key ratios while buying stocks

LOOKING to buy stocks but you are not sure how to select them? Don't fret. We have, here, eight ratios that would make your life easier, and of course, enable you to make the best possible stock selection.

1. Ploughback or Reserves
Every year, the company divides its net profit (profits in hand after subtracting various expenses including taxes) in two portions: ploughback and dividends.

While dividends are handed out to the shareholders, ploughback is kept by the company for its future use and is included in its reserves. Ploughback is essential because, besides boosting the company’s reserves, it is a source of funds for the company’s expansion plans. Hence, if you are looking for a company with good growth prospects, check its ploughback figures. Reserves are also known as shareholders’ funds, since they belong to the shareholders. If a company’s reserves are twice its equity capital, the company can reward its shareholders with a generous bonus. Also any increase in reserves will push the share price of your share.

2. Book value per share
This ratio shows the worth of each share of a company as per the company's accounting books. It is calculated as:
Shareholders' funds
------------------------------------------------ = Book Value per share
Total quantity of equity shares issued

Shareholders' funds can be computed as such:
Total assets (equity capital to the company's reserves) less total liabilities (money owed to creditors).

Book value is an old record that uses the original purchase prices of the assets.

However, it doesn't show the present market price of the company’s assets. As a result, this ratio has a restricted use when it comes to estimating the market price of the shares, but can give you an estimate of the minimum price of the company’s shares. It will also help you judge if the share price is overpriced or under-priced.

3. Earnings per share (EPS)
One of the most popular investment ratios, it can be computed as:
Profit Post Tax
------------------------------------------------ = EPS
Total quantity of equity shares issued

This ratio computes the company's earnings on a per share basis. Say, you own 100 shares of ABC Co., each having a face value of Rs 10. Assume the earnings per share is Rs 10 and the dividend declared is 30 per cent, or Rs 3 per share. This implies that on every share of ABC Co., you earn Rs 6 each year, but you actually get Rs 3 via dividend. The balance of Rs 4 per share goes into the ploughback (retained earnings). Had you purchased these shares at par, it implies a return of 60 per cent.

This example shows that instead of looking at the dividends received from to company as the base of investment returns, always look at earnings per share, as it is the actual indicator of the returns earned by your shares.

4. Price Earnings Ratio (P/E)
This ratio highlights the connection between the market price of a share and its EPS.
Price of the share
------------------------ = P/E
Earnings per share

It shows the degree to which earnings of a share are protected by its price. Say, the P/E is 40, it means the share price is 40 times its earnings. So if the company's EPS is constant, it will need about 40 years to make up for the purchase price of the share, after taking into account the dividends and the capital appreciation. Hence, low P/E means you will recover your money quickly.

P/E ratio shows what the market thinks about the earnings potential and future business forecast of a company. Companies with high P/E ratios are the darlings of the investors and thus enjoy a higher market rating. In order to use the P/E ratio properly, take into account the future earnings and growth projections of the company. If the current P/E ratio is low, as against the future prospects of a company, then the shares make an attractive investment option. But if the company is saddled with losses and falling sales, stay away from it, despite the low P/E ratio.

5. Dividend and yield
Dividend is the portion of the profit that is distributed amongst shareholders. Companies offering high dividends, normally don’t have much of growth to talk about. This is because the ploughback required to finance future development is insufficient. Similarly, those companies in high growth sector don’t give any dividend. Instead here they give sharp capital appreciation, which ultimately will lead to higher dividends.

So it makes much more sense to invest for capital appreciation instead of dividends. Rather it makes more sense to invest for yield, which is nothing but the association between the dividends and the market price of the shares. Yield (dividend yield) can be calculated as:

Dividend per share
----------------------------- x 100 = Yield
Market price of a share

Yield shows the returns in percentage that you can expect via dividends earned by your investment at the current market price. It is more useful than simply focusing on the dividends.

6. Return of capital employed (ROCE)
ROCE is the ratio that is calculated as:
Operating profit
----------------------------------------
Capital employed (net value + debt)

To get operating profit, add old taxes paid, depreciation, special one-off expenses, and special one-off income and miscellaneous income to get the net profit. The operating profit is a far better indicator of the profits earned by the company instead of the net profit. Hence this ratio is the better indicator of the general performance of the company and the company’s operational efficiency. It is one of the most useful ratio that lets you compare amongst the companies.

7. Return on net worth (RONW)
RONW is calculated as
Net Profit
-----------------
Net Worth

This ratio gives you an idea of the returns generated by investing in the company. While ROCE is an effective measure to get a general overview of the profitability of the company’s business operations, RONW lets you gauge the returns you can earn on your investment. When used along with ROCE, you get an overview of the company’s competence, financial standing and its capacity to generate returns on shareholders’ finances and capital employed.

8. PEG ratio
PEG is an essential and extensively used ratio for calculating the inbuilt worth of a share. It helps you decide whether the share is under-priced, totally priced or overpriced. To derive the ratio, you have to associate the P/E ratio with the expected growth rate of the company. It assumes that higher the growth rate of the company, higher the P/E ratio of the company’s shares. Vice versa also holds true.

P/E
----------------------------------
Expected growth rate of the EPS of the company

In general, a PEG lesser than 0.5 is a lucrative investment opportunity. However if the PEG exceeds 1.5, it is time to sell.

These are some of the most critical ratios that must be considered when purchasing a share. Extensive reading of the financial performance of the company in newspapers and magazines will help you get all the relevant information to arrive at the correct decision.

12 golden rules needed in the equity market

The author (Max) son of a very wealthy Swiss citizen by name, Franz Heinrich, (whom Americans preferred to call Frank Henry), jotted down all the principles of speculation strategies, particularly in stocks, adopted by his father and his father's several other Swiss friends to make large fortunes on the Wall Street in USA in roaring Eighties. Principles perfected by these Swiss gentlemen have therefore been called "Zurich Axioms" by Max.

Enumerated below are twelve major principles and sixteen minor ones

First Major Axiom: On Risk
“Worry is not a sickness but sign of health. If you are not worried, you are not risking enough.”
Adventure is what makes life worth living. Every occupation has its aches and pains. The rich have to worry about their wealth. But, if there is a choice between remaining poor and worry-free, the selection is obvious. It is better to be wealthy and worried than to be worry-free and poor.

Minor Axiom I:
“Always play for Meaningful Stakes.”
If you invest Rs. 1000 and your investment doubles, you have only Rs. 2000 and are still poor! So if you want to be rich, you must increase your stakes.

Minor Axiom II:
“Resist the allure of diversification”.
Firstly, diversification negates the earlier principle of playing for meaningful stakes. Secondly, it may keep you where you began so that your gains on few will cancel out the losses on the other few. Thirdly, it entails keeping track of many more items leading to confusion and occasional panic.

Second Major Axiom: On Greed
“Always take your profit too soon.”
Lay investors having made the investment tend to stay too long on it out of greed for higher profits. But, one must conquer this weakness and book profits soon. If one is less greedy for more profits one will take in more. Don't stretch your luck. In effect, it suggests, SELL sooner than later.

Minor Axiom III:
"Decide in advance what gain you want from the venture, and when you get it, get out. Decide where the finish line is before you start the race".

This is self explanatory and hence needs no comment.

Third Major Axiom: On Hope
“When the ship starts to sink, don't pray, jump”
This axiom is about what to do when things go wrong. Learn how to accept a loss. One should accept small losses to protect oneself from big ones. When the market starts falling, sell, take your money and run!

Minor Axiom IV:
"Accept small losses cheerfully as a fact of life."
Expect to experience several smaller losses while awaiting a large gain.

Fourth Major Axiom: On Forecasts
"Human behavior cannot be predicted. Distrust anyone who claims to know the future, however dimly."
The story of a monkey throwing darts on the stock exchange page of a newspaper, to select the companies to buy, and coming out a winner is too well known to be recited. Recent news from London, further proves the truth, when an untrained chemist's stock selections, in a widely publicised contest open to all and sundry, registered higher appreciation over several full time highly qualified fund managers' well researched selections. Human events cannot be predicted by any method by anyone and, hence, don't trust anybody's predictions.

Fifth Major Axiom: On Patterns
"Chaos is not dangerous until it begins to look orderly."
The truth is that the world of money is a world of patternless disorder and utter chaos. This axiom is a commentary on Technical Analysis - a branch of investment strategies based on charts and patterns. The fact is, no formula that ignores own intuition's dominant role can ever be trusted.

Minor Axiom V:
"Beware the Historian's Trap".
This is based on the age old but entirely unwarranted belief that history repeats itself.

Minor Axiom VI:
"Beware the Chartist's Illusion".
Life is never a straight line. Let us not be hypnotised by a line on a chart.

Minor Axiom VII:
"Beware the Co-relation and Causality Delusions."
Don't be taken in by coincidences in the market.

Minor Axiom VIII:
"Beware the Gambler's Fallacy."
There is a gambling theory which suggests that one should put small stakes initially and test their luck, and if these turn out well one should go for big stakes on the dice table. But this is not correct. It only shows that winning streaks happen. But nothing is orderly about it. You can't know how long it will last or when it will strike.

Sixth Major Axiom: On Mobility
"Stay away from putting down roots. They impede motion".
You may feel socially comforting to have roots. But in financial life, roots can cost a lot of money. Have a flexible approach while investing. This axiom implies a state of mind.

Minor Axiom IX:
"Do not become trapped in a souring venture because of sentiments like loyalty and nostalgia."
Do not develop emotional attachment to your investment. You should feel free to sell when desired.

Minor Axiom X:
"Never hesitate to abandon a venture if something more attractive comes into view."
Never get attached to things, but only to people. Otherwise it hits your mobility. Never get rooted in an investment. You should remain footloose, ready to jump away from trouble or into a profitable opportunity as and when circumstances demand.

Seventh Major Axiom: On Intuition
'A hunch can be trusted if it can be explained.'
A good hunch is something that you know but you don't know how to recognise it. When a hunch hits you, try to locate some data in your mind for any familiarity. Then only should you act on it.

Minor Axiom XI:
'Never confuse a hunch with a hope'.
Be highly skeptical. Examine every hunch with extra care.

Eight Major Axiom: On Religion and The Occult
'It is unlikely that god's plan for the universe includes making you rich'.
You can't only pray that you should be made rich. You will have to work at becoming rich. Mere prayers will not suffice.

Minor Axiom XII:
'If Astrology worked, all astrologers would be rich.'
This is self explanatory. Don't trust predictions.

Minor Axiom XIII:
'As superstition need not be exorcised, it can be enjoyed provided it is kept in its place.'
In your day-to-day financial matters, act rationally. But, when buying a lottery ticket, give it a full play to amuse yourself.

Ninth Major Axiom: On Optimism and Pessimism
'Optimism means expecting the best, but confidence means knowing how you will handle the worst. Never make a move if you are merely optimistic.'
In poker and a lot of other speculative worlds, things are never as bad as they seem - most of the times they are WORSE.

Confidence comes not from expecting the best but from knowing how you will handle the worst. Optimism can be treacherous because it makes you feel good.

Tenth Major Axiom: On Consensus
'Disregard the majority opinion. It is probably wrong'.
It is likely that the Truth has been found out by a few rather than by many.

Minor Axiom XIV:
'Never follow speculative fads. Often, the best time to buy something is when nobody else wants it.'
This is the best way to get a good stock cheaply.

Eleventh Major Axiom: On Stubbornness
'If it doesn't pay off the first time, forget it'.
If at first you don't succeed, try and try again and you will succeed in the end. This is good advice for spiders and kings but not for ordinary persons with regard to financial matters. Every trial is a costly error.

Minor Axiom XV:
'Never try to save a bad investment by averaging down.'
If the price of the stock goes down after your purchase don't buy more to bring down' the average cost of your total holding. Investigate why the price went down rather than put good money in a bad bargain.

Twelfth Major Axiom: On Planning
'Long-range plans engender the dangerous belief that the future is under control. It is important never to take your own long-range plans, or other people's seriously.'
This is self explanatory and hence needs no comment.

Minor Axiom XVI:
'Shun long-term investments.'
If possible try to stay away fro long-term investments. The author noticed that the Swiss group never took a long-term view of their stock purchases. They always sold out as soon as their targeted profit was achieved.