Key Investment Ratios

We previously discussed various financial statement ratios which helps in comparing and analyzing companies. In addition to these ratios, there are other ratios which combine financial statement items with market prices and help us make better investment decisions. Let's look at the 4 most important ones.

PE Ratio

Price-Earnings Ratio

Let’s assume 1 kg of wheat costs Rs.X at the nearby supermarket. Now suppose, 1 kg of wheat represents one unit of a company’s earnings and price of Rs.X represents the market price of 1 share. So when you pay Rs.X to buy 1 share of a company, basically you are buying 1 unit of company’s earning by paying Rs.X. PE ratio is the price paid per unit of earnings and is calculated by dividing current market price by earnings per share. In our example, PE ratio would be X as X/1 = X.

You might have read that PE ratio of a stock is 25 or Nifty is trading at a PE ratio of 16. You might naturally wonder why anybody would pay that much to buy Rs.1 earnings. So it is important to understand that when you pay money and invest in a company,  you are eligible to receive a part of the earnings generated by the company, every year, as long as you hold the share.   

Suppose the price of 1kg wheat of brand A is Rs 15 and that of brand B is Rs 20. You believe that both A and B are equally good quality wise. So naturally you will buy brand A wheat as it is cheaper. Similarly, let’s suppose there are two companies operating in the same sector and are expected to perform similarly in the future . A has a PE ratio of 18 and B has a PE ratio of 20. We can easily say that A is undervalued compared to B as it has lower PE ratio. It would be prudent to buy shares of A as we have to pay lesser amount per unit of earnings compared to shares of B.

Just as price of 1 kg wheat cannot be meaningfully compared to price of 1 litre of petrol or any other product for that matter, PE ratio of companies operating in different sectors cannot be meaningfully compared. Only PE ratio of companies operating in the same sector can be meaningfully compared to each other. One can also compare the current PE ratio of the company with its historical PE to deduce whether the stocks is currently undervalued/overvalued.

PB Ratio

Price-to-Book Ratio

Let’s first understand book value of a stock. Book value broadly represents the amount that a shareholder can recover from a company if the company decides to shut its business today. From our articles about balance sheet items we are aware of the terms assets and liabilities. Suppose a company XYZ Inc.is shutting down its business, it will have to sell all assets and recover money and at the same time it will have to repay all its loans and liabilities. Let’s assume XYZ Inc. received INR 500 crore through asset sale and has a liability of INR 300 crore in the form of bank loans. After paying back the loans, the company will have INR 200 crore left which can be distributed to owners/shareholders. In this case book value of XYZ Inc is INR 200 crore. If the company has 20 crore shares outstanding, each shareholder will then receive INR 10 (200/20) which is the book value per share. Now suppose XYZ is a publicly listed company and the current stock price is INR 15. Price to book value ratio is defined as the current price divided by book value per share. In XYZ Inc.’s case price to book value ratio would be 1.5. This means that you need to pay more to buy a stock, than what will accrue to you if the company decides to shut down its business today.  Investors will buy at this price only if they believe that in future, value of net assets will grow as company progresses. If the value is below 1, then it usually means that investors do not believe that the company will be able to recover the book value.

Price to book value ratio of less than 1 could indicate that the stock is undervalued and it is a good investment opportunity. The ratio could also be less than 1 because investors believe that the company will not do very well in the future and might not be able to recover the amount represented by the book value. Hence it is prudent not to base investment decision on just PB ratio. And just like in the case of PE ratio, PB ratio of 2 different companies can be compared only if they operate in the same sector. A company’s current PB ratio can also be compared with its historical ratio.

Correlation

When it rains in Mumbai, India defeats Pakistan

Correlation represents how any two variables move together. Without going into its mathematical derivation, let’s discuss how correlation is used and interpreted in stock market. The value of correlation always lie between -1 and + 1 (-100% to 100%). If one were to declare that there is 80% correlation between rains in Mumbai and India beating Pakistan in a cricket match, what does it represent? It tells us that out of 100 cricket matches when India beat Pakistan, 80 times it simultaneously rained in Mumbai. Correlation number indicates nothing more or nothing less. So when we say that correlation between Stock A and Stock B is 80%, it means that out of 100 times when stock price of A increases, stock price of B will increase 80 times. The reverse can also be true that out of 100 times when stock price of A decreases, stock price of B will decrease 80 times. Thus correlation tells us what’s the probability of increase in stock price of B, when stock price of A has increased or what’s the probability of decrease in stock price of B, when stock price of A has decreased. Please remember correlation doesn’t tell anything about the extent of expected movement in a stock, based on movement in another stock.

Beta

Beta is a measure of risk. To understand this, first let’s understand two types of risk faced by a company. Let’s take the example of Maruti Suzuki. Sometime back, it had a labor strike in its Manesar plant. This hampered production and tarnished Maruti’s image. Due to this, investors started moving away from Maruti’s stock and it experienced sharp fall. This was a Maruti specific risk, as only the stock price of Maruti was impacted, not the other stocks trading at the exchange. This type of company specific risk faced by a stock is called unsystematic risk. In this case, if I had put all my money in Maruti’s stock, definitely I would have been hospitalized. But if Maruti was a small part of my portfolio, then I might have suffered a small loss. That’s why we say that company specific risk can be avoided by investing in various unrelated stocks, i.e. having a diversified portfolio.

The second type of risk faced by a company is called Market Risk. Suppose there is a political party called CNG headed by a very weak politician. The party is generally viewed as non-progressive and against modern reforms, required to bring in rapid economic growth. If such a party gets elected, then obviously prices of all the stocks will go down. This is not a company specific risk, but the general market risk. Irrespective of the fact that whether I have invested my money just in Maruti or have a big portfolio of unrelated stock, I would have experienced a significant loss. That is why we say it’s not possible to avoid market risk by investing in a portfolio of unrelated stocks, as all will be impacted by market events.

Beta is a measure of market risk. If the beta of a stock is more than 1, it means stock moves along with market in the same direction and is more volatile than the market. So if market is expected to increase by 10%, a stock with a beta of more than 1 is expected to generate more returns than 10%. Generally, in a bull market we invest in high beta stocks, to enhance returns. If the beta is less than 1, it means that stock is less volatile and not related to the market. These stocks are best bet in a bear market, to protect against sharp price drops.