📁 Finance 🏷️ Stock-Market 🏷️ Fundamental-Analysis

📋 Topics Covered

  1. 4.1 📖 Core Terminology and Financial Basics
    • Book Value, Capital Employed, and EPS
    • Capital raising models (Debt vs. Equity)
  2. 4.2 💰 Profitability Ratios
    • Operating Profit (EBITDA), Operating Margin, and PAT Margins
  3. 4.3 🔄 Return Ratios
    • ROE vs. ROCE vs. ROA
    • How return ratios are manipulated by leverage and dividends
  4. 4.4 ⚖️ Leverage Ratios
    • Debt-to-Equity (D/E) threshold guidelines
    • Interest Coverage Ratio (ICR) safety limits
  5. 4.5 🏷️ Valuation Ratios
    • Price-to-Earnings (P/E), Price-to-Book (P/B), and PEG valuation metrics

4.1 📖 Core Terminology and Financial Basics

Before evaluating ratios, it is important to understand the fundamental accounting figures used in calculations:

  • Total Equity (Shareholders’ Equity): Equity Share Capital + Preferred Equity + Reserves & Surplus. This is also referred to as the Book Value (BV) of the company.
  • Capital Employed: The total long-term capital injected into the business: Total Equity + Debt Capital.
  • Book Value Per Share (BVPS): Book Value / Total Outstanding Shares.
  • Net Sales (Topline): Total revenue generated by the business.
  • Earnings Per Share (EPS): Net Profit / Total Number of Equity Shares. EPS changes during corporate actions like stock splits, bonus shares, or fresh share issuances.

💰 Funding & Capital Raising Options

Companies fund operations through two main channels:

Funding Source Ownership Dilution Payment Obligation Impact on Risk
📈 Equity Capital Yes (New shares issued). No fixed obligation (Dividends are discretionary). Low risk (No repayment threat).
🏦 Debt Capital No (Retains full control). Yes (Fixed interest and principal repayment). High risk (Default can lead to bankruptcy).

4.2 💰 Profitability Ratios

Profitability ratios measure the company’s ability to generate earnings relative to its sales revenue:

graph TD
    A[Net Sales / Topline] -->|Minus Operating Costs| B[EBITDA]
    B -->|Minus Depreciation & Amortization| C[EBIT / Operating Profit]
    C -->|Minus Finance Costs / Interest| D[PBT / Profit Before Tax]
    D -->|Minus Tax Expense| E[PAT / Net Profit / Bottomline]
    
    style A fill:#e1f5fe,stroke:#03a9f4,stroke-width:2px
    style B fill:#e8f5e9,stroke:#4caf50,stroke-width:2px
    style C fill:#fff3e0,stroke:#ff9800,stroke-width:2px
    style D fill:#ffebee,stroke:#f44336,stroke-width:2px
    style E fill:#f3e5f5,stroke:#9c27b0,stroke-width:2px
  • PAT Margin (Bottomline Margin): Shows what percentage of revenue remains as final profit after all interest, depreciation, and taxes have been paid: PAT = PBT - Taxes PAT Margin = PAT / Net Sales
  • EBIT Margin (Operating Margin): Measures the profitability of core business activities before finance costs and tax burdens: EBIT = PAT + Taxes + Finance Cost (Interest) EBIT Margin = EBIT / Net Sales
  • EBITDA Margin (OPM): Measures a company’s operational efficiency before financing, taxes, depreciation, and amortization: EBITDA = EBIT + Depreciation + Amortization EBITDA Margin = EBITDA / Net Sales

4.3 🔄 Return Ratios

Return ratios evaluate how efficiently a company uses its capital to generate profits.

📈 Return on Equity (ROE)

ROE measures the return generated on shareholders’ capital: ROE = PAT / Shareholders' Equity (typically calculated using average equity over the year).

  • Ideal for: Debt-free companies (e.g., FMCG sectors like HUL and ITC).
  • Limitation: Debt-heavy companies can artificially inflate ROE by shrinking their equity base and funding operations through debt.

🏭 Return on Capital Employed (ROCE)

ROCE measures total return on all capital injected into the company (both debt and equity): ROCE = (EBIT / Capital Employed) * 100

  • Ideal for: Capital-intensive or debt-carrying industries (e.g., Infrastructure, Telecom, and Utilities).

🏦 Return on Assets (ROA)

ROA measures how efficiently a company uses its assets to generate net income: ROA = PAT / Total Assets

  • Ideal for: Banking and NBFC sectors, since loans are recorded as assets on bank balance sheets.

⚠️ Warning: Return Ratios Manipulation:

  1. Debt Leverage: High debt reduces the equity portion, which can cause ROE to look extremely high. Always compare ROE alongside ROCE.
  2. High Dividends: If a company pays out massive dividends, it reduces Reserves & Surplus (and thus Shareholders’ Equity). This artificially inflates both ROE and ROCE by shrinking the denominator.

4.4 ⚖️ Leverage Ratios

Leverage ratios measure a company’s financial risk and solvency.

📊 Debt-to-Equity (D/E) Ratio

The D/E ratio compares a company’s total debt capital to its shareholder equity: D/E = Total Debt / Shareholders' Equity

  • Interpretation:
    • D/E < 1 ➔ Equity capital exceeds debt (Conservative/Safe).
    • D/E > 1 ➔ Debt capital exceeds equity (Leveraged).
  • Guidelines: A ratio below 1 is generally ideal. A maximum of 2:1 is acceptable in capital-intensive sectors. Banks and NBFCs are exceptions due to their business model of borrowing to lend.

🛡️ Interest Coverage Ratio (ICR)

Measures the safety margin by showing how easily a company can pay interest on its debt from its operating profits: Interest Coverage Ratio = EBIT / Interest Expense

  • Guidelines: An ICR above 2.4 is generally considered safe. Lower ratios signal potential default risk if profits drop.

4.5 🏷️ Valuation Ratios

Valuation ratios indicate whether a stock is cheap or expensive relative to its earnings, assets, or growth prospects.

📈 Price-to-Earnings (P/E) Ratio

Tells us how much premium investors are willing to pay for every ₹1 of company earnings: P/E = Market Price per Share / Earnings per Share (EPS) or P/E = Market Cap / PAT

  • Types: Trailing 12-Month (TTM PE) and Forward PE (based on future estimates).
  • Market Indices Guideline:
    • P/E ~16 ➔ Undervalued (Buying Zone)
    • P/E ~21 ➔ Overvalued (Caution Zone)

📦 Price-to-Book (P/B) Ratio

Compares a stock’s market price to its book value (net asset value): P/B = Market Price per Share / Book Value per Share (BVPS)

  • Note: Extremely stable and useful during market downturns or for evaluating banks. It is not useful for capital-light service and IT companies.

🚀 Price/Earnings-to-Growth (PEG) Ratio

PEG scales the P/E ratio by the company’s expected earnings growth rate (e.g., 5-year PAT CAGR): PEG = P/E / PAT Growth Rate

  • Valuation signals:
    • PEG < 1 ➔ Undervalued (Growth outpaces valuation multiple).
    • PEG = 1 ➔ Fairly Valued.
    • PEG > 1 ➔ Overvalued.
  • Advanced PEG: For a more robust ratio, calculate average growth based on PAT, Revenue, and EBITDA combined.

📖 References & Video Lectures

🎥 Video Lectures by CA Rachana Ranade:

  • Return on Equity (ROE)
  • Return on Capital Employed (ROCE)
  • ROE vs ROCE Comparison
  • Price to Earnings (P/E) Ratio
  • Price to Book (P/B) Ratio