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You are here : Moneycontrol» Wealth » Equity investing

8 key ratios while buying stocks


AbithaDeepak October 22, 2009
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LOOKING to buy stocks


but you are not sure
how to select them?
Don't fret. We have,
here, eight ratios that
would make your life
easier, and of course,
enable you to make the
best possible stock
selection.

1. Ploughback or
Reserves
Every year, the company divides its net profit (profits in hand after subtracting
various expenses including taxes) in two portions: ploughback and dividends.

While dividends are handed out to the shareholders, ploughback is kept by the
company for its future use and is included in its reserves. Ploughback is
essential because, besides boosting the company’s reserves, it is a source of
funds for the company’s expansion plans. Hence, if you are looking for a
company with good growth prospects, check its ploughback figures. Reserves
are also known as shareholders’ funds, since they belong to the shareholders.
If a company’s reserves are twice its equity capital, the company can reward
its shareholders with a generous bonus. Also any increase in reserves will

http://wealth.moneycontrol.com/yourstartupkit/equity-investing/8-key-ratios-while-buying-stocks-/14152/0 10/22/2009 1:12:13 PM


Moneycontrol || Wealth >> Equity investing >> 8 key ratios while buying stocks Page 2

push the share price of your share.

2. Book value per share


This ratio shows the worth of each share of a company as per the company's
accounting books. It is calculated as:
Shareholders' funds
------------------------------------------------ = Book Value per share
Total quantity of equity shares issued

Shareholders' funds can be computed as such:


Total assets (equity capital to the company's reserves) less total liabilities
(money owed to creditors).

Book value is an old record that uses the original purchase prices of the
assets.

However, it doesn't show the present market price of the company’s assets. As
a result, this ratio has a restricted use when it comes to estimating the market
price of the shares, but can give you an estimate of the minimum price of the
company’s shares. It will also help you judge if the share price is overpriced or
under-priced.

Also read: 4 golden rules of equity investing

3. Earnings per share (EPS)


One of the most popular investmentratios, it can be computed as:
Profit Post Tax
------------------------------------------------ = EPS
Total quantity of equity shares issued

This ratio computes the company's earnings on a per share basis. Say, you
own 100 shares of ABC Co., each having a face value of Rs 10. Assume the
earnings per share is Rs 10 and the dividend declared is 30 per cent, or Rs 3
per share. This implies that on every share of ABC Co., you earn Rs 6 each
year, but you actually get Rs 3 via dividend. The balance of Rs 4 per share
goes into the ploughback (retained earnings). Had you purchased these
shares at par, it implies a return of 60 per cent.

This example shows that instead of looking at the dividends received from to
company as the base of investmentreturns, always look at earnings per share,
as it is the actual indicator of the returns earned by your shares.

4. Price Earnings Ratio (P/E)


This ratio highlights the connection between the market price of a share and
its EPS.
Price of the share
------------------------ = P/E
Earnings per share

It shows the degree to which earnings of a share are protected by its price.
Say, the P/E is 40, it means the share price is 40 times its earnings. So if the
company's EPS is constant, it will need about 40 years to make up for the
purchase price of the share, after taking into account the dividends and the
capital appreciation. Hence, low P/E means you will recover your money
quickly.

P/E ratio shows what the market thinks about the earnings potential and future
business forecast of a company. Companies with high P/E ratios are the
darlings of the investors and thus enjoy a higher market rating. In order to use
the P/E ratio properly, take into account the future earnings and growth
projections of the company. If the current P/E ratio is low, as against the
future prospects of a company, then the shares make an attractive investment
option. But if the company is saddled with losses and falling sales, stay away
from it, despite the low P/E ratio.

Also read: Tips to invest in equity

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Moneycontrol || Wealth >> Equity investing >> 8 key ratios while buying stocks Page 3

4 more tips on page 2

Illustration: Vipurva Parekh

Abitha Deepak is Head of Content & Research at BankBazaar. com - An online


marketplacewhere you can instantly get loan rate quotes, compare and apply online
for all your personal loan, home loan and credit card needs from India's leading
banks and NBFCs.

Disclaimer: While we have made efforts to ensure the accuracy of our content
(consisting of articles and information), neither this website nor the author
shall be held responsible for any losses/ incidents suffered by people
accessing, using or is supplied with the content.

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Othercomments
a very important ratio has been missed out namely EV/EBITDA. EV IS MARKET
CAP PLUS NET DEBT WHICH IS GROSSDEBT MINUS CASH AND BANK. this
ratio eliminated the depreciationand a;lso considers the level of debt. one
should use various parameters.to arrive at the fair range of price of a share.
Posted by on 22 Oct, 2009 at 11:15 AM

See all comments (2 comments)

More tips on Equity investing

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more »

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The basics

8 key ratios while buying stocks


Ads by Google Tips to invest in equities
I sold shares; do I have to pay tax?
more basics»

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Moneycontrol || Wealth >> Equity investing >> 8 key ratios while buying stocks Page 1

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Prakash Gaba
Technical Analyst ,
(23 Oct- 15:30hrs)

How to be an effectivetrader?
UpcomingChat Schedule»
Previous Chat Transcripts»

CNBC TV18 Markets Mutual Funds IPO Commodity Wealth Portfolio Messages Specials Videos Mail Poll
File tax returns online Will you buy power stocksat
current levels?

Yes No
Earn Borrow Plan Invest INSIDE WEALTH: Can't Say
Salary & negotiation Loans Financialplanning Stocks and funds
Entrepreneurship Credit cards Tax Insurance ExpertBlogs Features Videos
Retirement Property Galleries Calculators People's Stories
College planning Fixed income BasicGuides View Result View all comments

You are here : Moneycontrol» Wealth » Equity investing

8 key ratios while buying stocks


AbithaDeepak October 22, 2009
Email Print

ads by google
Free Penny Stock Alerts Learn about profitable, fast-moving stocks first. Subscribenow!

Make 6% per mo. in ETFs Proven system. Trade only 5 min per night. Easier than
forex. No hype.

5. Dividend and yield


Dividend is the portion of the profit that is distributed amongst shareholders.
Companies offering high dividends, normally don’t have much of growth to talk
about. This is because the ploughback required to finance future development
is insufficient. Similarly, those companiesin high growth sector don’t give any
dividend. Instead here they give sharp capital appreciation, which ultimately
will lead to higher dividends.

So it makes much more sense to invest for capital appreciation instead of


dividends. Rather it makes more sense to invest for yield, which is nothing but
the association between the dividends and the market price of the shares.
Yield (dividend yield) can be calculated as:

Dividend per share


----------------------------- x 100 = Yield
Market price of a share

Yield shows the returns in percentage that you can expect via dividends
earned by your investmentat the current market price. It is more useful than
simply focusing on the dividends.

Also read: Will dividend yield stock make you rich?

6. Return of capital employed (ROCE)


ROCE is the ratio that is calculated as:
Operating profit

http://wealth.moneycontrol.com/yourstartupkit/equity-investing/8-key-ratios-while-buying-stocks-/14152/1 10/22/2009 1:13:20 PM


Moneycontrol || Wealth >> Equity investing >> 8 key ratios while buying stocks Page 2

----------------------------------------
Capital employed (net value + debt)

To get operating profit, add old taxes paid, depreciation, special one-off
expenses, and special one-off income and miscellaneous income to get the net
profit. The operating profit is a far better indicator of the profits earned by the
company instead of the net profit. Hence this ratio is the better indicator of the
general performanceof the company and the company’s operational efficiency.
It is one of the most useful ratio that lets you compare amongst the companies.

7. Return on net worth (RONW)


RONW is calculated as
Net Profit
-----------------
Net Worth

This ratio gives you an idea of the returns generated by investing in the
company. While ROCE is an effective measure to get a general overview of
the profitability of the company’s business operations, RONW lets you gauge
the returns you can earn on your investment. When used along with ROCE,
you get an overview of the company’s competence, financial standing and its
capacity to generate returns on shareholders’ finances and capital employed.

8. PEG ratio
PEG is an essential and extensively used ratio for calculating the inbuilt worth
of a share. It helps you decide whether the share is under-priced, totally
priced or overpriced. To derive the ratio, you have to associate the P/E ratio
with the expected growth rate of the company. It assumes that higher the
growth rate of the company, higher the P/E ratio of the company’s shares. Vice
versa also holds true.

P/E
----------------------------------
Expected growth rate of the EPS of the company

In general, a PEG lesser than 0.5 is a lucrative investmentopportunity.


However if the PEG exceeds 1.5, it is time to sell.

These are some of the most critical ratios that must be considered when
purchasing a share. Extensive reading of the financial performanceof the
company in newspapers and magazineswill help you get all the relevant
information to arrive at the correct decision.

Read: 'I sold shares; do I have to pay tax?'

1|2|

e-mail: AbithaDeepak

Suggesta story idea! Write to us!


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Rating: 1.75 out of 4 votescast

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Moneycontrol || Wealth >> Equity investing >> 8 key ratios while buying stocks Page 3

Name e-mail (optional)

Othercomments
a very important ratio has been missed out namely EV/EBITDA. EV IS MARKET
CAP PLUS NET DEBT WHICH IS GROSSDEBT MINUS CASH AND BANK. this
ratio eliminated the depreciationand a;lso considers the level of debt. one
should use various parameters.to arrive at the fair range of price of a share.
Posted by on 22 Oct, 2009 at 11:15 AM

See all comments (2 comments)

More tips on Equity investing

I learnt stock market lessons from the casino


Small investors: Don't buy; don't sell!
Market crash: Tips to cut losses

more »

Get Wealthy Tool Kit

The basics

8 key ratios while buying stocks


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