Stock Market Investing – Understanding Indices & Ratios
After attaining the ability to analyze a company’s financials and understanding the first step of fundamental analysis, we can now dive deeper and understand how this analysis manifests itself at the stock market. If you haven’t read my previous posts on Income Statement and Balance Sheet, I strongly advise you to spend some time on it and come back.
Before we directly look at a single stock quote and its ratios on any stock market index, we must first ask “What is the Index?” and “How is the Index calculated in points when stock price quotes are declared as currency?”. There are several stock indices across the globe(list), and each index measures the performance of a section of the market. For example, the S&P 500 is a list of 500 large companies whereas NIFTY 50 is an index comprising of only 50 companies. Some indexes only track performance of technology company stocks, whereas others look at the inflation or consumer price index. While every index is calculated using different weighting criteria, let us use a basic example and understand.
Let’s say we have an index called FinVana with 3 listed companies : A, B & C
As seen in the above image, at time T0(inception date of FinVana), each company was listed with 1000, 500 and 250 shares. One of the key terms to note here is Market Capitalization which translates to the total market value of a company’s outstanding shares. Therefore, if an investor wished to buy out company A, he would need $25,000 in the above case.
MCAP = Price x No. of Shares
Thus, at inception, the total MCAP for FinVana was $300,000
Now after a year at time T1, the index has seen some changes. Company A announced a split and the number of shares increased to 200, company B announced buybacks whereas company C performed well to show significant increase in its stock price. The new MCAP can be easily calculated as $260,000
At the time of listing an index, a random base value is chosen for it. Let’s say that the base value for FinVana at T0 is 1000 points. This is simply any number that can be chosen and all future performance calculations for the index are based on this chosen value.
Therefore, at T0 , FinVana = 1000 points when MCAP = 300,000
then using the basic cross multiplication rule we can compute the value of FinVana at T1 when MCAP = 260,000
Index at T1 = Index at T0 x MCAP(T1) ÷ MCAP(T0) = 1000 x 260,000 ÷ 300,000
Index value at T1 = 866.67 points
This is calculated using the market capitalization weighting and different weighting methods could be used to compute the index. However, the basic principle remains the same and we can now understand what it means when somebody says “The S&P dropped 10% today!”.
Now let’s move on to understanding the several ratios associated with a company’s stock. We often hear analysts mentioning several ratios in their discussion, which can sometimes make a retail investor feel overwhelmed and leave the important investment decisions to the expert. However, I’m here to make it easier for you 🙂
1. P/E Ratio
Let us first understand Earnings per Share(EPS). The EPS tells an investor how much is a company earnings for the total number of shares outstanding in the market. While this ratio is widely used, an investor must always be skeptical of its accuracy.
EPS = Net Income ÷ weighted average of outstanding shares
P/E = Price per Share ÷ EPS
Therefore, if P/E = 10, it means that the current stock price is listed at $10 for $1 in earnings. When the P/E ratio is high, many investors are willing to pay high dollar amounts in anticipation of future growth of the company. A low P/E in unattractive to most retail investors indicating modest future growth. However, our goal is to become Value Investors and to look for undervalued bargain stocks that will yield high returns in the future.
When researching a stock, it is also important to look for the Industry P/E and the overall market P/E. For example, the P/E ratio for Netflix must be compared with its competitor companies such as Amazon or Comcast. This will allow an investor to evaluate whether the stock is undervalued or overvalued. If a stocks P/E is 40 whereas the Industry P/E is 25, one must look for reasons why the market is willing to pay 40 times its earnings and research its financial performance.
2. PEG Ratio
The Price/Earnings to Growth Ratio(PEG) compares the P/E ratio with earnings growth rate over a specific time period. This ratio provides a better insight as opposed to the P/E ratio as we can account for a company’s growth rate. A lower PEG ratio would indicate an undervalued stock compared to its earnings potential.
PEG = P/E ÷ Earnings Growth Rate
Let’s look at the stocks from our example in the image above to compute this value
Let us say that EPS for company A at time T1 is 3 and 2.5 at time T0.
Therefore, P/E = 15 ÷ 3 = 5
The earnings growth rate can be calculated as below,
[ EPS(T1) ÷ (EPS(T0) ] – 1 = [ 3 ÷ 2.5 ] – 1 = 0.2 or 20%
PEG = 5 ÷ 20 = 0.25
This ratio offers a bigger picture as opposed to relying only on P/E ratio and can play a significant role when comparing two stocks from the same industry. A value below one is usually considered favorable for investing.
3. PRICE/BOOK VALUE
Another ratio to consider is the price-to-book value.
P/B = Stock Price ÷ Stockholder’s Equity per Share
The book value refers to the company’s assets on the balance sheet by subtracting the liabilities. This is also referred to as shareholder’s equity. This indicates how much investors are willing to pay for the stock compared to the value of the assets of the company.
If P/B has a value of 4, investors are ready to pay 4 times the value of the company’s assets. This ratio has its limitations, as assets such as property are listed with their historical price and sometimes not adjusted to inflation. However, the P/B ratio could be useful when the company has high liquidity and intangible assets.
A low P/B ratio and excellent company performance and fundamentals often show signs of an undervalued bargain stock, whereas poor company financials indicate that the market is right to lower the value of the concerned company. This is why understanding the business model is key to value investing thereby validating the relevance of these ratios.
4. Dividend Yield
It is the annual percentage of dividends offered to investors calculated as below,
Div Yield = Annual Dividend per Share ÷ Stock Price
As I noted in my previous post, companies paying dividends are often mature stable and are great investments for a value investor. For example say company A offers a dividend of $5 in 2017 and its stock price is $50. This shows a dividend yield of 10%. This is a clear sign of a great pick as the company is distributing its earnings among shareholders at 10%.
Historically, dividend-paying companies have performed better than non-paying companies. We must always look for high dividend paying stocks to ensure we are investing for the long run.
5. Debt-to-Equity Ratio
While I have already discussed this in my previous post, I’d like to reiterate its significance. Value investors must beware of high debt companies, as these may show high gains in the beginning, but often collapse in the long run. It is also important to consider the industry in which the company operates, as a lot of industries, such as manufacturing, rely heavily on debt to finance their operations. A stocks D/E should only be compared with another from the same industry. A D/E ratio below one is always a favorable pick among value investors.
There are several other ratios that are used by analysts, but our goal with value investing is to rely on fundamentals and overall growth. These ratios certainly help us understand how the company is performing in the market, but we must rely heavily on our research and analysis of the business in general. If you feel I should elaborate on some other ratios or even the ones I have explained, please let me know in your feedback.
We will continue this learning curve in our next topic to identify whether a market is overvalued or undervalued. Until then …
Be Frugal, Be Smart, Be Rich!