“In the short-term, the stock market is a voting machine, but in the long-term, the market is a weighing machine,” the legendary American investor Warren Buffet once said.
This means that on a day-to-day basis, stock prices are volatile and are greatly influenced by transitory news flows and investors' emotions, somewhat similar to voters’ behaviour during elections. However, in the longer term, the noise surrounding a stock dies out and its financial metrics such as revenues, profits and the balance sheet become the most important factors. The clarity about the company’s business and financial performances emerges over time and the market begins to weigh its value, with the stock price reflecting the company’s true intrinsic valuation.
This also means that in the short term, a company’s stock price can deviate from its intrinsic value thanks to investors’ sentiment. It creates a good opportunity for long-term investors to pick value stocks at a low price.
However, this requires some basic skills to help you find the gap between a stock's current price and its long-term intrinsic value. The recent correction in Indian equity with a double-digit fall in the share price of many frontline stocks offers a good opportunity for long-term investors to do stock picking.
Warren Buffet also says that equity investing is simple but not easy. Selecting the right stock in a rising or falling market is simple and you just have to track the changes in a company’s key financial and valuation ratios. It’s not rocket science. Remember, we have a far greater number of successful equity investors than top-class rocket scientists.
Here are five common financial ratios easily available for all listed companies that you can use to evaluate the potential gap between their current stock price and their true value in the long term.
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 it has received from its shareholders and owners.
As a thumb rule, RoNW or RoE should be consistently higher than benchmark interest rates in the economy such as the yield on 10-year government of India bonds.
Companies with high double-digit RoNW tend to grow faster than their companies with low RoEs. Higher RoE translates into strong internal cash flows that allow these companies to invest in their growth and expansion without resorting to debt financing.
This also insulates these companies from the vagaries of business cycles and changes in interest rates in the economy. Companies with consistently high RoE also tend to be cash-rich and pay generous dividends to shareholders or do large share buybacks. High RoE companies tend to outperform their 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.
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.
We can know this by calculating a company’s return on its capital employed or RoCE. 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 long-term borrowing.
And everything being equal you should invest in a company with a higher RoCE. For debt-free companies, RoE and RoCE are the same.
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 balance sheet with 0.4 to 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.
Also Read: Ten mid-cap stocks for investment in 2024
4. Price to earnings (P/E) multiple or ratio
The price-to-earnings multiple is the first and basic tool to value a stock. It is calculated by dividing a company’s current market capitalisation by its annual net profit or its cumulative net profit in the latest trailing 12 months (TTM) or last four quarters. Alternatively, the P/E multiple can be calculated by dividing a company’s current share price by its latest annual earnings per share (EPS) or its trailing 12-month EPS.
For example, Reliance Industries is currently trading at a P/E multiple of 26 times while ONGC is trading at a P/E multiple of 6.8 times. As a general rule, companies with faster growth in revenues and profits and those with higher RoNW and RoCE and lower debt-to-equity ratio get higher P/E and vice versa.
So you can invest in a company if its P/E has fallen but it continues to grow at a decent pace, and is reporting consistently higher RoNW and RoCE and has low debt.
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. Networth in turn is the difference between a company’s total assets and its total liabilities.
As a general rule, a financially healthy company’s P/B ratio should always be greater than one. A company’s valuation becomes cheap when its P/B falls below one.
Here again, fast-growing companies and those with higher RoNW and RoCE and lower debt-to-equity ratios have higher P/B ratios than others. 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 and software services.
For example, Reliance Industries is currently trading at a P/B ratio of 2.42, ONGC at 0.95 while TCS is at a P/B ratio of 14. 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.
(Disclaimer: This article is for information purposes only. Readers are advised to consult a certified financial advisor before investing in any of the funds or securities mentioned above.)
(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist)
Also Read: Seven ways to save and grow your money