Introducing ratio analysis part 3 : Profitability and Valuation
You could read the earlier parts on ratio analysis here and here.This post discusses the profitability and valuation ratios.
Profitability Ratios
The profitability ratios try to associate the amount of profits generated with the amount of resources used. These ratios measure the economic efficiency of the firm,
a) Return on assets
This is one of the most effective measures of resource utilization. This is defined as
Return on assets (ROA) = Net Operating profit after taxes/ average assets
The Operating profit is found by removing from the net profit other nonrecurring incomes. Since the operating profit includes, interest expenses as well the return on assets ratio will not be partial to the capital structure of the company.
b) Return on invested capital
This ratio measures the efficiency of the firm to generate income from all assets that are committed for longer periods of time. The ratio is calculated as
Return on invested capital (ROIC) = Net income (modified)/ (Total assets-Current assets)
As in the above case, to make this ratio independent of the capital structure of the firm the after tax interest expense given by Interest expense *(1-tax rate) is added back to the net income.
c) Return on equity
This is a measure of income generated to the stock holders on their investments. This is usually calculated as
Return on Equity (ROE) = Net income/Average stock holders’ equity
d) Net profit margin
This ratio measures the percentage of contribution to net income from each rupee of sales. It is calculated as
Net profit margin = Net Income/Net sales.
One should understand that a high profit margin does not necessarily imply a good performance. One should judiciously use this metric along with other ratios such as return on assets (ROA). For example a firm with very high profit margin, but a low return on assets might not be generating high value to the stockholders.
Valuation Ratios
a) Price to Earnings ratio (PE ratio)
This ratio measures how much investor is willing to pay for each rupee of earnings generated by the firm. One of the most commonly used valuation ratio, it is calculated as
PE ratio = Market price of the share/ Earnings per share
The Earnings per share used in the denominator is usually the forecasted earnings for the next year. This ratio being simple to calculate is widely used by the investors. Companies that are growing rapidly and are thought to have higher potential for future growth usually trade at higher PE ratios. A variation of the ratio called PEG ratio is also commonly used to value growth companies. It is calculated by dividing the PE ratio of the firm with its earnings growth rate. A PEG ratio of one usually indicates a fair pricing for the stock.
b) Price to Book value ratio (P/B ratio)
The book value of a company could be thought of as the amount the shareholders of the company receive if the company gets liquidated. This ratio is calculated as
P/B ratio= Market price of the share/Book value per share
As with PE ratio generally, lower the P/B ratio more the value for investors. ‘Value Investors’ traditionally look out for companies that are trading at a discount to their book value. But investors should be careful enough to use the P/B ratio along with other metrics. Most often stocks that are trading at a low P/B ratio are just ‘bad companies’.
c) EV/EBITDA
This ratio termed as the enterprise multiple, is often preferred over the PE ratio by analysts. The main reason for that being this ratio is neutral to the capital structure of the company. The Enterprise value of the firm might be thought of as the amount required to be paid if you are going to acquire the company today as valued by the markets. It’s calculated as
Enterprise value = Market capitalization of the stock + Long term debts –Cash and equivalents held
EBITDA = Earnings before interest, depreciation and taxes
Enterprise multiple = Enterprise value/EBITDA
As with PE ratio it’s common to use the EV/EBITDA ratio with forecasted earnings.
In the next part we will talk about some common mistakes to be avoided when using ratio analysis for investment decisions.
Tags: Book value, Enterprise value, PE Ratio, PEG ratio, profitability ratios, Ratio analysis, Return on assets, return on equity, Valuation ratios
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