Stock Market for Beginners: Must know Financial Ratios Before Investing in a Stock | CA Aleena Rais

Introduction

This tutorial is designed for beginners looking to invest in the stock market. It outlines six essential financial ratios to consider before making any investment decisions. Understanding these ratios will help you evaluate a company's financial health and make more informed choices.

Step 1: Understand Price to Earnings Ratio

• The Price to Earnings (P/E) ratio measures a company's current share price relative to its earnings per share (EPS).
• Calculation:
  • P/E Ratio = Share Price / Earnings per Share
• Practical Advice:
  • A lower P/E ratio may indicate that a stock is undervalued, while a higher P/E could suggest it is overvalued.
  • Compare the P/E ratios of peer companies in the same industry for better context.

Step 2: Analyze Price to Book Ratio

• The Price to Book (P/B) ratio compares a company's market value to its book value.
• Calculation:
  • P/B Ratio = Market Price Per Share / Book Value Per Share
• Practical Advice:
  • A P/B ratio under 1 might mean the stock is undervalued.
  • Use this ratio to assess asset-heavy companies, like those in manufacturing or real estate.

Step 3: Evaluate Earnings Per Share

• Earnings Per Share (EPS) indicates a company's profitability on a per-share basis.
• Calculation:
  • EPS = (Net Income - Dividends on Preferred Stock) / Average Outstanding Shares
• Practical Advice:
  • Look for companies with consistently growing EPS over time, as this suggests solid financial health and profitability.

Step 4: Consider Debt to Equity Ratio

• The Debt to Equity (D/E) ratio measures a company's financial leverage by comparing its total liabilities to shareholders' equity.
• Calculation:
  • D/E Ratio = Total Liabilities / Shareholders' Equity
• Practical Advice:
  • A lower D/E ratio indicates less risk, as the company relies less on debt to fuel growth.
  • Be cautious of companies with a very high D/E ratio, as they may face challenges during downturns.

Step 5: Check Return on Equity

• Return on Equity (ROE) measures a company's ability to generate profits from its shareholders' equity.
• Calculation:
  • ROE = Net Income / Shareholders' Equity
• Practical Advice:
  • A higher ROE indicates efficient use of equity capital. Aim for companies with ROE above the industry average.

Step 6: Review Current Ratio

• The Current Ratio assesses a company's ability to cover its short-term liabilities with its short-term assets.
• Calculation:
  • Current Ratio = Current Assets / Current Liabilities
• Practical Advice:
  • A ratio above 1 suggests the company can easily pay its short-term obligations.
  • Ratios significantly below 1 may indicate liquidity issues.

Conclusion

Understanding these six financial ratios—P/E, P/B, EPS, D/E, ROE, and Current Ratio—can significantly enhance your ability to evaluate stocks. As you start your investment journey, remember to analyze these metrics in the context of the industry and the company's overall performance. Keep learning and stay informed to make the best investment choices.