Fundamental Ratios for Stock Analysis

Classroom

oi-Investment

By Investment

Published: Thursday, November 3, 2011, 17:02 [IST]

Every publicly listed company is bound by law to publish its financial statements quarterly and yearly. There are mainly three types of financial reports; income statement, balance sheet, and cash flow statement. These reports tell you about the health of the company.

While these numbers convey a good idea about the health if the company, these reports do not convey comprehensive information on their own. For example, if balance sheet of a company shows Rs 1000 crores as debt of the company, Is it high? Similarly, stocks of a company are selling at Rs 89. Is it cheap or expensive?

Fundamental Ratios
To answer the questions mentioned above, we have to look at the numbers “with respect to” another number. This relation is usually known as ratios.
All the data will still come from financial statements but the ratios present the data in such a way that investors get a better picture which helps them plan their investment. The number of ratios can be many but not all are equally important. We will look at some of the important ratios which will help us understand a company’s finances better and make right decision.

Note: The data for HUL and ITC has been taken from moneycontrol.

Earnings per share (EPS) –
EPS is an important concept that helps investors understand the earnings which should come to them if the company pays all the earnings to shareholders.
Let’s take two companies, Hindustan Unilever Limited (HUL) and ITC. The earnings of HUL and ITC for the year ending in March, 2011 are Rs 2,306 Crores and Rs 4,988 Crores respectively. If you go by just this data, you may go for ITC as it has larger earnings. But you have to also look at how this earning translates in terms of each share. If I have 10 shares of HUL and 10 shares of ITC, should I sell HUL and buy ITC more?

To answer this, we have to look at the number of shares outstanding for both the companies. Number of shares outstanding for HUL and ITC are 21,595 Crores and 77,381 Crores. If you divide the earnings with the number of shares, the EPS is 10.68 and 6.45 for HUL and ITC respectively. This means an HUL shareholder has notional claim over bigger sum.

Price Earnings Ratio (PE Ratio) –
If you read reports by analyst, PE ratio dominates almost every other ratio. PE ratio tells about the valuation of stock. A higher PE ratio expresses higher valuation. Unlike in the case of EPS, it is very difficult to say whether higher PE is good or bad.

A higher PE may be an indication that investors are expecting better growth while a lower PE may indicate that the company is in trouble. Let’s again take the example of HUL and ITC. The PE ratios are 30.51 and 28.54. The figures are very close. This may mean that market expects both of them to do very well and grow at higher rate in future.