Initial Public Offering (IPO) – the first public sale of shares of a company – is a closely watched and much-anticipated event in the lives of investors as well as company insiders. However, identifying good IPOs can be a daunting task, as investors need to carefully analyze the financials of the company to make an informed decision about valuation. To make things easier, we at IPO Central have compiled a list of the 5 most important financial ratios in IPO investing.
Table of Contents
#1 Price-to-Earnings (P/E) Ratio – Among Most Popular Ratios in IPO Investing
The P/E ratio is a measure of a company’s stock price relative to its earnings per share (EPS). It is calculated by dividing the current stock price by the EPS. A high P/E ratio indicates that the stock is overvalued, while a low P/E ratio indicates that the stock is undervalued.
For example, if a company has a P/E ratio of 20, it means that investors are willing to pay INR 20 for every INR 1 of earnings. On the other hand, if a company has a P/E ratio of 10, it means that investors are willing to pay only INR 10 for every INR 1 of earnings.
P/E ratio is very easy to understand and intuitively makes sense. It is for this reason that it is among the most used ratios in IPO investing. However, it is not uniform across industries and a figure of 20 may be too high for some industries and too low for others. Generally speaking, companies from mature industries with low growth rates tend to have lower P/E ratios than their counterparts from high-growth sectors. In addition, several other factors such as corporate governance are also at play in deciding valuation.
Read Also: Nifty PE Ratio – Most Important Points You Need to Know
#2 Price-to-Sales (P/S) Ratio
The P/S ratio is a measure of a company’s stock price relative to its revenue per share. It is calculated by dividing the current stock price by the revenue per share. A high P/S ratio indicates that the stock is overvalued, while a low P/S ratio indicates that the stock is undervalued.
For example, if a company has a P/S ratio of 3, it means that investors are willing to pay INR 3 for every INR 1 of revenue. On the other hand, if a company has a P/S ratio of 0.5, it means that investors are willing to pay only INR 0.5 for every INR 1 of revenue.
Similar to P/E ratio, P/S ratio is also subject to vary a lot across industries. Value investors tend to place a lot of emphasis on this metric as it offers a bird’s eye view regarding the valuations of companies in an industry.
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#3 Debt-to-Equity (D/E) Ratio – IPO Investing Made Easy
The D/E ratio is a measure of a company’s debt relative to its equity. It is calculated by dividing the company’s total debt by its total equity. A high D/E ratio indicates that the company has a high level of debt, which can be risky for investors as the company has to pay interest on the debt which eventually reduces profits for shareholders.
As an example, a company with a D/E ratio of 2 simply has twice as much debt as equity. On the other hand, if a company has a D/E ratio of 0.5, it means that the company has half as much debt as equity.
While low debt is always preferred, it may be indispensable in capital-intensive industries such as capital goods and EPC. In a similar vein, high-debt companies tend to post higher profits than their debt-free counterparts in low-interest regimes but fare worse otherwise. Simply put, as long as a company is able to generate higher returns than its cost of debt, debt isn’t bad for its balance sheet.
#4 Return on Equity (ROE)
The ROE is a measure of a company’s profitability relative to its equity. It is calculated by dividing the company’s net income (net profit) by its total equity. A high ROE indicates that the company is generating a high level of profits relative to its equity.
Unlike the earlier ratios, this metric is calculated as a percentage figure and works well across industries. As a rule of thumb, any business that consistently generates ROE above 15% is considered investment worthy.
Read Also: IEPF Form 5: Important points about claiming unclaimed dividend and shares
#5 Return on Capital Employed (ROCE)
Like ROE, ROCE is also used to assess a company’s profitability and capital efficiency. However, it differs from ROE in the sense that it also takes into account debt capital. It is calculated by dividing the company’s Earnings Before Interest and Tax (EBIT) by Capital Employed which is defined as the difference between Total Assets and Current Liabilities.
As mentioned earlier, debt isn’t necessarily a bad component on the balance sheet and thus, ROCE is a comprehensive indicator regarding the effective use of capital. A higher figure is better and it can also be denominated in percentage. Since it provides a comprehensive view of capital efficiency, ROCE is among the most valuable ratios used in IPO investing.
Conclusion
There is no dearth of ratios and financial figures that can be analyzed to gain a better understanding of a company’s financial performance. However, these five ratios in IPO investing can do the heavy lifting for you and help in building an initial impression that wouldn’t be very far from reality.
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- Source: https://ipocentral.in/important-ratios-in-ipo-investing/
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