Four financial ratios to help you buy the best stocks

A few years ago, a leading stock brokerage ran a television and print advertisement with the following punchline. “Buy right and sit tight.” The phrase is self-explanatory but it means that you should invest in high-quality stocks with the right attributes and then hold them for years to earn the best returns on your investment. 

It's the correct advice and that’s what retail investors should follow to protect their portfolio from the market volatility and the confusion resulting from the daily stock price movement.

But the next question is how should you select the right stocks. The short answer is that you should invest in stocks with the best potential to deliver faster earnings growth but the company should achieve this without taking undue risks.

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To do that, you have to sift through your target company’s annual and quarterly results and then compare its financial ratios with its competitors. Here are four golden ratios that have the maximum bearing on a company’s financial performance. Companies report all these ratios in their annual reports:

1. Return on equity (RoE) or return on net worth (RoNW): The return on shareholders’ equity, also called RoNW as per Indian accounting standards, is one of the best ways to select high-performing companies from a heap. 

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The ratio shows how much profit the company can generate on the shareholders’ capital invested in the company. As a thumb rule, RoE should be consistently higher than the long-term borrowing cost such as the yield on the 10-year government of India bonds. Companies with high double-digit RoEs tend to grow faster than those with low RoEs. Higher RoE translates into strong internal accruals that allow these companies to invest in growth and expansion without resorting to high borrowings. This makes them less susceptible to the ups and downs of business cycles and changes in interest rate cycles. 

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High RoE companies especially do well in an economic recession when companies with poor financial ratios struggle and even face bankruptcy.

All listed companies report their annual RoE in their annual reports that they mail to their shareholders or are available for download from the company's website or BSE and NSE portals.

2. Return on capital employed or RoCE: Companies not only use shareholders’ capital or equity for their businesses but also borrow capital from banks or the bond market for investment. That’s why it’s important to know the returns being generated not only on the shareholders’ equity but on the entire capital employed in the business. This is obtained from RoCE. 

It is calculated by dividing a company’s annual net profits by the average capital employed in the business during the year multiplied by 100. Many analysts also take profit before interest and taxes (PBIT) instead of post-tax net profit (PAT) to calculate RoCE. 

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Using PBIT gives higher RoCE compared to the one using PAT. As a general rule, RoCE should be higher than the cost of capital or long-term borrowing. 

3. Leverage Ratio or debt-to-equity ratio (DER): The debt-to-equity ratio shows the extent of financial leverage or borrowing that the company is using to grow its business. It is calculated by dividing a company’s average debt during the year by its average net worth or shareholder’s equity during the year. 

A company with DER will spend a large part of its operating profit on interest payments, leaving little for reinvestment in the business or distribution to shareholders. In fact, most of the higher performing or alpha stocks in India such as Hindustan Unilever, TCS, Infosys, Nestle, Asian Paints, Titan, Page Industries, Cipla and Divi’s Lab, Colgate Palmolive, Maruti Suzuki and ITC among others have little or no debt on their balance sheets.

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4. Interest Coverage Ratio (ICR): The ratio shows the ease with which the company can service its debt. A higher ratio means that it has a higher level of financial flexibility while a low ratio indicates a low financial headroom and poor profitability. 

It is calculated by dividing a company’s operating profit or EBITDA by its interest expenses during the period. An ICR of 1.5 or less means that the company is very close to defaulting on its loan and ideally the ratio should be 5 or higher. ICR is meaningless if the company is debt free or has very little debt on its books. The ratio is only used for non-financial companies.

(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).

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