Personal financing 102 - Basic know hows of Equity Investing

We come across such news quite often, wherein an individual turned one lakh rupees into 86 lakhs within a short span of 10 years! The stock was valued at INR 12 in 2005 and per share price was INR 1000 in 2015. Well that is a CAGR of ~56%.

Amazing! Isn’t it?

It surely is! But while reading through such news, what everyone discounts is:

1.       What were the reasons that led to the rise of the stock?

2.       Was any broker/investor recommending this particular stock in 2005?

3.       Would you have the guts to invest such a huge amount in a penny stock?

4.       If it tumbles at some point in between this duration of ten years, would you be patient enough to wait for ten years?

5.       Would you be smart enough to deep dive into each stock and figure out which one is strong fundamentally?

So, first and foremost rule of equity investing is:” Never believe hearsay. Always analyse data yourself before coming to any conclusion.”

We ended our last post discussing about benefits of equity over other investment products.

Having understood the importance and need of equity investing, let’s dive one step down into the important factors which should be considered before one takes the plunge.

There are two types of analysis which help decide the stock to be chosen and the time when it should be chosen. They are called fundamental analysis and technical analysis.

-          Fundamental analysis helps one figure out which companies to invest in. This is important from a long term investment perspective eg. 10 years or so. If one company is fundamentally strong, it will end up giving you good returns in long run.

-          Technical analysis helps one figure out the time of entry and exit in a particular stock. It helps one in figuring out the price at which the stock should be bought and what is stop loss when one should exit the stock. It helps in getting short term gains based on current market conditions eg. Before announcement of quarterly results, change in management etc. These factors give an initial spurt to the share price, which one can always benefit from.

The first and foremost part of a fundamental analysis is understanding the financial statements. With respect to the financial statements, there are few key ratios which should be looked at before making an investment decision. These financial ratios are broadly classified into four categories:

1.       Profitability ratios

2.       Leverage ratios

3.       Valuation ratios

4.       Operating ratios

In the current blog post, we will try to cover all the profitability ratios, i.e.

1.       EBITDA

2.       PAT Margin

3.       ROE

4.       ROA

5.       ROCE

Take a pen/paper/excel or a mental calculator before we move ahead.

Let us take the example of any company whose balance sheet and P&L statement are as follows:

We shall first figure out the calculations for different ratios and then understand how can they be helpful.

1.       EBITDA: Operating revenue – operating expenses

Operating revenue = total revenue – other income

Operating expenses = total expenses – finance cost – depreciation & amortization

EBITDA margin = EBITDA/[Total revenue – other income]

From the data given above (for the year ending March 2014);

1.       EBITDA = [3482-46] – [2942-0.7-65]

=560 crores

EBITDA margin= 560/3436=16.3%

2.       PAT Margin = PAT/Total revenue

=367/3482=10.5%

*Both EBITDA and PAT margin have no significance on a standalone basis. If you compare current year EBITDA or PAT margin against previous years, you get to know the real picture.

3.       Return on Equity (RoE) = Net profit / shareholders equity*100
·   ROE is a tricky ratio. With just a little increase in debt, one can increase RoE. So, RoE should never be looked at as a standalone term (assuming sum of debt and equity remains constant).

4.       Return on assets (RoA) = [net income +interest (1-tax rate)]/total average assets

RoA = [367.5+4.76]/1955

 = 19.3%
Please note that average tax rate is taken as 32%

5.       Return on Capital employed (RoCE) = profit before interest and taxes/overall capital employed

Overall capital employed = long term debt + short term debt + equity

ROCE = 537.7/1446.2

 = 37.18%

Too much, eh?

We will have a Food for thought activity before we end the post.

I would draw your attention to the point of RoE I mentioned above. Let us take the example of a pizza corner. Let’s say Vijay started a pizza corner, for which he bought an oven worth 10,000/-. In the books of account, shareholders’ equity is 10,000/- and he owns assets worth 10,000/-. Let’s say he earned 2500/- that year from the sale. Hence, RoE = 2500/10000 = 25%

Now assume that Vijay took a loan of 2000/- from his uncle (instead of financing the whole oven himself). In books of accounts,

Shareholders’ equity = 8000/-

Debt = 2000/-

And assets = 10,000/-

Assuming same revenue, the RoE comes out to be 2500/8000 = 31.25%

So, with total assets remaining the same, RoE has increased substantially, something to be cautious of.

In the next post, we shall try to cover leverage and valuation ratios.

Till then, stay healthy and continue learning!

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