If you are tired of sitting through hundreds of YouTube videos or reading thousands of articles and blog posts, but still do not know how to measure the financial health of a company, then you've come to the right place. In this article, we will discuss six simple and vital metrics that every retail investor should understand before investing in any company. These metrics will guide you toward making informed decisions and establishing whether a company is worth your money.
Return on Equity (ROE)
Return on equity (ROE) is an important measure of the efficiency with which a firm operates. ROE measures how well a company uses shareholders' equity to generate profits. It helps investors to understand whether or not shareholders' capital is being used efficiently and if returns are in accordance with expectation.
Companies have a large number of shareholders who place their money with expectations that the firm will utilize these assets properly and profitably. ROE measures how good a firm is at properly using the shareholders' equity to build up significant profitability. A high ROE means that the firm is properly using the shareholders' equity to achieve great profits whereas a low ROE might indicate inefficiency.
It allows one to determine if the company has met and surpassed shareholder's expectations. An increasingly high ROE indicates strong effective capital management and also excellent performance in managing.
Example:
If a company reports a net income of ₹100 crore alongside shareholders’ equity of ₹500 crore, the return on equity (ROE) would be calculated as 20%. This indicates that the company produces a 20% return on each rupee invested by its shareholders, reflecting an efficient utilization of equity.
Return on Capital Employed (ROCE)
Return on Capital Employed is a comprehensive measure taken as an extension of Return on Equity. This returns measure the ability of a company to earn profits using its total capital, made of both equity and debt. In order to understand the concept of ROCE, one needs to start first by defining what capital is.
What is capital? A firm gets capital in two primary ways:
Equity: Ownership refers to equity. Equity capital is thus created when a firm issues part of itself, or its shares, in return for cash into investors.
Debt: Debt is defined as loans. Organizations acquire funds from banks, non-banking financial companies (NBFCs), or other institutions at a predetermined interest rate and are required to repay the borrowed sum over a specified period.
The sum of equity and debt yields the total capital of the company. ROCE differs from ROE and is considered more effective because of its scope. While ROE measures returns only on the returns generated from the shareholders' equity alone, ROCE considers the returns on the entire capital employed, including both equity and debt.
Example:
If a firm has net income of ₹100 crore, shareholders' equity ₹500 crore, and debt of ₹200 crore, its ROCE would be 14.28%. To say simply, it is generating a return on equity of 14.28% for every rupee invested by its shareholders and its debtholders.
Price to Earnings (P/E) Ratio
P/E ratio is the quantity that the market is willing to pay for every ₹1 of the company's earning per share. The P/E ratio helps to calculate whether the stock price of a company is undervalued or overvalued. However, while using this ratio should not be used as the only discretion for calculating the valuation of a stock. Other valuation metrics should also be considered; however, this ratio gives an overall view. This has to be compared constantly with the industry average P/E ratio. For instance, if a company's P/E ratio stands at 20 but the average P/E ratio in its industry is 30, then market is pricing it much lower than the average industry average. This can thus make the stock look undervalued.
Example:
If a company has ₹100 crores as net income, the total number of shares are 50 lakhs, and its share price is ₹5000. The Earning per Share would be 200 (100 crores / 50 lakhs) and PE ratio will be 25 (5000/200).
Other Income as Percentage of Total Revenue
This ratio becomes crucial to draw a judgment whether revenue of a company comes from core business operations or otherwise. Sometimes companies inflate the size of their revenues by reporting a large amount under the "other income" category, thereby making the size of the revenue figure in the Profit and Loss Statement greater than it actually is.
In this respect, an investor should ensure that the vast majority of the revenues reported in the Profit and Loss Statement primarily arise from the company's underlying business operations. Some ancillary revenue is acceptable, as companies may earn some additional income throughout the year. Still, "other income" should not be an meaningful percentage of overall revenue. If it's large, then there might be something wrong with company's revenue strategy.
The lower it is, the better it is. A low ratio indicates that a firm's revenue comes from core business activities, and this is a healthy and sustainable revenue model. The more the high ratio is, the more a firm is reliant on non-operating income as a source of revenue, which is a warning sign to investors.
Example:
If a company's Other Income is 20 crore and the Total Revenue is 400 crores, then the ratio of Other Income to Total Revenue will work out to be 0.05 or 5%.
Interest Coverage Ratio
This ratio shows the rate at which a company can pay the interest of its loan using its operating income. It measures a firm's ability to pay off the interest from the income earned by the operations it conducts. Operating income refers to the income left after deducting any manufactured or core business expense, as it constitutes necessary expenses that the company must incur.
This ratio is expressed in terms of times. The higher the ratio, the better is the condition. This ratio becomes handy to check companies with huge debts. This is how a company's ability to deal with its debt can be measured. But if a firm has almost nil debt, then it is not worth considering this ratio.
Example:
If it has an operating income of ₹ 150 crores and carries a loan with an interest burden of ₹300 crore at 10%, then the interest charge would be ₹30 crore. Thus, interest coverage ratio will be calculated as 5 times (150/30). This reflects that the company has enough means to pay five times the interest cost in one year.
Promoter's Shareholding
A promoter's holding refers to the percentage share of the equity owned by the promoters of any company. This is considered a measure of great importance in evaluating the commitment and stake of the promoters in the business they own or finance.
If the promoter's holding is high, it indicates that the promoters have a strong interest in the company. This means that any decisions they make are likely to be in the best interest of the company because if the company suffers losses due to poor decisions, it will not only affect the investors but also result in significant losses for the promoters, as they hold the largest share of the company. On the other hand, if the promoter’s holding is low, it could suggest that the promoters might not be as serious about the company, and the decisions they make could be less focused on the company’s long-term well-being. In this case, if the company faces losses, the promoters would not be as severely impacted, as their stake is minimal.
Hence, a company that shows a high level of holding by the promoter is normally regarded as a good signal while low holding by the promoters may be considered as bad signal.
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