An equity investor can compute many ratios for a select company by using the numbers presented in its financial statements but it is the set of relevant ratios that facilitate the investment decision-making process.
Return on equity
It computes the portion of the net profit that is available for the equity shareholders of a company. It is computed by dividing the year-end earnings available for equity shareholders (taken from the income statement of the company) by the year beginning shareholders’ funds or networth of the company. Higher the ROE, higher is the overall profitability of the company. If a company earns a positive and stable ROE then it indicates that it is a good company for investment. One can also compute the trend in the future ROE of a company using the numbers from its projected financial statements. Conclusion on good or bad performance must be arrived at by comparing the company’s ROE with that of the industry average.
Price to earnings ratio.
This is one of the most widely used yardstick to measure the overall performance of a company. It is computed by dividing the current market price per share by the earnings per share. This ratio reflects the price paid by the market for every one rupee earning of the company. The current market price per share can be taken from the website of the stock exchanges such as the BSE or NSE. The earnings per share (EPS) is computed by dividing the earnings available for equity shareholders i.e profit after tax minus preference dividend by the number of outstanding equity shares of the company.
There are four variants of PE — current PE, trailing PE, forward PE and future PE. The PE ratio of a company is determined by three factors — growth rate in earnings, pay-out ratio, and risk of the company. Here growth rate and pay-out ratio are the positive traits and hence a company can increase its PE ratio by increasing its growth rate and its pay-out i.e. dividend per share divided by earnings per share.
Price to book value ratio
This ratio is similar to the PE ratio as both the ratios use current market price as the numerator. But it differs from the PE ratio as it uses book value per share as the denominator. Book value per share is computed by dividing the networth of the company by its number of outstanding equity shares. In other words, PE ratio compares the market price of a company with that of its earnings for a specified period while P/B ratio compares the market price of the company with that of its cumulative earnings and capital. One again needs to read the number in relation to the industry average.
Dividend pay-out ratio and dividend yield are the two ratios that can be computed by those equity investors who would like to receive dividends on a regular basis. Dividend pay-out ratio is computed by dividing the dividend per share by the earnings per share. Higher the pay-out ratio, better is the performance of the company. Dividend yield is computed by dividing the dividend per share by the market price per share. Higher the dividend yield, better is the performance of the company.
The writer teaches accounting and finance courses at IIM Ranchi