As a fundamental analyst, I would give importance to all the ratios and in-depth knowledge is recommended in terms of understanding what each ratio is signifying. Ratios broadly into two categories first, ratios which signify profitability parameters, and second ratios are those which signify valuation parameters.
Amongst many ratios, I would recommend few important ratios like Price to Earnings (PE), Returns on capital employed (ROCE), Return on equity (ROE), Debt to Equity (D/E), Price to Book value, Operating profit margins, EV/EBIDTA, PEG ratio, Return on Assets, etc. The importance and standard value of these ratios will vary based on industries. For eg financial industry more importance may be given to Price to book value, similarly manufacturing industry more importance can be given to EV to EBIDTA.
While short listing companies, I give importance to ALL three factors (not either/or) and in the order it’s mentioned: –
1. Quality of management
2. Thorough understanding of business
3. Price at which opportunity to invest.
All ratios mentioned above are considered to evaluate 3rd factor i.e. “Price”.
Further, I have adopted a technique wherein I not only see annual ratios as mentioned above but I give more importance to three main ratios compounding sales growth, compounding profit growth and compounding ROCE of a company in short-term (3 years), medium-term (5 years) and long-term (10 years). This technique may not work where business is cyclical in nature eg commodity stocks. These three additional parameters give me comfort which is as follows:
1. Compounding sales growth: – This will signify at what % company is consistently growing in sales. My preference is at least 20%
2. Compounding profit growth: – This will signify at what % the company is growing in their profits and are able to consistently earn more. My preference is at least 10%
3. ROCE: – Returns on capital employed. The return on capital employed shows us how much operating income is generated for each rupee of capital invested. A higher ROCE is always more favourable, as it indicates that more profits are generated per rupee of capital employed. My preference is at least 20%.
