Since the beginning of the month, the Indian stock market has been reaching new highs on a daily basis. This could lead to one getting tempted to invest in stocks.
To navigate this market safely, it’s important that you consider these four matrices so that you can ride the wave of success.
Billionaire venture capitalist and investor Warren Buffett had famously said, “Be fearful when others are greedy and greedy when others are fearful.” This means that during market slowdowns, rather than refraining from investing, it can be wise to pick stocks with good fundamentals. But to do that, one must have a solid understanding of the key metrics.
These metrics can help you evaluate a company’s performance and help you make informed investment decisions.
The PE ratio, or price-to-earnings ratio, is calculated by dividing a company’s current stock price by its earnings per share (EPS).
Current stock price is available on the website of the stock exchange, whereas EPS can be calculated by dividing the company’s net income by its total number of outstanding shares.
Let’s say the price of one share is Rs. 1,500 and EPS is Rs. 60. In that case, the PE ratio would be 1,500 divided by 60, or 25. Compare this with stocks from the same sector. It will help you determine if a stock is undervalued or overvalued based on its current earnings.
The PE ratio only considers historical aspects of a company and not its future growth. Thus it is useful for comparing companies within the same industry because different industries have different growth rates.
The PEG ratio, or price/earnings to growth (PEG) ratio provides a more complete picture of a stock’s value by considering both its PE ratio and projected earnings growth rate. For example, if a company has a PE ratio of 15 and an expected earnings growth rate of 10 per cent, its PEG ratio would be 1.5 (15/10).
Typically, a PEG ratio of less than 1 suggests that a stock may be undervalued, while a ratio greater than 1 may indicate overvaluation. This metric is especially beneficial when comparing companies with different growth rates or in different industries.
RETURN ON EQUITY (ROE)
Return on Equity (ROE) measures the profitability and efficiency of a company by calculating the net profit generated for shareholders relative to its equity. It reflects how well a company utilises its profits for reinvestment.
ROE is equal to net profit/net worth (Equity). A company’s net worth, includes equity capital and free reserves generated from profits. Free reserves are the remaining profits after dividends are paid to shareholders, which is ploughed back into the company.
Here it should be noted that capital-intensive businesses like energy industry, may have lower ROEs because they have to plough back more money back into business. Less capital-intensive businesses, like FMCG companies, tend to have higher ROEs.
RETURN ON CAPITAL EMPLOYED (ROCE)
This evaluates how efficiently a company uses its available capital, including both equity and long-term debt.
ROCE is equal to earnings before interest and tax (Ebit)/capital employed.
Ebit represents the earnings generated by a company solely from its operations, excluding interest expenses and taxes. It is calculated by deducting the cost of goods sold (COGS) and operating expenses from the total revenues. Capital employed is current liabilities less total assets, which gives the shareholders’ equity plus long-term debts.
Thus, this ratio considers the earnings generated from a business’ operations alone, without considering interest on debt or taxes.
It’s important to note that one shouldn’t rely on just a single metric. Employing multiple metrics based on the specific situation can help one in selecting stocks wisely for long-term investment. By considering these key metrics, one can enhance one’s ability to navigate the stock market and work towards one’s financial objectives. The key fundamental is to always remain invested in equity for the long term and not get swayed by the market momentum.