Learn Fundamental Analysis: Operating Ratios & Valuation Ratios
Operating Ratios
These ratios indicate the efficiency of the company’s operational activity. These ratios are also known as Asset Management Ratios because they provide insight into how effectively a company utilizes its assets. To gain an accurate assessment of a company’s operational ratios, it is essential to either compare these ratios with those of its competitors or analyze them over several years for the same company.
Some of the operating ratios include:
Fixed Assets Turnover Ratio
This ratio measures the amount of revenue generated in relation to the investment made in fixed assets. Fixed assets include the property, plant, and equipment. A higher ratio indicates that the company is proficiently and productively managing its fixed assets.
To calculate the Fixed Assets Turnover Ratio,
Fixed Assets Turnover Ratio = Operating Revenues/Total Average Asset
Working Capital Turnover Ratio
Working capital refers to the capital required by the firm to run its day-to-day operations. Working Capital can be calculated by (Current Assets — Current Liabilities). A positive working capital indicates a surplus, signifying the company’s ability to smoothly handle its daily operations. Conversely, a negative working capital signifies a deficit, indicating that the company lacks the necessary capital for its day-to-day needs.
To calculate the Working Capital Turnover Ratio,
Working Capital Turnover Ratio = Revenue/Average Working Capital
A higher working capital turnover ratio is better because it signifies that the company is generating more sales relative to the funds it employs to support those sales.
Total Assets Turnover Ratio
It indicates the company’s capability to generate revenues with the given amount of assets (both fixed and current assets). If the total asset turnover ratio is higher than both its historical performance and that of its competitors, it indicates that the company is efficiently utilizing its assets to generate more sales.
To calculate the Total Assets Turnover Ratio,
Total Assets Turnover Ratio = Operating Revenue/Average Total Assets
Valuation Ratio
When deciding to invest, what really matters is how much a business is worth. The value of the business determines the price you pay to buy it. Sometimes, it’s better to invest in a mediocre business that’s really cheap rather than an exciting business that’s very expensive. Valuation ratios show us how the market values a stock’s price. They also tell us if the stock is a good investment or not.
Some of the valuation ratios include:
Price to Sales (P/S) Ratio
Sometimes, investors prefer to use sales instead of earnings when assessing their investments. This is because earnings can be misleading, especially if a company is going through a low-earning period due to economic cycles. This ratio compares the company’s stock price to its sales per share.
To calculate Price to Sales Ratio,
Price to Sales Ratio = Current Share Price/Sales Per Share
Also, Sales per share = Total Revenues/Total number of shares
A P/S ratio of 2 means that for every Rs.1 in sales, the stock is valued at Rs.3.24. A higher P/S ratio indicates a higher valuation for the company. To determine if the stock is expensive or inexpensive, it’s essential to compare its P/S ratio with competitors in the same industry.
When calculating the P/S ratio, consider this important point. Picture two companies, Company A and Company B, both selling the same product and earning Rs.1000 in revenue each. Company A has a 25% profit margin, whereas Company B has a 15% profit margin. In this case, Company A’s sales are more valuable than Company B’s sales. So, if Company A has a higher P/S ratio, it might be justified because it generates more profit for every rupee of sales. Therefore, when you see a company with a higher P/S ratio, consider checking its profit margin for better insights.
Price to Book Value (P/BV) Ratio
The “Book Value” of a company is like the money left on the table after the company has paid all its debts. Think of it as the amount a company would have if it sold everything and settled all its obligations. If a company has a Book Value of Rs. 200 crores, it means that’s the amount it could get after selling everything and paying off debts. Usually, this Book Value is divided by the number of shares, so if the Book Value per share is Rs. 60, each shareholder could expect Rs. 60 if the company decided to sell everything and distribute the money. The Price-to-Book (P/BV) Value ratio shows how many times the stock is trading compared to the book value of the company. If this ratio is high, it means the stock is more expensive.
To calculate the Price to Book Value Ratio,
Price to Book Value Ratio = Current Stock Price/Book Value (BV)
Also, Book Value (BV) = Share Capital + Reserves (excluding revaluation reserves) / Total Number of shares
A P/BV Ratio of 7 indicates that the stock price is trading 7 times its book value.
Price to Earnings (P/E) Ratio
The Price-to-Earnings (P/E) ratio is a widely used financial measure. It shows how much the market is willing to pay for a company’s stock for each rupee of profit the company makes.
To calculate Price to Earnings Ratio,
Price to Earnings Ratio = Current Stock Price/Earnings Per Share (EPS)
Also, EPS = PAT/Total Number of shares
Earnings Per Share (EPS) assesses a company’s profitability for each share. It helps us understand the profits earned for each share.
A P/E Ratio of 30 indicates that for every unit of profit the company earns, the market participants are willing to pay 30 times. The higher the P/E, the more expensive is stock.
When considering the P/E ratio, keep these important points in mind:
- P/E tells you if a stock is expensive or cheap. Avoid stocks with high valuations.
- Remember that the “Earnings” in P/E can be manipulated.
- If a company’s earnings are going up, but its cash flows and sales aren’t, something is not right.
- Watch how depreciation is accounted for; lower depreciation can make earnings seem higher.
In this article, we learned about Operating Ratios and Valuation Ratios.
Next Chapter: Summing Fundamental Analysis
