Tips on Evaluating Stock Performance

Total Returns

One of the most important metrics to look at when evaluating a stock’s performance is the total
return over different periods of time. A stock may have increased significantly in value within the
past few days or months, but it could still have lost value over the past year or five years.

Investors may want to consider how long they plan to hold a stock and look into each stock’s
historical performance. Some common periods to look at are the past year (52 weeks), the year to
date (YTD), the five-year average return, and the 10-year average return. Investors can also look at
the average annual return of a stock.

Using Indexes

Another step investors may want to take to evaluate a stock’s performance is comparing it with the
rest of the stock market. A stock might seem like an attractive investment if it has had a 7% return
over the past 52 weeks, but if the rest of the stock market has increased by more than that, there
might be a better choice.

A single stock can be compared to the overall stock market using stock indexes. Indexes show
averages of the market performance of a handful or even hundreds of stocks. Index performance
metrics show how any particular stock compares to the broader market. If a stock has been
performing similarly or better than the market, it may be a good investment.

Looking at Competitors

An additional way investors might consider evaluating a stock’s performance is by comparing it to

other companies within the same industry. One might discover that an entire industry is doing well
in the current market, or that another stock within the industry would actually be a better
investment.

Not every company within an industry will be a good comparison, so it’s best to look at companies of
a similar size, those that have been around for a similar amount of time, or that have other
similarities. Even if a giant, established corporation offers a similar product or service to a small
startup, they may not be the best two stocks to compare within an industry.

Two good questions investors might consider asking are:

• Does the company have a competitive advantage? If the company has a unique asset or ability,
such as a patent, a new research or manufacturing method, or great distribution, it may be more
likely to succeed within the industry.
• What could go wrong? This could be anything from poor management to a new form of
technology making a company irrelevant. Nobody can predict the future, but if there are any red
flags it’s important to pay attention to them.

Reviewing Company Revenue

Looking at stock returns is useful, but it’s also a good idea to look into the actual revenue of a
company. Stock prices don’t necessarily follow a company’s revenue, but looking at revenue gives
investors an idea about how a company is actually performing.

Like stock returns, investors can look at revenue over different periods of time. Revenue is
categorized as operating revenue and nonoperating revenue. Operating revenue is more useful for
investors to look at because non-operating revenue can include one time events such as selling off a
major asset.

Using Stock Ratios in Evaluations

There are several financial ratios that can be used to evaluate a stock and find out whether it is
currently under or overpriced in the market. These ratios can help investors gain an understanding
about a company’s liquidity, profitability, and valuation. Some of the most commonly used ratios
are:

Price to Earnings (P/E)

The most popular ratio for evaluating stock performance is the P/E ratio, which compares earnings
per share to the share price. P/E is calculated by dividing stock share price by the company’s
earnings per share. It’s important because a stock’s price can shoot up based on good news, but the
P/E ratio shows whether the company actually has the revenues to back up that price. One can
compare the P/E ratios of companies in the same industry to see which is the best investment.

There are two different ways to calculate P/E. A trailing P/E ratio can be calculated by dividing
current stock price by earnings per share. A forward P/E ratio is a prediction that can be calculated
by dividing stock price by projected earnings.

Price to Earnings Growth (PEG)

P/E is a useful ratio, but it doesn’t take growth into account. PEG looks at earnings, growth, and
share price all at once. To calculate PEG, divide P/E by the growth rate of the company’s earnings. If
the PEG is higher than 2, the stock may be overpriced, but if it’s under 1 the stock may be
underpriced.

Price to Sales (P/S)

The price to sales ratio is calculated by dividing the company’s market capitalization by its 12-month
revenue. If the P/S is low in comparison to competitors, it may be a good stock to buy.

Price to Book (P/B)

The P/B ratio looks at stock price compared to the book value of the company. The book value
includes assets such as property, bonds, and equipment that could be sold. Essentially, the P/B looks
at what the value of the company would be if it were to shut down and be sold immediately. This is
useful to know because it shows the value of a company in terms of assets, rather than valuing it
based on growth. Ideal price to book value is less than or equal to 1. This signals an undervalued
company. However, price to book value up to 3 is also acceptable.
However, industry and peer comparison are a better approach to understanding the ideal price to
book value.

For example: The PB ratio of Kotak Mahindra Bank Ltd is 5.09. PB ratio of Axis Bank Ltd. 2.49.
Industry PB ratio of private banks is 1.83. In this case, Axis Bank is undervalued in comparison
to Kotak Mahindra Bank.

But low price to book value should be accompanied by high return on equity (ROE). Only then you
can conclude that the stock is truly undervalued.

If the P/S is low, the stock may be a good investment because the stock might be underpriced.

Dividend Yield

Dividend yield is calculated by dividing a stock’s annual dividend amount by the current price of the
stock. This gives investors the percentage return of a stock’s price. If the dividend yield is high, this
means an investor may earn more cash from the stock. However, this can change at any time so isn’t
a good long-term indicator.

Dividend Payout

The dividend payout ratio tells investors what percentage of company profits get paid out to
shareholders. Companies that don’t pay out dividends or pay low dividends are likely reinvesting
their profits back into the business, which could help the business continue to grow. Paying out
dividends isn’t a negative thing, but if a company pays out high dividends they will have less money
to reinvest and may not be able to continue to grow.

Return on Assets (ROA)

The ROA ratio compares a company’s income to its assets, which gives investors an indicator of how
they handle their business.

Return on Equity (ROE)

ROE provides a calculation of how much profit a company makes with every dollar that shareholders
invest. To calculate ROE, divide a company’s net income by shareholder equity. This gives an
indication of how a company handles its resources and assets. However, as with every calculation,
ROE doesn’t always provide a full and accurate picture of a stock’s performance. Companies can
temporarily boost their ROE by buying back shares, which lowers the amount of equity held by
shareholders.

Profit Margin

Profit margin compares a company’s total revenues to its profits. If a company has a high profit
margin, this shows that a company is good at managing expenses, because they are able to keep
revenue rather than spending it.

Current Ratio
The current ratio is calculated by dividing a company’s current assets by its current liabilities. This
shows if a company will have enough money to pay off its debts. Current assets include cash and
other highly liquid property. Current liabilities are any debts that a company must pay within one
year.

Earnings Per Share (EPS)

This ratio is just what it sounds like, how much profit is a company generating per share of stock. A
high EPS is a positive indicator. It’s a good idea for investors to look at EPS over time to see how it
changes, because EPS could be boosted in the short term if a company has cut costs. EPS is also
useful for comparing different companies, since it gives a quick indication of how well each stock is
doing. However, EPS doesn’t give a full picture of how a company is doing or how they manage their
money, because some companies pay out earnings in the form of dividends, or they reinvest them
back into the business.

Debt to Equity Ratio

Even if a company is growing and earning more profit, they could be doing so by getting into more
and more debt. This could be a bad sign if they become unable to pay back their debts or if
borrowing becomes more difficult. An ideal debt equity ratio is under 0.1, and over 0.5 is considered
to be a bad sign.

Additional Factors

Aside from all the tools above, there are other factors to consider when evaluating a stock.

• Dividends: If a stock pays dividends, investors may want to consider how those payments affect
the overall returns of the stock.
• Inflation: Factoring in how much inflation will affect stock returns is another helpful factor. This
can be done by subtracting inflation amounts from a stock’s annual returns.
• Analyst Reports: Another resource available to investors is Wall Street analyst reports put
together by professional analysts. These can give in-depth insights into the broader market as well as
individual companies.
• Historical Patterns: Looking at past trends to get a sense of what the market might do in the
coming months and years can help investors make informed decisions. Past trends aren’t predictions
for the future, but they can still be useful. For instance, over the past 21 election years, there have
only been 3 years in which the S&P 500 Index had a negative return. This means that, in general, the
stock market performs well in election years.

The 4 Basic Elements of Stock Value

Price-To-Book (P/B) Ratio

Made for glass-half-empty people, the price-to-book (P/B) ratio represents the value of the company
if it is torn up and sold today. This is useful to know because many companies in mature industries
falter in terms of growth, but they can still be a good value based on their assets. The book value
usually includes equipment, buildings, land, and anything else that can be sold, including stock
holdings and bonds.

With purely financial firms, the book value can fluctuate with the market as these stocks tend to
have a portfolio of assets that goes up and down in value. Industrial companies tend to have a book
value based more on physical assets, which depreciate year over year according to accounting rules.

In either case, a low P/B ratio can protect you—but only if it's accurate. This means an investor has
to look deeper into the actual assets making up the ratio.

Price-To-Earnings (P/E) Ratio

The price to earnings (P/E) ratio is possibly the most scrutinized of all the ratios. If sudden increases
in a stock's price are the sizzle, then the P/E ratio is the steak. A stock can go up in value without
significant earnings increases, but the P/E ratio is what decides if it can stay up. Without earnings
to back up the price, a stock will eventually fall back down. An important point to note is that one
should only compare P/E ratios among companies in similar industries and markets.

The reason for this is simple: A P/E ratio can be thought of as how long a stock will take to pay
back your investment if there is no change in the business. A stock trading at $20 per share with
earnings of $2 per share has a P/E ratio of 10, which is sometimes seen as meaning that you'll
make your money back in 10 years if nothing changes.1

The reason stocks tend to have high P/E ratios is that investors try to predict which stocks will enjoy
progressively larger earnings. An investor may buy a stock with a P/E ratio of 30 if they think it will
double its earnings every year (shortening the payoff period significantly). If this fails to happen, the
stock will fall back down to a more reasonable P/E ratio. If the stock does manage to double
earnings, then it will likely continue to trade at a high P/E ratio.

Price-to-Earnings Growth (PEG) Ratio

Because the P/E ratio isn't enough in and of itself, many investors use the price to earnings growth
(PEG) ratio. Instead of merely looking at the price and earnings, the PEG ratio incorporates the
historical growth rate of the company's earnings. This ratio also tells you how company A's stock
stacks up against company B's stock. The PEG ratio is calculated by taking the P/E ratio of a
company and dividing it by the year-over-year growth rate of its earnings. The lower the value of
your PEG ratio, the better the deal you're getting for the stock's future estimated earnings.2

By comparing two stocks using the PEG, you can see how much you're paying for growth in each
case. A PEG of 1 means you're breaking even if growth continues as it has in the past. A PEG of 2
means you're paying twice as much for projected growth when compared to a stock with a PEG of 1.
This is speculative because there is no guarantee that growth will continue as it has in the past.

The P/E ratio is a snapshot of where a company is and the PEG ratio is a graph plotting where it
has been. Armed with this information, an investor has to decide whether it is likely to continue in
that direction.
Dividend Yield

It's always nice to have a backup when a stock's growth falters. This is why dividend-paying stocks
are attractive to many investors—even when prices drop, you get a paycheck. The dividend
yield shows how much of a payday you're getting for your money. By dividing the stock's annual
dividend by the stock's price, you get a percentage.1 You can think of that percentage as the interest
on your money, with the additional chance at growth through the appreciation of the stock.

Although simple on paper, there are some things to watch for with the dividend yield. Inconsistent
dividends or suspended payments in the past mean that the dividend yield can't be counted on. Like
water, dividends can ebb and flow, so knowing which way the tide is going —like whether dividend
payments have increased year over year—is essential to making the decision to buy. Dividends also
vary by industry, with utilities and some banks typically paying a lot whereas tech firms, which often
invest almost all their earnings back into the company to fuel growth, paying very little or no
dividends.

The Bottom Line

The P/E ratio, P/B ratio, PEG ratio, and dividend yields are too narrowly focused to stand alone as a
single measure of a stock. By combining these methods of valuation, you can get a better view of a
stock's worth. Any one of these can be influenced by creative accounting—as can more complex
ratios like cash flow.

As you add more tools to your valuation methods, discrepancies get easier to spot. These four main
ratios may be overshadowed by thousands of customized metrics, but they will always be useful
stepping stones for finding out whether a stock is worth buying.

1. Earnings per share (EPS)

This is the amount each share would get if a company paid out all of its profit to its shareholders. EPS
is calculated by dividing the company’s total profit by the number of shares.

Example – If a company’s profit is $200 million and there are 10 million shares, the EPS is $20.

EPS can tell you how companies in the same industry compare. Companies that show steady,
consistent earnings growth, year after year, will often outperform companies with volatile earnings
over time.

2. Price to earnings (P/E) ratio

This measures the relationship between the earnings of a company and its stock price. It’s calculated
by dividing the current price per share of a company’s stock by the company’s earnings per share.

Example – A company’s stock currently sells for $50 per share and its earnings per share are $5. That
means it has a P/E ratio of 10 ($50 divided by $5).
The P/E ratio can tell you whether a stock’s price is high, or low, compared to its earnings.

Some investors consider a company with a high P/E to be overpriced. But sometimes a company
with a high P/E today may offer higher returns, and a better P/E, in the future. How do you know?
You’ll likely have to look at other indicators before you decide.

3. Price to earnings ratio to growth ratio (PEG)

This helps you understand the P/E ratio a little better. It’s calculated by dividing the P/E ratio by the
company’s projected growth in earnings.

Example – A stock with a P/E of 30 and projected earnings growth next year of 15% would have a
PEG of 2 (30 divided by 15). A stock with a P/E of 30 but projected earnings growth of 30% will have
PEG of 1 (30 divided by 30).

The PEG can tell you whether a stock may or may not be a good value. The lower the number, the
less you have to pay to get in on the company’s expected future earnings growth.

4. Price to book value ratio (P/B)

This compares the value the market puts on a company with the value the company has stated in its
financial books. It’s calculated by dividing the current price per share by the book value per share.
The book value is the current equity of a company, as listed in the annual report.

Most of the time, the lower the P/B is, the better. That’s because you’re paying less for more book
value.

If you’re looking for a well-priced stock with reasonable growth potential, you may want to use a low
P/B as a tool to identify possible stock picks.

5. Dividend payout ratio (DPR)

This measures what a company pays out to investors in dividends compared to what the stock is
earning. It’s calculated by dividing the annual dividends per share by the EPS.

Example – If a company paid out $1 per share in dividends and had an EPS of $3, the DPR would be
33% (1 divided by 3).

The DPR can give you an idea of how well a company’s earnings support the dividend payments.
More mature companies will typically have a higher DPR. They believe that paying more in dividends
is the best use of their profits for the firm and its shareholders. Since growing companies are likely to
have less or no earnings to pay out dividends, their DPR would tend to be low or zero.

6. Dividend yield

This measures the return on a dividend as a percentage of the stock price. It’s calculated by dividing
the annual dividend per share by the price per share.
Example – 2 stocks each pay an annual dividend of $1 per share. Company A’s stock is trading at $40
a share, but Company B’s stock is trading at $20 a share. Company A has a dividend yield of 2.5% (1
divided by 40), while Company B’s is 5% (1 divided by 20).

The dividend yield can tell you how much cash flow you’re getting for your money, all other things
being equal.

For a start, you must have gauged that a higher P/E ratio is better than a lower one. However
obvious this may seem to you, it may not always be the best choice while selecting a company stock.
Some investors claim that a stock with a lower ratio is better to purchase as you pay less for every
rupee of earnings. In this sense, a low P/E ratio implies a low price tag. It may look like a winning
deal to investors. Nonetheless, while it may be a bargain for investors at times, it may also indicate
that a company is on the decline, so this is where the traps come in.

What exactly is the P/E trap and How to Avoid the P/E Trap? There are 3 traps to avoid. Firstly, there
is the growth trap to avoid. A high growth company may not only enjoy a higher P/E but also justify
it. On the other hand, a low P/E stock may not necessarily be a sign of an under priced stock.
Secondly, Low P/E ratios may be the market’s way of signalling that the something is either wrong
with the company in question or with the industry as a whole. It is essential not to miss out on this
signal. Lastly, P/E used to value a stock is normally forward P/E and such forward P/Es are based on
estimated earnings. Therefore, there is too much emphasis being laid on the sanctity of cash flow
projections, which may not necessarily reflect a precise understanding of how the industry and the
company are evolving. The key question, therefore, is “How to avoid the P/E Trap”?

1. How to factor in growth and ROE into P/E comparisons

There are some clear trends that are visible when it comes to P/E ratios in India. Consider a few
classic cases. The P/E ratio of FMCG stocks and pharma stocks normally tend to be high because they
have shown consistently high levels of growth and ROE. On the other hand, IT stocks have seen their
P/E ratios shrinking from 30+ levels to sub-20 levels as global tech spending has been shrinking and
Indian IT companies are seeing their growth rates and their ROE taper. Then there are companies in
the steel and PSU banking space, where they always tend to quote at very conservative P/E ratios of
less than 10. In case of metals, the risk is on metal prices which are vulnerable to global shifts while
in case of PSU banks the fear is that NPAs could dent their growth and ROE in a big way.

Therefore, how to avoid the P/E trap in such circumstances? Using P/E ratio to value a stock is fine as
long as it is able to factor in the growth aspects. A very good example is D-Mart which is already one
of the most expensive retail stocks in the world with valuations at over 60 times earnings. That is
because the online stock market is building in very aggressive sales growth over the next 5 years,
aggressive growth in ROE and reduction in debt. Growth therefore becomes a key factor when using
P/E ratio to value a stock.

2. Signalling that something is amiss via low P/E

When we understand how to avoid the P/E trap, it is very essential to understand that P/E ratio also
works as a very important early warning system. Take the case of any popular company that
eventually went under in the past. For example, Satyam was always getting a P/E ratio that was
lower than either Infosys or TCS. If you merely use P/E ratio to value a stock, then Satyam may have
appeared to be underpriced. But, there was obviously something that the markets in all its wisdom
had sensed about Satyam, which was not obvious to most investors. In 2009 when Satyam went
bust, it was merely a case of P/E ratio acting as an advance warning signal. Similarly, stocks like
Kingfisher started quoting at apparently low P/Es much long before the airline ceased operations in
2012. Even in the banking space, banks like HDFC Bank and Kotak Bank have consistently
commanded premium P/E ratio compared to ICICI Bank and Axis Bank as the P/E differential was
indicative of the perceived differences in asset quality. In most of these cases, low P/E does not
necessarily make a stock an attractive investment, just as high P/E is not necessarily a sign of
stretched valuations. That is why you need to know how to avoid the P/E trap.

3. Sanctity of cash flow projections

The big debate when you use P/E ratio to value a stock is whether to use rolling P/E (historic P/E
based on last 4 quarter EPS) or forward P/E based on projections. While the rolling P/E is more
reliable as it is documented, it is more useful from an academic perspective and less from a valuation
perspective. However, the big worry about cash flow projections is that they are prone to the
assumptions and personal biases of individuals. It is quite normal for analysts to get a little
aggressive on projections and then downgrade the projections. Hence, apart from the fundamentals
of the company, one also needs to look at the track record of the analyst in question. Visit here to
know Is there a relationship between low-P/E and high stock returns?

In a nutshell, P/E ratio to value a stock is perhaps the best approximation available. However, one
needs to adjust a pure P/E measure for growth, futuristic signals and one also needs to provide for
the individual bias. That is How to avoid the P/E trap!

P/E is a very misleading ratio.

Most people feel that a lesser P/E it is cheap and higher P/E is expensive, this is a
highly incorrect notion.

ITS, Infosys,HUL,Asian Paints, HDFC, HDFC bank etc are high P/E stocks but these
stocks have continuously made money irrespective of P/E due to their ability of
creating value and profits.
A high P/E may be justified due to several reasons

1. Quality of management
2. Growth of company
3. Profits
4. High Return of Equity/High Return on Capital
5. Innovation
and many more

Several companies have been low P/E like many Public sector companies, 10 years
back also they were low P/E and today also they are low P/E but prices are same
they have never made money for investors

CASE STUDY

SJVN was listed at Rs.28 and was P/E of 7 in 2010 and today in 2015 it is Rs.24 at
P/E of 6.5. In last 5 years it has made zero money for investors inspite of it being
low P/E

Moral: LOW P/E is not always cheap and good value.

United Breweries is P/E of 100 in 2010 was Rs.400 and is Rs.900 at P/E of 84. In
spite of high P/E it has made money.

Moral: HIGH P/E is not always expensive and bad!

Price to Book (P/B)

The P/B ratio looks at stock price compared to the book value of the company. The book value
includes assets such as property, bonds, and equipment that could be sold. Essentially, the P/B looks
at what the value of the company would be if it were to shut down and be sold immediately. This is
useful to know because it shows the value of a company in terms of assets, rather than valuing it
based on growth. Ideal price to book value is less than or equal to 1. This signals an undervalued
company. However, price to book value up to 3 is also acceptable.

However, industry and peer comparison are a better approach to understanding the ideal price to
book value.

For example: The PB ratio of Kotak Mahindra Bank Ltd is 5.09. PB ratio of Axis Bank Ltd. 2.49.
Industry PB ratio of private banks is 1.83. In this case, Axis Bank is undervalued in comparison
to Kotak Mahindra Bank.

But low price to book value should be accompanied by high return on equity (ROE). Only then you
can conclude that the stock is truly undervalued.

Price-to-Earnings Growth (PEG) Ratio

Because the P/E ratio isn't enough in and of itself, many investors use the price to earnings growth
(PEG) ratio. Instead of merely looking at the price and earnings, the PEG ratio incorporates the
historical growth rate of the company's earnings. This ratio also tells you how company A's stock
stacks up against company B's stock. The PEG ratio is calculated by taking the P/E ratio of a
company and dividing it by the year-over-year growth rate of its earnings. The lower the value of
your PEG ratio, the better the deal you're getting for the stock's future estimated earnings.2
By comparing two stocks using the PEG, you can see how much you're paying for growth in each
case. A PEG of 1 means you're breaking even if growth continues as it has in the past. A PEG of 2
means you're paying twice as much for projected growth when compared to a stock with a PEG of 1.
This is speculative because there is no guarantee that growth will continue as it has in the past.

The P/E ratio is a snapshot of where a company is and the PEG ratio is a graph plotting where it
has been. Armed with this information, an investor has to decide whether it is likely to continue in
that direction.

Stocks with PEG of less than 1 merits investment. But, we should not jump to the conclusion that a
PEG more than 1 indicates overvaluation and high risk. In recent times, some stocks with PEG of
more than 1 have delivered good returns