What great investors look in the growing company?

The knowledge of the fundamentals of the company is the key for the successful investing. The great investors generally look and analyze the fundamentals of the company through their financial ratios as it is one of the effective and the easiest way to know the health of the company. 

Here I will discuss investing in those companies which are listed on the stock exchanges. The listing in the stock exchanges makes the investing process easy as one can get the relevant information about any listed company from the website of the stock exchange.
There are certain financial ratios which analyze the health of the company and help in taking the investment decision wisely.
The important financial ratios that an every investor must know are as follows:

(1) The Price to Earning (P/E) ratio

It is the ratio of market price of the stock to the earning per share of the company. It can be represented as:

• P/E ratio = Market price per share / Earnings per share (EPS)

Suppose, the company is trading at Rs. 200/- and its earnings per share over the last 12 months period is Rs. 10/-, then its PE ratio will be 200/10 = 20. 
If you take EPS from the last 12 months, then it is called trailing P/E ratio and if the projected EPS is taken for the next year, then it is called forward or projected P/E ratio. One should compare P/E ratios of the companies of the same industry. The companies which have negative income do not have the P/E ratio.

• A higher P/E ratio indicates that the investors are expecting higher returns from that company

(2) The Price-earnings to Growth (PEG) ratio

The PEG ratio is next layer of analysis after looking at the P/E ratio of the company. This ratio helps in shortlisting the undervalued company. It can be represented as:

• PEG ratio = (P/E ratio) / Earnings growth rate
• If PEG < 1, then the company is considered undervalued; hence a good investment choice.
• If PEG > 1, then it is considered overvalued.

You can get the value of the PE ratio form the websites but you need to calculate the growth rates by yourself. I have written a good article on How to calculate the realistic growth rate of the company? You can refer it for calculating the growth rate.
For example, the PE ratio of company XYZ Ltd is 12 and its realistic growth rate is 16%, the PEG ratio of the company is 12/16 = 0.75 < 1 (the company is assumed undervalued; hence a good investment choice.

(3) The Price to Book value (P/B) ratio

This ratio is a good indicator, showing the willingness of the investors to pay for  each rupee of the company's tangible assets. rupee of the company’s tangible assets.
It is the ratio of the market price of the share to its net assets excluding any intangibles like goodwill

• P/BV ratio = Market price / net assets (Total assets – total liabilities)
• A value < 1 indicates that stock is under priced
• Where a value > 1 indicates that the value is overpriced

Usually, the P/BV ratio of the software companies and FMCG companies are higher as compared to the companies in auto, engineering, steel, and banking sectors because these companies have fewer tangible assets.

• The P/BV ratio may not be correct valuation method for the software and FMCG sector.
• The auto, engineering sector companies have a lot of tangible assets, the P/BV ratio is a good indicator to measure companies in these sectors.

(4) The Price to Free cash flow (P/FCF) ratio

It is the ratio of the market price of the share to free cash flow per share. The cash flow remaining after deducting the capital expenditure from the operating income is called free cash flow; the company can use this free cash for expansion, acquisitions or support its operations during bad market conditions.
Free cash flow = Operating cash flow – Capital expenditure 
P/FCF ratio = Market price of the share / free cash flow per share
You can get the value of free cash flow per share by dividing the free cash flow by the number of shares outstanding. You can find number of shares outstanding from any finance website like www.moneycontrol.com or www.yahoofinance.com

• The great investors look for lower P/FCF ratio, if it is < 15, then it is considered a good investment choice.

(5) The Debt-Equity (D/E) ratio

It indicates the proportion of the debt and the equity a company is using to run its operations and the assets.

• Debt to equity ratio = Total liabilities / Total shareholders’ equity
• The Debt to equity ratio > 1 means that the proportion of debt in the company is more than its equity. A higher D/E ratio shows that company is financing its growth with large proportion of debt and if it does not maintain its growth and not able to keep its earning more than the cost of the borrowed fund then the company may come under financial stress, therefore a higher D/E ratio company is associated with higher risk. 
• The wise investors generally look for the companies with D/E ratio < 1
  The debt/equity ratio help the investor to identify those companies which are highly leveraged and pose the higher risk.

(6) The Return on capital employed (ROCE)

It indicates the profitability of any company and it is a strict measure of the performance than return on equity as it takes into account the debt part of the company. It is represented as follows:

• ROCE = Earnings before Interest and Taxes/ Capital employed

where, capital employed = Shareholders equity + debt liabilities
It is useful in the capital intensive sectors like telecoms, utilities companies

• The investors generally consider ROCE >= 15%, a good investment option

(7) The Inventory turnover ratio

It is a good indicator, which shows the number of times the company's inventory is sold in a year's time. It indicates the efficiency of the management.

• Inventory turnover = Cost of goods sold/ Average inventory
• A low inventory turnover indicates less sales
• A high inventory turnover indicates strong sales

(8) The Current ratio

This ratio measures the liquidity of the company as to what extent the company is able to meet it's short term and the long term liabilities. It is ratio of total current assets the the total current liabilities.

• Current ratio = Total current assets/ Total current liabilities
• A ratio < 1, indicates that the company is unable to meet its obligations and is finding difficulty in running its daily operations
• A ratio > 1, indicates that the company is able to meet its obligations and is running its operations effectively
• It is also true that very high value of current ratio > 3 is also not good for the health of the company as it indicates that the company is not utilizing it's assets effectively

Conclusion

Although, the above mentioned ratios are the good indicators for the investors to gauge the performance of the company. But the few points have to be kept in mind while using these ratios like:

• Never compare the ratios of two companies of different sector or the industry
• Don't solely rely on any one ratio rather give weightage all the ratios equally. When you find at least 6 out of 8 ratios in  your favor then go ahead and invest in that company
• Try to get all the relevant variable and assumptions while predicting the growth rates

You can get the information from the financial websites like www.moneycontrol.com, www.money.rediff.com or www.yahoofinance.com. Now, it all depends on you that how you make the investment decision based on the values of the above ratios.