Fundamental Analysis

II
WALL STREET LECTURE 4
 RATIOS
• Profitability Ratios
• Leverage Ratios
• Operating Ratios
• Valuation Ratios
 Profitability Ratios
The Profitability ratios help the analyst measure the
profitability of the company. The ratios convey how well
the company is able to perform in terms of generating
profits. Profitability of a company also signals the
competitiveness of the management. As the profits are
needed for business expansion and to pay dividends to
its shareholders a company’s profitability is an important
consideration for the shareholders.
 Profitability Ratios

• PAT Margin
• EBITDA Margin (Operating Profit Margin)
• Return on Equity (ROE)
• Return on Asset (ROA)
• Return on Capital Employed (ROCE)
 PAT Margin

PAT Margin = Net Income / Net Sales

= Profit After Tax for the year / Total
revenue

Net Income is Total Income with removal of tax, expense and

COGS
Total revenue/Net Sales is the gross sales with removal of
returns, allowances, and discounts.

Higher it is, the better it is!

 EBITDA Margin
EBITDA Margin = EBITDA / (Total Revenue – Other Income)

EBITDA is Earnings Before Interest, Tax, Depreciation and

Amortization.
Other Income here is income from non-operating activities.

The higher value of EBITDA margin compared to its peers

is good.
It is a measure of the operating profitability of the
company.
 Return on Equity
ROE = (Net Profit / Shareholder’s Equity)*100%

Shareholder’s Equity = Assets – Liabilities

It shows how well the company uses its investments to

generate profits.

A high ROE is preferable but not at the cost of high

debt.
Come to DuPont Model.
 DuPont Model
Net Profit Net Sales Avg. Total Assets

ROE = 100 x X X
Net Sales Avg. Total Assets Shareholder’s Equity

• Net Profit Margin (PAT margin) = (Net Profit / Net Sales) *100 : Ability to
generate profits (higher the better)
• Asset Turnover = (Net Sales/Avg. Total Assets) : efficiency of using assets
to generate revenue (higher the better)
• Financial Leverage = (Avg. Total Assets / Shareholder’s Equity) : For every
unit of shareholder’s equity, how many units of asset does the company
own: ( A high financial leverage with high debt is not desired)
 Return on Asset
RoA = [Net income + interest*(1-tax rate)] / Total
Average Assets

The company benefits in terms of paying lesser taxes when

interest is paid out, this is called a ‘tax shield’. For these
reasons, we need to add interest (by accounting for the tax
shield) while calculating the ROA.

It shows how effectively the management uses the

Assets to generate profit.
The higher the better.
• Just by themselves, the ratios can seem meaningless.
And therefore, it makes sense to compare them
among different companies. For example, Indigo’s
profit margin for 2019 was 0.54%, while SpiceJet’s was -
3.46.
• And it’s also reasonable to make comparisons within
the same industry. Why? Say we consider RoA.
Companies that rely on manufacturing (using heavy
duty and expensive machines) will have a lower RoA
(because assets are too expensive) than companies
involved in Consultancy or Financial Services, and so it’s
unfair to compare stocks across the two industries.
 Leverage Ratios

The Leverage ratios also referred to as solvency ratios/

gearing ratios measures the company’s ability (in the long
term) to sustain its day to day operations. Leverage ratios
measure the extent to which the company uses the debt to
finance growth. Remember for the company to sustain its
operations, it has to pay its bills and obligations. Solvency
ratios help us understand the company’s long term
sustainability, keeping its obligation in perspective.
It kinda represents how much “opened up” the company is,
because there’s going to be a limit to how much debt you can
afford to take.
 Leverage Ratios
• Interest Coverage Ratio
• Debt to Equity Ratio
• Debt to Asset Ratio
• Financial Leverage Ratio
 Interest Coverage Ratio
Interest Coverage Ratio = (EBIT / Interest Expense)

EBIT = Earnings Before Interest, Tax

Interest Expense is the amount by which the debt has grown

The interest coverage ratio helps us understand how

much the company is earning relative to the interest
burden of the company. This ratio helps us interpret
how easily a company can pay its interest payments.
If the ratio is below 1.4-1.5, then it’s a red flag.
 Debt to Equity
Debt to Equity = (Total Debt/ Total Equity)

It’s basically the ratio between how much the company

needs to pay back and how much equity is there is there
in the company.

ASSETS

DEBT EQUITY
Debt allows you to expand your company at a rate
insanely better than one without debt. But debt
grows, and you need to pay it back.
That’s why the interpretation is not straight forward.
• So if a company has just started out, then a high debt
to equity ratio is justified. If it’s low, it might mean
that banks have identified red flags with it and refuse to
lend money to the business.
• On the other hand, if the company’s large and
significant in the market, it’s expected to pay off its debt
regularly. Therefore if debt/equity is high, and not
declining that’s a bad sign. And thus if going down /
already low, it’s justified.
• In general, the ratio being high (say way above the
industry average) is only justified if the company has
planned / is executing a major expansion. Large
companies may also fall in this category.
• A spike in debt to equity ratio is not always a red flag.
• What you should do in this case is check if it’s the debt
that’s spiked. If it did, it means that the company has
borrowed a huge chunk of money. Whether it’s good or
bad depends upon why the company has put itself into
more debt. Indigo taking on more debt to expand its fleet,
is considered good. Jet airways borrowing cash because
it’s not able to operate without it, is considered bad.
 Operating Ratios

The Operating Ratios, also called the ‘Activity Ratios’

measures the efficiency at which a business can convert
its assets (both current and noncurrent) into revenues.
This ratio helps us understand how efficient the
management of the company is. For this reason,
Operating Ratios are sometimes called the ‘Management
Ratios’.
 Operating Ratios
• Fixed Assets Turnover Ratio
• Working Capital Turnover Ratio
• Inventory Turnover Ratio
• Total Assets Turnover Ratio
• Inventory Number of Days
• Receivable Turnover Ratio
• Days Sales Outstanding (DSO)
 Fixed Asset Turnover Ratio
Fixed Assets Turnover = Net Sales / Average Fixed
Assets

Fixed Assets is property, plant and equipment.

It tells us how efficiently are the fixed assets being

used to generate revenue.
The higher the better.
 Working Capital Turnover Ratio
Working Capital Turnover Ratio = Net Sales / Average Working Capital

Working Capital = Current Assets – Current Liabilities

Working capital is capital required by the firm to run its day to day operations.

The working capital turnover indicates how much revenue the company
generates for every unit of working capital.
The higher the better.

If it’s way too high (over 80ish%), it could be a red flag indicating that the
company doesn’t have enough assets they’ll make money from in the near
future. This could lead to a situation known as insolvency which basically is a
bad situation.
 Inventory Turnover Ratio
Inventory Turnover = [Cost of Goods Sold / Average
Inventory]

Cost of goods sold is the cost involved in making the finished good.
Inventory refers to the finished goods that a company maintains in
its store or showroom with an expectation of selling the finished
goods to prospective clients.

It measures how many times a company sold its total

average inventory dollar amount during the year.
A higher ratio is better while comparing two companies.
• A ratio that’s too low indicates that the sales of the
company (being made in whatever time frame) is not
at par with the rate at which production is going on.
This means that the company is stockpiling products.
Unless this is a strategic move, it’s usually a bad sign
for the company.
• However, if the ratio’s way too high, it might mean
that the company isn’t able to keep up with the
market demand. This could result in the business
losing their market share, and eventually getting
squeezed out of the market.
 Valuation Ratios
The Valuation ratios compare the stock price of the
company with either the profitability of the company or
the overall value of company to get a sense of how cheap
or expensive the stock is trading. Thus this ratio helps us
in analysing whether the current share price of the
company is perceived as high or low. In simpler words,
the valuation ratio compares the cost of a security with
the perks of owning the stock.
 Valuation Ratios
• Price to Sales (P/S) Ratio
• Price to Book Value (P/BV) Ratio and
• Price to Earnings (P/E) Ratio
• Price to Cashflow (P/CF) Ratio
• Price to DPS Ratio
 Price to Sales (P/S) Ratio
Price to Sales (P/S) Ratio = Current Share Price / Sales per
Share

Sales per Share = Sales / Total number of shares

This ratio compares the stock price of the company with the
company’s sales per share.
It is used because to some investors sales give a better
sense of the performance than earnings itself.
One has to compare the P/S ratio with its competitors in the
industry to get a fair sense of how expensive or cheap the
stock is.
Price to Book Value (P/BV) Ratio
P/B ratio = Share Price / BV

BV = [Share Capital + Reserves (excluding revaluation

reserves) / Total Number of shares]

The “Book Value” of a firm is simply the amount of money left on table
after the company pays off its obligations. Consider the book value as
the salvage value of the company.
Why P/B not always 1?

The P/BV indicates how many times the stock is trading over
and above the book value of the firm.
Clearly the higher the ratio, the more expensive the stock is.
 Price to Earnings (P/E) Ratio
P/E = Share Price / EPS

EPS = Earnings per Share = PAT / Total Number of Shares

It is very popular which is why it is called ‘financial

ratio superstar’.
The P/E ratio indicates the willingness of market
participants to pay for a stock, keeping the company’s
earnings in perspective
Clearly, higher the EPS, better it is for its shareholders.
• So if the P/E is higher than the industry average, the
stock would look overvalued (because the price is too
high) and if it’s too low, the stock would look
undervalued (because the price...).
• However, a counter argument is that the reason a
stock’s P/E might be high is because it’s so good that
people are willing to pay that much to own a stock.
Similarly, if it’s way too low, maybe it’s because the
company is pakka about to fail.