 1%. This means that company A gives 10% ROE, while company B gives it at 1%.

Hence you will want to invest in company A as it has a high ROE of 10%. This ratio briefly tells about the profitability of the company and its efficiency in using the resources.

The next ratio is the Price to Book value ratio. This is quite interesting. It informs whether the share of a company is over/undervalued or not.

I spoke about this thing before. But over here, I have something else to share. Let's first understand its formula.

Price to Book value ratio informs about the company's market value divided by the book value per share.

This is the formula of the P/B ratio. Now I will be telling you about net assets and its calculation.

Net assets are total assets minus total liabilities. Suppose that company's total assets and liabilities are Rs.5 lakh and Rs.4 lakh, respectively. This means Rs.5 lakh minus Rs.4 lakhs gives Rs 1 lakh- the net assets.

Now you need to divide net assets by the total number of shares. Suppose the total shares to be 1000. Rs.1 Lakh divided by 1000 gives out 100 as the P/B ratio.

You will not be able to comprehend anything solely with a number. I have told you this as a thumb rule.

You need to compare the ratio with the company's competitors and the industry average. With these comparisons, you will make out the performance of the company.

One special thing over here is that the P/B ratio is read along with ROE. ROE is the return on equity that was discussed a while ago.

If both ROE and P/B ratio is increasing together, then it is perfectly fine. But if one is low, while the other is rising, it is like a red flag.

This means that there is something fishy as a low ROE means that the company is not profitable. P/B ratio tells that if the company is sold today, the liabilities will be paid first out of total assets.

Out of Rs.5 lakh, Rs.4 lakh will be paid; the remaining Rs.1 lakh will be among the shareholders that were equal to Rs.100 in our example.

P/B ratio explains the company's share value and the amount receivable one the company is sold today.

It means that if the ROE is falling, i.e., it is incurring losses or low profits. Now, when the P/B ratio is rising, it means that the valuation. Valuation is directly related to profitability.

When profitability is falling and valuation is rising, it means that something is wrong. Both must increase or decrease together.

However, in the case of both decreasing, you might not want to invest. In cases where you find one of the ratios falling while a rise in other, you can refer to previous quarters' trends to make a decision.

Briefly, the P/B ratio tells that if the company is sold today, then what will be the shareholders' amount receivable.

P/B ratio is a valuation ratio. Our next and last ratio is the Current Ratio.

The current ratio is a short and simple ratio which tells about a company's short term liquidity.

By studying the current ratio, you can understand whether a company can pay and cater to its liabilities.

It tells about the company's short term liquidity. Its formula is current assets divided by current liabilities.

It is difficult to tell an appropriate current ratio as these numbers vary from one company/industry to another.

But I would still give you a number which is between 1.5 and 2. This range is considered appropriate.

If the current ratio is 2, it means that for Rs.2 current assets, the current liabilities are Rs.1.

Here we are talking of short term current assets and liability. For Rs.2 current assets, the current liabilities are Rs.1.

This means that I have enough to pay Rs.1 as against Rs.2. Nobody will bother the company for the liabilities due.

The current ratio notifies whether the company has adequate cash in its pocket or not.

However, the Current Ratio is not the sole ratio to form your major decisions. You need to consider other ratios as well because the Current ratio deals with only short-term concerns.

If you need to make long term decisions, then other important ratios need to be considered as told before.

But still, you can pay heed to the Current ratio. It will let you know if a company has great cash in its pocket and a remarkable financial condition or not.

Also, it explains that the company doesn't take such operations, which could give it issues in the short term.

So these were the 6 ratios from my side. I hope this video was an enriching session for you. I thoroughly enjoyed making the video.

If you liked today's video, then please put your views in the comment section. I would love to hear from you. Hope to see you again.

Take care of yourself. Bye

ThanksAleena, for such an insightful session. I hope that you might have learned from her session.

If you liked today's video, then like it and comment below your favorite ratio while investing.

Also, comment on the topics on which you want us to make a video. You can comment #AskGroww in case of any doubts; these doubts will be answered in coming videos.

Happy investing!