Buying Stocks (value investing) using financial ratio : Profitibility Analysis

Return On Capital Employed (ROCE):

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ROCE measurement is more comprehensive profitability indicator because it measures management's ability to generate earnings from a company's total pool of capital. As a general thumb rule, ROCE should be greater than company's average borrowing rate to remain profitable.

Return On Equity:

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ROE ratio is an important measure of a company's earnings performance. The ROE tells common shareholders how effectively their money is being employed.  In general return on equity ratios in the 15-20% range as representing attractive levels of investment quality.

While highly regarded as a profitability indicator it does not throw light on the  disproportionate amount of debt in a company's capital structure that could translate into a smaller equity base. Thus, a small amount of net income (the numerator could still produce a high ROE off a modest equity base).


ROE must be used as a complimentary to ROCE to determine profitability. 

Profit Margin Analysis:

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Gross Profit Margin 
Total revenue from goods sold - total expense in production 


Operating Profit Margin
Gross Profit Margin - Operating Expenses (General administrative cost)

Net Profit Margin 
Simply as a company's profit margin. It is calculated after paying tax. companies use a variety of techniques to manipulate this, so, Operating Profit Margin must be used to compliment it.

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Buying Stocks (value investing) using financial ratio : Debt Analysis

Debt-Equity Ratio  & Debt Ratio :

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The debt-equity ratio provides company's leverage position by comparing total liabilities to shareholders' equity where as debt-ratio compares a company's total debt to its total assets,. A lower percentage means that a company is using less leverage and has a stronger equity position.

The debt-equity ratio is one of the most frequently used term in investment literature. This simple ratio provides a general indication of a company's equity-liability relationship and is helpful to investors looking for a quick take on a company's leverage. Generally, large, well-established companies can push the liability component of their balance sheet structure to higher percentages without getting into trouble.

The debt-equity ratio percentage can give  dramatic perspective on a company's leverage position than the debt ratio percentage. For example, Company A's debt ratio of 70% seems less onerous than its debt-equity ratio of 210%, which means that creditors have more than twice as much money in the company than equity holders. 

 

If the company manages to generate returns above their cost of capital, investors will benefit. However company can be easily hurt by this leverage if it is unable to generate returns above the cost of capital. Basically, any gains or losses are magnified by the use of leverage in the company's capital structure as leverage is a two edge sword.

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Capitalization Ratio :

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This ratio measures the debt component of a company's capital structure.

Long-term debt is divided by the sum of long-term debt and shareholders' equity. This ratio is considered to be one of the more meaningful of the "debt" ratios.

There is no right amount of debt. Leverage varies according to industries, line of business and its stage of development. However low debt and high equity levels in the capitalization ratio indicate investment quality.

Company's capitalization (not the market capitalization which equals No of free-float share multiplied by share price) is used to describe the composition of a company's long-term capital, which consists of both long-term debt and shareholders' equity. A low level of debt and a healthy proportion of equity in a company's capital structure is an indication of good financial health.

A highly leveraged company(high percentage of debt in caitalization) may find :

a) freedom of action restricted by its creditors 

b) have its profitability hurt by high interest costs 

c) Worst of all scenarios is having trouble meeting operating and debt               liabilities on time 

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Buying Stocks (value investing) using financial ratio : Valuation Analysis -1

P/E Ratio
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P/E Ratio = Price of share/ Earning per share (annual) of the audited result

For example, if a company is currently trading at $45 a share and earnings over the last 12 months were $2.25 per share, the P/E ratio for the stock would be 20.00 ($45/$2.25).

EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E). A third variation uses the sum of the last two actual quarters and the estimates of the next two quarters.

In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.

The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 ($45 for $2.25) of  current earnings.

It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone. The denominator (earnings) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number.
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Price/Book value :

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The book value of a company is an estimation of the value per share if it were to be liquidated. How much value can an investor get per share if all the assets is liquidated.
The price/book value ratio, often expressed simply as "price-to-book", provides investors a way to compare the market value, or what they are paying for each share, to a conservative measure of the value of the firm.

Formula:




If a company's share price is lower than its book value, it can indicate one of two possibilities. 
1.) The first scenario is that the stock is being undervalued by investors because of some transitory circumstance and represents an attractive buying opportunity at a bargain price. It is assumed that the company's fundamentals are intact and will eventually lift it to a much higher price level.

2.) On the other hand, if the market's low opinion and valuation of the company are correct, it will be perceived at its worst as a losing proposition and at its best as being a stagnant investment.
 
pitfalls

1.) Generally company's assets are recorded at historical cost that its book value is outdated so of limited use.
2.) Intellectual property particularly is difficult to assess in terms of value. Book value may well grossly undervalue these kinds of assets, both tangible and intangible.
The P/B ratio therefore has its shortcomings but is still widely used as a valuation metric. It is probably more relevant for use by investors looking at capital-intensive or finance-related businesses, such as banks.
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Purchase stock for long term using "Nifty P/E ratio"

Statistical Features:

S.Quantity		P/E		P/B		Div.Y
Max		28.47		6.55		3.18
Min		10.68		1.92		0.59
SD		3.8		0.98		0.5
P95		24.92		5.42		2.48
P75		21.06		4.34		1.8
P25		14.89		292		1.09
Mean		18.3		3.7		1.485

The approximated linear fit for the P/E ratio has been drawn on the P/E graph. The linear equation for the above drawn line is:

                                       Y=A+BX, Err(A)=127,  Err(B)=5.2E-5

                                       Y= -1850+0.000762 X

A positive sloping Linear fit for P/E  translate into a rising P/E of Nifty over the year. The slope translate into increase in P/E  to a vale of (0.000762 x 365  = 0.278) per year.

P75 (75 percentile ) of 21.06  of P/E means 25% of time nifty-P/E ratio is above 21.06 and with average value of P/E at 18.3 it is good to go for value investing at 18-20 level or below (with current value ~20.3 can be said a good entry level)

Other important point to be taken from the chart is converging and diverging charts of P/B and Div. Yield of Nifty. A converging charts (at bottom) leads to fall in P/E value which generally leads to fall in Nifty and opposite happens when charts diverge.

As of now (25 Feb 2011) the P/E value approximately is touching the linear fit line. so Below this line buying can be said as value investing.

P/E is a lagging indicator. The denominator is earning-per-share of last audited result.Most quarterly result comes unaudited so generally annual result is taken that's why its value changes over a period of time. Its historical value can be used to make an informed and on time decision about entry and exit for long term investing in stock market.

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