Financial ratios.

Understanding PEG ratio

PEG RATIO

Popularized by the legendary Peter Lynch, It’s a  ratio that will help you look at future earnings growth  You calculate the PEG by taking the P/E and dividing it by the projected growth in earnings.

  • PEG = (P/E) / (projected growth in earnings)

For example, a stock with a P/E of 20 and projected earning growth next year of 10% would have a PEG of 20 / 10 = 2.

WHAT DOES IT SHOW?

Consider this situation; you have a stock with a low P/E. Since the stock is has a low P/E, you start do wonder why the stock has a low P/E. Is it that the stock market does not like the stock? Or is it that the stock market has overlooked a stock that is actually fundamentally very strong and of good value?

To find the answer, PEG ratio would help. Now, if the PEG ratio is big (or close to the P/E ratio), you can understand that this is probably because the “projected growth earnings” are low. This is the kind of stock that the stock market thinks is of not much value.

On the other hand, if the PEG ratio is small (or very small as compared to the P/E ratio, then you know that it is a valuable stock) you know that the projected earnings must be high. You know that this is the kind of fundamentally strong stock that the market has overlooked for some reason.

WHAT IS THE RIGHT PEG?

There are no hard and fast rules regarding the right PEG ratio. Normally, A PEG Ratio of 2 or below is considered excellent. A PEG Ratio of 2 to 3 is considered OK. A PEG Ratio above 3 usually means that the company’s stock is over priced.

Technically speaking

If PEG ratio=1, it means that  the share at today’s prices is fairly valued.

If PEG ratio>1, it indicates that the share is possibly over-valued.

PEG ratio<1, it indicates that  the share is possibly under-valued.

PROBLEMS WITH PEG.

The first problem is the P/E itself. Which P/E should be used for this? Is it the trailing P/E or the forward P/E? What ever P/E you may use, the ‘E’ factor in P/E   is a number not fully trusted by analysts due to the estimates that go with it.

Second, difficult part is the estimation of growth rate figures. Flaws in estimating both these figures would affect the results obtained by the PEG analysis.

What Peter Lynch has said in his one up on wall street is that “the P/E ratio of any company that’s fairly priced will equal its growth rate”. Therefore, according to him, a properly priced company will have a PEG of 1. But what if the growth rate is 0? So, the ratio doesn’t work well for all stocks . It works for a stock with normal rate of growth and earnings.

CONCLUSION.

The two most important numbers that investment analysts look at when evaluating a stock are the P/E ratio and the PEG ratio. The PEG is a valuable tool for investors to use. It reveals whether the high price of a stock is justified based on whether earnings will grow enough to continue to drive the stock higher.

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Evaluate debt-Understanding Current and quick ratios

MEASUREMENT OF DEBT

There are several measurements you can use to gauge whether a company may be carrying too much debt. Both come off the balance sheet if you want to do the math yourself or you can find the ratios on several online services.

We need two definitions before we move on:

CURRENT LIABILITIES AND CURRENT ASSETS

Current Liabilities are bills that will come due in the next 12 months. These include the company’s normal operating expenses such as salaries, utilities, and so on. Long-term debt, such as mortgages would not be included, however that portion of payments due in the next 12 months would be included.

Current Assets are marketable securities, cash and other assets that can be easily converted to cash within 12 months. Land and real estate do not fall into this category because it often takes longer than a year to sell property.

The term ‘debt’ includes short term liabilities, such as accounts payable, creditors for expenses and taxes payable.These are short term liabilities generated on aren’t really considered as “debts”. Basically, these kind operational liabilities would be there for all companies.

QUICK RATIO

The first ratio is the Quick Ratio. This ratio gives you an idea how easily the company can pay its current obligations – that is those bills due in the next 12 months.

The Quick Ratio is cash, marketable securities and accounts receivable divided by current liabilities (those due in the next 12 months). However, not all Current Assets are included in this ratio – excluded are doubtful accounts receivables and inventory. Basically, you are saying if all income stopped tomorrow and the company sold off its readily convertible assets, could it meet its current obligations?

A Quick Ratio of 1.00 means the company has just enough current assets to cover current obligations. Something higher than 1.00 indicates there are more current assets than current obligations.

It is important to compare companies with others in the same sector because different industries operate with ratios that may vary from one sector to another. Some industries such as utilities, for example carry much more debt than other industries and should only be compared to other utilities.

So, quick ratio is :

  • Current assets – doubtful debtors and inventory / Current liabilities.

It’s also called ‘acid test ratio’ since it takes into account only those assets of the company that can be converted to cash immediately. That’s why even doubtful debtors or debtors which may delay payment are excluded.

CURRENT RATIO

The second ratio is the Current Ratio. The Current Ratio is very similar to the Quick Ratio, but broadens the comparison to include all Current Liabilities and all Current Assets. It measures the same financial strength as the Quick Ratio that is a company’s ability to meet its short-term obligations.

Some analysts like the Current Ratio better because it is more “real world” in that a company would convert every available asset to stay afloat if needed. The Current Ratio measures that better than the Quick Ratio.

Current ratio is computed as follows:

  • Current assets / Current liabilities.

Like the Quick Ratio, a current ration of minimum 1.00 or better is good, and you should always compare companies in the same sector.

CASH RATIO

Talking about liquidity ratios, there is another ratio commonly described in academic texts called cash ratio which measures the liquid cash in hand against the current liabilities of the company. cash ratio is computed by the  equation-

  • Cash balance as shown in balance sheet  / current liabilities

From the investor’s pint of view, only the current ratio is relevant, because nobody is interested in the very short term liquidity measurements of the company. In the very short term, stock movements are more influenced by the demand,  supply and sentiments of the market participants. However, It would be nice to know whether the company is sitting on huge cash reserves or not.

CONCLUSION

These three ratios, which you can find on any Web site that offer quotes, tell you a great deal, about how a company may or may not weather tough times.  Low numbers in these ratios should be a red flag when you are evaluating a stock

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Understanding interest coverage ratio

INTEREST COVERAGE RATIO

This ratio relates the fixed interest charges to the income earned by the business. It indicates whether the business has earned sufficient profits to pay periodically the interest charges. It is calculated by using the following formula.

  • Interest Coverage Ratio = Net Profit before Interest and Tax /Fixed Interest Charges

What it shows is:

1. The amount of interest expense the company bears in a current year due to loan funds and its impact on profitability.

2. The profit of the company in terms of ‘number of times’ the interest obligation. This information would show the financial strength of the company. A company which merely manages to generate the required income to pay interest obligations is prone to severe liquidity crisis.

3. An interest coverage ratio of less than 1 is an indication that the company is not generating enough cash to pay its interest obligations.

4 . Any improvement in interest coverage ratio is a good sign. On the same lines, any decrease in the interest coverage ratio of the company is a red flag.

WHAT KNID OF DEBTS ARE TO BE INCULDED?

All kind of Debts of a company- long term, short term, bank loans, bonds, debentures, notes payable.. In fact, any form of debt for which there is an obligation on the part of the company to pay interest should form part of this calculation.

ICR- A part of debt ratios.

The ICR is in fact, the smallest form of debt ratios. The big brother is debt ratio which measures the total debts against the total assets. The equation is:

  • Total debt / Total assets.

The debt ratio gives us the big picture about the company’s debts and the proportion it bears to the total assets.

There is also one more ratio called the debt equity ratio which measures the amount of debt in relation to the total equity share capital. Debt equity ratio is calculated as follows:

  • Debt / equity

A high debt equity ratio shows that the company has larger amount of debts and hence the risk of running into financial difficulties is much more.

That’s about debt ratios …

…. have a nice day !!

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Understanding ROE & ROCE.

RETURN ON EQUITY (ROE)

‘Equity’ means shareholder’s funds.

Share holder’s funds in a company includes the equity capital they invested + their share of earnings retained by the company for further expansion.

Hence, return on equity means, the return generated by using shareholder’s capital.

How does a company generate return from it’s capital? It’s by investing in assets which are capable of producing returns. So, Return on Equity (ROE) is a measure of how efficiently a company uses its assets to produce earnings. ROE is the speed at which the company might grow without sorting to additional fund raising.

The formula for computing return on equity is:

  • Earnings / shareholders equity

AVERAGE ROE

Instead of taking the ROE figure of just one year and forming an opinion on that basis, it’s better to study the financial history of the company and find the average ROE of 5 or more years. This would give you a reasonable assurance about the rate of return that the company is capable of generating.

An average ROE of 15% -20% is the preferred range for a company that’s growing at a steady pace.

THREE COMPONENTS OF ROE

The ROE is not a simple equation as you saw above. Let’s try to split and expand the equation and try to find what boosts the ROE of a company and why. Let’s check the expanded formula.

  • ROE= (Earnings / Sales) x (Sales / Assets) x (Assets / Shareholder’s  equity)

If you notice the equation carefully, you’ll take note that ‘sales’ and ‘assets’ are both the numerator and denominator and hence they get nullified.  When we break the equation in this manner, the three components of ROE is revealed. They are;

  • Earnings or profits
  • Assets
  • Leverage

Earnings or profits:

Profits, in simple terms, are the money left after all the expenses is met. So the first part of the equation – (earnings / sales) shows the profit margin that’s generated by the company from its sales. A low profit margin can mean many things including:

  • Inefficient pricing policy
  • Inefficient cost control ( hence a drop in profits)
  • Unprofitable product ( hence it eats into the profits generated by other products of the company)
  • Cut throat competition ( hence, the company is forced to sell at a low margin)

A high profit margin, on the other hand, may mean that the company is enjoying a monopoly in its field. It also indicates that the company has a product or product range that has some brand image and quality and hence it’s possible for them to sell their products at a higher margin. Such companies are also capable of eliminating competition from new entrants by lowering the prices temporarily or by enhancing the quality of the product without enhancing the price.

Assets:

The second part of the equation is sales / assets. So that measures the sales generated from per rupee of assets invested by the company. It’s also called asset turnover ratio.

The asset turnover ratio of a company throws light into an important aspect. How much assets does the company need to generate the required volume of sales? If the company is capable of generating sales by investing heavily in assets, it could mean that the company is capital intensive in nature. The capital intensive nature of the company affects the ROE of the company negatively.

Leverage or debt:

The last part of the equation is assets / shareholder’s equity. It is basically a measure of leverage. Leverage is nothing but the amount of debt funds used by the company to sustain business. If the ratio is less, it shows that the company has resorted more to debt funds. If the ratio is 1 it shows that the company has built all the revenue producing assets from shareholders funds.

if a company raises funds through to do business through borrowing rather than issuing stock it will reduce its shareholder’s equity. A lower equity means that you’re dividing earnings by a smaller number,  so the ROE is artificially higher.

So, higher the debt, higher the ROE.

So, earnings, assets turnover and debt are the three factors that boost the ROE of a company. Hence,

  • ROE = Net margin x asset turnover x financial leverage.

In general, It’s important to screen companies for a higher earnings, higher assets turnover and a lower debt.

SECTION 2


RETURN ON CAPITAL EMPLOYED (ROCE)

ROCE is different from ROE we discussed above. ROCE is the ability of the company to earn return from ‘all the capital’ it employs. The term ‘All the capital’ means that it includes debt funds like loans and preference capital as well.

The equation for computing ROCE is:

  • Return (before interest and Tax) / capital employed.

Debt funds are included in the denominator; logically the numerator should be the earnings before deducting the interest paid on debts.

For a company to remain in business over the long term, it’s important to generate an ROCE which is higher than its ‘cost of capital’. ‘Cost of capital’ is nothing but the compensation that the company should pay to each category capital contributors. That is, for using debt it has to pay interest, for preferred capital it has to pay a fixed return and for ordinary equity holders it has to pay what the equity holders expect – something above the risk free return rate and average return they expect from any other stock investment.

Since the proportion of equity, preferred capital and loan funds would be different, the weighted average of all is taken as the cost of capital of a company.

The higher the ROCE, the better it is.

So that’s about ROE and ROCE.

Bye for now….

……have a nice day !!

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