Have you felt confused by the amount of advice and recommendations that experts provide? You are not alone… many investors face this problem. Most of us are baffled with information overload regarding stocks from the TV, the Internet, newspapers, and business magazines. The best way to get clarity is to reduce the noise and focus on the important criteria or metrics that help one to evaluate and choose the right stocks. This article discusses how to gain such clarity.
Need for Investment Metrics
A few people have asked me how to identify stocks and insist that I share the secret formula or method. I can understand their curiosity and I’ve asked the same question of numerous people several years ago. Frankly, I tell them that I have no magic formula and admit that my estimates can be wrong. No single formula or a guru mantra exists that will work perfectly to generate 25– 30% every year. Why? Simple investing involves a mix of science and art, subjective and objective factors, current as well as future trends, and so on.
Like any art, it gets better with practice. In this article, we focus on the science part; i.e., the ratios or metrics that tell us how good a company is on specific parameters.
Let’s now go to the interesting part of understanding these metrics and how they are useful in practical situations. Remember, these are not the only indicators but just a few key metrics that help one evaluate stocks in which one may want to invest.
Key Investment Metrics
Many investors may feel that profit margins are secret or hidden information. However, most public companies publish this information on financial websites and these data are covered in research reports, allowing even a small investor to gain access to this metric.
How are profit margins calculated? Profit margins are equal to profit divided by sales. Certain variants exist, such as gross profit/sales (gross margin) or net profit/sales (net profit margin).
Gross Margins and Net Profit Margins
Stable or increasing margins are a sign that the company is able to price its product effectively to earn profits. In contrast, low margins can be a cause for concern. Low margins caused by short-term problems are not necessarily an issue, but if the company is consistently performing badly, then a serious issue exists on the cost front or from the inability of a company to command good prices for its products and services in the market. When comparing two or more companies, companies with higher margins clearly stand out as better stock picks.
Earnings Per Share
Earnings per share equals net profits/earnings after tax divided by the number of equity shares issued and outstanding. This ration is also available in a company’s annual or quarterly results.
If a company earns Rs.100 crores in profits and has 1 crore shares issued and outstanding, its earnings per share is Rs.100 (100 crores divided by 1 crore). Out of this, if a dividend declared and paid is Rs.30 per share, then the remaining Rs.70 (100–30) is retained as reserves for the company’s future growth or expansion. Companies have to maintain a balance between dividend and retained earnings, which is why most companies choose to retain some earnings for future needs. Larger blue chips pay dividends in addition to maintaining a good amount of reserves for future growth; however, small- or mid-sized companies with a smaller balance sheet have to make a trade-off between dividend and growth.
Earnings per share for Company ABC of Rs.20, Rs,24, and Rs.30 for the financial years 2010, 2011, and 2012, clearly show an upward trend (approximately 20% growth p.a.). If analysts are expecting earnings per share of Rs.38 in FY2013, you can see a positive growth trajectory in the future as well, making the stock attractive. However, if the forecasted EPS for FY2013 is revised downward to Rs.32, then growth expectations are slowing and the stock should be closely examined.
A dividend represents the share of the profits of a company that are paid to shareholders, and dividend per share is smaller than the market price of a share. For example, ITC (trading at Rs.268) declared a dividend of Rs.4.5 per share, or 450% of its face value of Rs.10. Do you think that dividend is a good deal? It isn’t because the dividend yield is only 1.7%, or dividend yield = dividend per share/market price per share = 4.5/268 = 1.7%
The dividend yield cannot be the sole criteria for making an investment. However, for long-term investors, dividend yield and dividend income can become significant.
For instance, if you purchased ITC last year at Rs.200, your dividend yield is 4.5/200 = 2.25%, an increase from 1.7% during a year. This example shows how your yield gradually rises overtime and may even touch 5% or 6% after several years. Although not a big deal, the increase is significant because you are getting the additional yield over and above any stock price appreciation. Therefore, you receive both a 2.25% dividend yield for ITC and a capital appreciation of Rs.68 (Rs.268–Rs.200), which is approximately 34%. Your total return is a whopping 36%. Please remember, past performance may not always be an indicator of future performance.
The debt-to-equity ratio is a simple ratio that looks at the relative level of debt and equity used by a company when financing its business operations. Debt refers to funds borrowed from external sources, whereas equity refers to the owner’s (or shareholders’) own capital. A high debt-to-equity ratio indicates that the company is using too much of debt, or borrowed funds, a situation also known as high leverage. Generally, a lower debt-to-equity ratio is favorable and preferred by investors.
For example, take two companies, Company A and Company B. Company A has debt of Rs.100 crores and equity of Rs.150 crores, meaning that debt-to-equity ratio is 100/150, or approximately 0.66x (i.e., debt is 0.66 times equity). In contrast, Company B has debt of Rs.200 crores and equity of just Rs.100 crores, then Company B’s debt-to-equity is 2.0x (i.e., debt is 2.0 times equity). Hence, it is apparent that Company B with debt-to-equity of 2.0x is more highly leveraged than Company A.
Leverage significantly affects investors because during a slowing economy, Company B will be more vulnerable because it not only earns lower profits but also finds most of its profits going to pay its interest. However, Company A still thrives because it is able to limit interest costs and its debt burden, keeping the business engine running smoothly. For example, companies in real estate and infrastructure, which are over-dependent on debt financing, face this issue.
Return on Capital Employed (ROCE)
ROCE = Operating Profit/Capital Employed
Operating profit is profit before interest, taxes, depreciation, and exceptional items. Capital employed represents the total capital of the company, which includes equity/shareholder’s funds and debt holder’s funds. This ratio indicates the return on capital employed in the company through equity and debt financing.
This ratio is not only useful for shareholders but also for those who invest in the bonds/debentures/fixed deposits of a company. Assume that your company invests Rs.100 crores in its business and is able to generate earnings (before interest and taxes) of Rs.15 crores. Therefore, it is able to generate a 15% return on capital employed. However, if most companies in the same industry generate an average of 25% ROCE, then performance is likely not in line with industry standards. You can choose another company that delivers better returns.
Return on Shareholders’ Funds/Return on Net Worth (RONW)
RONW = Net Profit/Net Worth
Net profit is the residual profit remaining in the company after all expenses and taxes are paid, which results in the returns earned by an equity shareholder on his investment. Net worth is the difference between total assets and total liabilities, or can be interpreted as shareholder’s funds.
For example, if Company X is generating a net profit of Rs.20 crores and has a net worth of Rs.120 crores, the return on net worth is (20/120), or 16.67%. However, if Company Y in the same industry has profits of Rs.50 crores over its net worth of Rs.200 crores, the returns on net worth for Company Y is (50/200) or 25%. Therefore, Company Y has a higher net worth of 25%, and is the better choice.
Price/Earnings Ratio (PE ratio) or Earnings Yield
The PE ratio or PE multiple is one of the most common metrics used by analysts. A low PE ratio is generally favored, or indicates that a stock price is cheaper, other factors constant.
PE Multiple = Market Price of a Stock/Earnings per Share
The PE multiple is used to compare price and earnings on the same platform, or to make an apples-to-apples comparison. However, it only tells you a small part of the story. One has to look at other ratios and get different perspectives before taking a final decision.
For instance, TVS Motor Co. has a PE multiple of 8.9x whereas Hero MotoCorp has a PE ratio of 14.9x. In this case, I’m paying 8.9 times earnings for TVS and 14.9 times earnings for Hero MotoCorp. Therefore, the PE multiple makes TVS look significantly cheaper than Hero MotoCorp. However, remember that the PE multiple is just one metric used to make a decision.
Book value represents the net worth of the company. Price-to-book value can be computed as below
Price-to-Book Value = Market price of a Stock/Book Value per Share
Book Value per Share = Total Shareholders’ Funds/Number of Equity Shares Issued
Book value refers to the net worth or total shareholder’s funds. Book value per share is the bare minimum value that a company can command. It is historical in nature and, as the company grows, its market value typically becomes significantly higher than its book value. However, book value may be a good indicator that a stock is cheap if it is close in value to a company’s market value. Price-to-book is useful when evaluating banking and financial stocks.
For example, Yes Bank trades at a price-to-book value of 2.6 times, compared with Kotak Mahindra Bank’s PB of 5.4 times and Indusind Bank’s PB of 3.4 times. Hence, Yes Bank stock at 2.6 times its book value is cheaper than Kotak Mahindra Bank and Indusind Bank.
However, this ratio has a one-sided story; therefore, we must look at other metrics such as the PE multiple and ROCE to evaluate the stock in a holistic manner. A comparative analysis such as this will help you select the right stocks based on investment rationale, instead of relying on guesswork.
All said and done, picking stocks for your portfolio involves intelligent decision making, which is a combination of quantitative metrics and an understanding of the business of the company, its management, its products, and brands. Legendary investors such as Warren Buffet take a lot of time to understand a company’s business, in addition to its financials, which includes qualitative factors such as management quality, value of brands, market share/leadership, and others. If the business model is not strong, you must exclude such companies from your shortlist. Do not spend time researching these companies; instead, if your shortlist contains a set of large blue- chip companies, your chances of going wrong and your margin of error are smaller because you are betting on reputed names and brands with a track record.
As previously noted, these metrics are not a magic formula, but are key indicators that tell you where a company is heading (just like the dashboard on your car or an aircraft cockpit). In addition to reading metrics, you also need to do your research and put yourself in the driver’s seat to provide the right direction for your portfolio. If you take this initiative, you will certainly be able to build a million rupee portfolio one day, and later a million dollar portfolio in the long run.
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