Five financial ratios to pick value stocks in a volatile market

According to legendary American investor and industrialist Warren Buffett, the stock market is a voting machine in the short term, but in the long term, the market is a weighing machine. It means that on a day-to-day basis, stock prices are volatile and greatly influenced by daily news flow and investor sentiment. 

However, in the longer term, the noise surrounding a company dies out and its business and financial fundamentals like revenues, profits, capital, borrowings and other balance sheet ratios become key driving factors behind its stock price.  The true nature of a business and financial performance emerges over time and the market begins to weigh its value properly.

This also means that in the short-term, a company's stock price can be significantly higher or lower than its intrinsic value thanks to market noise or market sentiment. This creates an opening for long-term investors to pick quality stock when there is extreme pessimism in the market or there is great volatility. 

Stock picking is however a process and requires some skill to find the gap between a stock's current price and its long-term intrinsic value.

The recent correction in Indian equity with a 30-40 percent decline in the share price of many stocks in the last two days offers a good buying opportunity for long-term investors. Here are five common financial ratios easily available for all listed companies that any investor can use to evaluate a stock and find one that offers the greatest gap between its current market stock price and intrinsic value.

1. Return on net worth or equity (RoNW)

The return on shareholders’ equity, also called the return on net worth, is one of the best ways to filter out high-performing companies from poorly managed ones. The ratio is calculated by dividing a company’s annual net profit by its average net worth in the last two financial years. The ratio shows how much profit the company is making on the capital that shareholders and owners have provided it. 

As a thumb rule, RoNW should be consistently higher than benchmark interest rates such as the yield on the 10-year government of India bonds. Companies with high double-digit RoNW tend to grow faster than their peers with lower ratios. 

Higher RoE translates into strong internal cash flows that allow these companies to invest in their growth and expansion without resorting to debt financing or equity dilution. This insulates these companies from the vagaries of business cycles and changes in interest rates in the economy. Companies with consistent return on equity also tend to be cash-rich and pay generous dividends to shareholders. High RoE companies tend to outperform their financially weaker peers during an economic recession and market declines. So invest in a company with a high RoE if its share price declines without a matching decline in its profitability.

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2. Return on capital employed or RoCE

Companies not only use shareholders’ capital or equity in their businesses but also borrow capital from banks or the bond market to invest. That’s why it’s important to know the returns that it is generating on shareholder’s equity but on the entire capital that it has employed in its business. It is calculated by dividing a company’s annual net profits by the average capital employed in the business in the last two years. 

Many analysts also use profit before interest and taxes (PBIT) instead of post-tax net profit (PAT) to calculate RoCE. 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 the company’s borrowing cost. And everything being equal you should invest in a company with a higher RoCE. 

For debt-free companies, RoE and RoCE are the same only.

3. Leverage Ratio or debt to equity ratio (DER) 

The debt-to-equity ratio shows the extent of financial leverage or the 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. 

For a non-financial firm, a DER above 1.0 is considered to be risky while a company with a debt-to-equity ratio of between 0.4 and 0.6 is considered to be prudent and financially sustainable. 

A company with high DER will spend a large part of its operating profit on interest payment leaving little for reinvestment in the business or distribution to shareholders as dividends. In fact, most of the higher performing stocks in India such as Hindustan Unilever, TCS, Infosys, Nestle, Asian Paints, Titan, Cipla, Divi’s Lab, Colgate Palmolive, Maruti Suzuki and ITC are largely debt free.

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4. Interest Coverage Ratio (ICR)

The ratio shows the ease with which the company can service its debt from its profits. A higher ratio means that the company has a higher level of financial flexibility while a low ratio indicates that the company’s profits are inadequate compared to its financial liabilities.

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.

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5. Price to book value (P/B) ratio

This is another common ratio to value companies on the stock market. It is calculated by dividing a company’s current market capitalisation by its latest annual net worth or shareholders equity which is also called book value in accounting terms. Net worth in turn is the difference between a company’s total assets and its total liabilities. In a normal market, a financially healthy company’s P/B ratio is most often greater than one. 

A company’s valuation becomes cheap when its P/B falls below one. Fast-growing companies and those with higher RoE and lower debt-to-equity ratios have a higher P/B ratio. Also, companies in capital-intensive and cyclical businesses such as oil & gas, telecom, metals & mining, banking & finance, cement and infrastructure get lower P/B than companies in less capital-intensive industries such as manufacturing, FMCG and technology. Buy a stock if there has been a sharp fall in its P/B ratio without a matching fall in its profitability and other financial ratios.

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

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