May 30, 2016

Key Financial Terms and Ratios that are Useful for Evaluating Stocks - Part 1

For analyzing the stocks that look promising and then selecting the ones in which you can invest your hard-earned money it is helpful to be aware of and clearly understand some of the key financial terms and ratios.

Here are some such key financial terms and ratios that are useful for evaluating stocks:
  • CMP or P (Current Market Price) - as the name also suggests, is the price at which the stock is currently trading. P keeps on fluctuating from one second to another (when the stock market is open, of course!).
  • BV or B (Book Value) - is the value of the assets held by the company and indicates the cash that will get freed up in case the company goes bankrupt and its assets are liquidated.
  • EPS or E (Earning Per Share) - is the net income post-tax the company has earned and indicates the cash generating power of the stock.
  • DPS or D (Dividend Per Share) - is the dividend earned by the shareholder for every share held and can be viewed as regular cash inflow from stock investment.
  • P/E (Price to Earnings ratio) - indicates the premium or discount at which the stock is trading. P/E should be less than 20 (which implies a 5% rate of return on capital invested by you to buy the stock).
  • P/B (Price to Book ratio) - indicates how much you are paying for the stock as against the value of its assets in the books. P/B should be less than 5 (which implies if you buy a stock at Rs. 100/- and the company goes bankrupt you can expect to get Rs. 20/- back). 
  • ROCE (Return On Capital Employed) - is the cash generating ability of the capital employed by the company in the form of both equity and debt. ROCE should be more than 10%.
  • ROE / RONW (Return On Equity or Return On Net Worth) - is the cash generating ability of company for its owners or shareholders. It indicates  the return that can be expected by the owners for assuming the investment risk. ROE should be more than 15%.
  • D/E (Debt to Equity ratio) - is the composition of the capital employed by the company and indicates its financial leverage position. Higher leverage would generally translate into higher risk for the business. D/E ratio should be less than 2 (which implies if the capital of a company is Rs. 100/-, debt should not be more than Rs. 66.67)
  • DY (Dividend Yield) - is the dividend paid by the stock as against its market price. It indicates the return from the stock in the form of dividends. It indicates how much "hard" cash is shared by the company with its shareholders. DY should be more than 2%.
  • DPR (Dividend Payout Ratio) -  indicates the ratio of earnings the company distributes to its shareholders as dividend (or DPS/EPS). DPR should be within 20% to 40%.
  • NPM (Net Profit Margin) - is the profit post-tax or the net earnings generated by the company. Annualized growth in NPM during the last 5 years should be more than 10%.
  • OPM (Operating Profit Margin) - is the NPM from business operations. It is the net earnings from operations and not from the management of the company's finances. Average OPM during the last 5 years should not be negative.
Read Part 2 here:
Key Financial Terms and Ratios that are Useful for Evaluating Stocks - Part 2

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