Basic HTML Version
16 | The Lion King
Feature
the better. It is calculated as
Total Debt (Current + Long-term Liabilities) x 100
Total Assets (Current + Fixed Assets)
b. Total Debt to Equity Ratio:
It shows the relative
proportions of borrowed funds to owners’ funds.
It measures a company’s overall risk exposure;
therefore, the lower the ratio, the better. It is
calculated as
Total Debt x 100
Shareholders’ Funds
c. Long-term debt to Equity Ratio:
It measures
the proportion of long-term borrowed funds
to owners’ funds. It emphasizes more on the
company’s long-term risk exposure. It is calcu-
lated as
Long-term Liabilities x 100
Shareholders’ Funds
d. Interest Cover:
The ratio is used to assess how
easily a company can pay interest on its
outstanding debts. It indicates how many times
a company’s profits cover its interest charges,
since failure to meet these obligations could
force a company into bankruptcy. Some analysts
see this as an important measure of solvency.
The higher the interest-cover the less risky the
company is believed to be. It is calculated as
Operating Profit x 100
Interest Expense
VALUATION RATIOS
These are ratios that interest investors due to their
relevance at the point of making investment
decisions. Also, they vary more often than other
ratio classes because, for most of them, stock
market variables (which are volatile) are applied
in calculating them. By using these ratios, inves-
tors can gain an understanding of how cheap or
expensive a company is trading relative to its fair
value, peer/industry average or the overall market
average. In general, the less expensive a company
is, the more attractive an investment in that
company becomes. Some key valuation ratios will
be reviewed in turn.
a. Price to Earnings Ratio (P/E):
This is the most easily
available valuation ratio. While the recent stock
price can be obtained from the stock exchange,
earnings per share can be obtained from the
company’s latest financial results. It is calculated
as
Recent Price per share (times)
Earnings per share
Generally, the P/E ratio is an indication of investors’
desire for a stock/company but this may not always
be so. This is why analysts are cautious when inter-
preting the P/E. It is believed to be a two-edged
sword in that high P/Es could suggest an entry point
especially when expected growth in earnings is
high or an exit point as the stock is believed to be
overvalued (expensive).
b. Price to Book Ratio (P/B):
The ratio measures
a company’s market value relative to its book
value. It depicts how much premium or discount
an investor is paying for a company’s book value
(what will be left if the company goes bankrupt
immediately). The lower the ratio is the better;
however, very low P/B ratios could be an indica-
tion of some fundamental problems. It is calcu-
lated as
Recent price per share (times)
Book value per share
c. Price to Sales Ratio (P/S):
It measures the relation-
ship between a company’s market value to its
sales. It shows how much the company’s sales is
valued by the market. A lower P/S ratio indicates
that the stock is relatively cheaper. The ratio is
calculated as
Recent price per share (times)
Sales per share
d. Dividend Yield:
Besides capital appreciation,
this is the return investors actually get from their
investments in a company. It measures the
proportion of amount invested that the investor
actually earns. Usually a higher dividend yield is
an indication that investors should expect better
cash inflow. This is why high yielding stocks are
considered as safe investments; although, high
yields could impact adversely on the company’s
future growth where the company’s retention
ratio is low. Dividend yield is calculated as
Dividend per share x 100
Recent price per share
SUMMARY
Ratios are tools for comparing companies in the
same industry or business. They can also be used to
measure a company’s performance over time. It is
essential to exercise caution when analyzing ratios.
For instance, comparing the profit margin or P/E
multiple of a Building materials company with that
of a consumer goods company could be mislead-
ing, as the businesses have dissimilar economics of
operation and business cycles.
The information an investor requires to calculate
ratios can be obtained from a company’s financial
statement (which can be found on the company’s
website or on most stock quote sites/publications).