Why Fundamental Ratios Matter in Investing

Just like the process you would follow to read the reviews of a book and buy it, similarly, before investing your hard-earned money in stocks, you have to carefully examine the fundamental ratios. They are your reviews that guide you regarding the financial health of a company.

If investing is your passion, then mastering the fundamental analysis ratios is your gateway. In this article, I will introduce you to the world of P/E, P/B, ROE, and other critical financial ratios used in fundamental analysis.

1. P/E Ratio: The Price You Pay for Earnings

The Price-to-Earnings (P/E) ratio is the first and foremost of the ratios used to analyze the fundamentals of the stock. The P/E ratio is an indicator of how much investors are willing to pay for a company’s earnings.

• Formula: P/E (Price-to-Earnings) Ratio = Market Price Per Share​ / Earnings Per Share (EPS)
• Importance: A high P/E ratio may suggest high growth expectations, while a low ratio may mean that the stock is undervalued.

Example: On the surface, it appears that Company A, with a P/E of 20, is superior to Company B with a P/E of 10. But this is not always the case! You should also take into account the growth rates and industry standards. For example, companies that specialize in higher technology do have a high P/E ratio because of growth prospects, while electric companies usually have a low one because their growth is secure and slow but stable.

Practical Tip: Compare the P/E ratio with the sector average. A low P/E could signal undervaluation, but it might also reflect deeper issues like declining profits.

2. P/B Ratio: Valuing the Book

The Price-to-Book (P/B) ratio is your lens for evaluating the value of a company’s assets.

• Formula: P/B (Price-to-Book) Ratio = Market Price Per Share / Book Value Per Share
• Why it matters: It’s especially useful for asset-heavy industries like banking.

A lower P/B ratio might indeed signal a possible undervaluation, but it could also be the case that such a thing as a high P/B ratio is noticed in aspects of deterioration like declining profitability; always think of the other sectors of the same kind before carrying out a comparison.

Example: A scenario where a certain bank has a P/B ratio of 0.8 tells that the market prefers it later than its book value. This situation could either be alarming or favorable depending on the reason behind such a risk.

3. ROE: The Investor’s Gold Standard

Return on Equity (ROE) is one of the best ratios for fundamental analysis. It measures how efficiently a company uses shareholders’ equity to generate profits.

• Formula: ROE = Net Income / Shareholders’ Equity
• Why it matters: Higher ROE often signals strong management efficiency.

When evaluating ROE, look for consistency over years. A constant or an increasing ROE on average is a good proof of the stability and growth of the economy involved. However, a very high ROE may also be a sign of a distended capital base since such a metric can also be inflated through leverage.

Example: A company that hits a benchmark ROE of 25% is one that generates, for every ₹100 of equity, ₹25 of profit. This result inspires confidence, especially if it varies largely from the one in the sector of 15%.

4. Debt-to-Equity Ratio: Balancing Risk and Reward

The debt-to-equity ratio is used to determine a company’s financial authority.

• Formula: Debt-to-Equity = Total Liabilities / Shareholders’ Equity
• Why it matters: One of the main purposes is to delve into the ways a company uses its resources—through debt or equity.

It’s possible that the average unit for every company’s debt-to-equity ratio could lead to bankruptcies during the economic downswing. Do not include it as your only measure. Besides, a company in a sector like a manufacturer might have a higher-than-usual ratio, but in a different sector, like tech, the ratio is usually lower.

For example, if a company has a debt-to-equity ratio of 2, it means it raises ₹200 in debt for every ₹100 of equity, which might signal over-leverage and therefore increased risks during a slowdown in the economy.

5. Current Ratio: Short-Term Health Check

The current ratio is a tool used to measure a firm’s ability to clear short-term obligations with short-term assets.

• Formula: Current ratio = current assets / current liabilities
• Why it matters: A ratio higher than 1 indicates that the company can cover its short-term liabilities.

While having a high current ratio is an advantage, it could be a disadvantage if a high ratio is due to the fact that the firm is not using its assets effectively. For example, if the current ratio equals 5, the company may be holding extra cash or inventory, which is when it should employ them.

For instance, with a current ratio of 1.5, the company is in a healthy financial position since it has assets amounting to ₹150 for every ₹100 of liabilities.

6. Net Profit Margin: Profitability at a Glance

A company’s profit margin equals its profit to the revenue it derives from the market.

• Formula: Net Profit Margin = Net Profit / Revenue × 100
• Why it matters: A higher margin implies the company is more profitable.

Assume that there are two enterprises that generate equal revenue; the one with the higher profit margin will be the more efficient of the two in converting revenue into actual profit. The ratio is a must-have metric for startups and small businesses to identify the trend in profitability.

Example: If a company’s net profit margin is 20%, then ₹20 is earned as a profit, and only ₹80 are the business activities costs for every ₹100 of revenue.

7. Dividend Yield: Income from Your Investment

The main importance of the dividend yield ratio to income-oriented investors cannot be overstated.

• Formula: Dividend yield = Annual Dividends per Share / Market Price per Share × 100
• Why it matters: It allows assessment of dividend return against the value of the stock.

Dividend yields that are level-high look attractive to the eye, but one must check whether the company is able to continue them without risking growth. Payout ratios should be investigated to confirm that the company isn’t implementing any excessive profit distribution.

For example, if a market stock price is ₹5,000 and it pays a ₹200 dividend per share a year, then the yield is 4%.

8. PEG Ratio: Growth and Value Together

The Price Earnings to Growth (PEG) ratio is a further development of the P/E ratio, taking into account how fast earnings grow in order to find their true value.

• Formula: PEG Ratio = P/E Ratio / Earnings Growth Rate
• Why it matters: PEG less than 1 often means that shares are undervalued based on their growth potential.

For example, if the P/E ratio of a company equals 20 and its earnings growth rate is 25%, the PEG would be equal to 0.8. That indicates this stock is undervalued against its growth potential.

9. EV/EBITDA: For Deeper Valuation Insights

The ratio of Enterprise Value (EV) to Earnings Before Interest, Taxes, Depreciation, & Amortization (EBITDA) is a more elaborate measure of valuation than others.

• Formula: EV/EBITDA = Enterprise Value / EBITDA
• Why it matters: It takes into account the debt element, and that makes the results more indicative of the value.

In particular, this ratio has its assets when one is trying to compare firms with distinct capital structures. Such would be firms in the telecommunications and energy sectors.

Example: A low EV/EBITDA ratio might indicate undervaluation, especially when it is compared to industry peers.

Key Ratios at a Glance

Ratio	Application	Key Insights
P/E Ratio	Valuation of earnings	Indicates investor sentiment and growth expectations.
P/B Ratio	Asset valuation	Useful for evaluating capital-intensive industries.
ROE	Profitability measure	Highlights management’s efficiency in generating returns.
Debt-to-Equity	Financial risk indicator	Shows the extent of debt used to finance the company.
Current Ratio	Liquidity analysis	Measures the company’s ability to meet short-term obligations.
Net Profit Margin	Operational efficiency	Reflects how effectively revenue is converted into profit.
Dividend Yield	Income generation	Useful for income-focused investment strategies
PEG Ratio	Valuation adjusted for growth	Balances price, earnings, and growth for better perspective.
EV/EBITDA	Comprehensive valuation metric	Incorporates debt and cash flow for industry comparisons.

Practical Application of Fundamental Ratios

Basing my decision purely on a company’s low P/E ratio, I bought their shares. But soon their prices virtually stagnated, and, upon studying the problem further, I discovered dwindling ROE. Even more, the company suffered from a very high debt-to-equity ratio. In retrospect, the lesson I took away from this is that effective fundamental analysis must integrate several ratios to guarantee proper judgments.

Lesson: Make sure to use fundamental ratios of stocks as a variety of tools rather than solely one measure.

How to Use These Ratios Effectively

• Compare with Peers: You can get the most out of the ratios in fundamental approaches to value a stock if you compare them to the same industry.
• Trend Analysis: Examine the trends that have taken place over some years.
• Combine Ratios: The financial ratios could aid the fundamental analysis if a mix of them is employed to reduce the one-sidedness of the analysis.

FAQs

What is the most important ratio for stock analysis?

ROE and P/E are pivotal; nevertheless, it is improved by a projective ensemble of key ratios for fundamental analysis.

Can I rely solely on the P/E ratio?

No, it is necessary to use it as a supplement with P/B and ROE or other financial ratios that are essential in the analysis of fundamentals.

How often should I review these ratios?

A quarterly check-up on the performance of the ratios is a credible suggestion.

Are fundamental ratios enough to pick stocks?

They are the first point to consider while you also have a look at the management and industry trends, which are qualitative aspects of current market conditions.

Where can I find these ratios?

Companies such as Zerodha, Upstox, Paytm Money, and Alice Blue provide an advanced display of the financial information needed for fundamental analysis.

Final Conclusion: A Quick Wrap-Up

Effective ratio methods are among the most important for investigating a company’s overall indicators of solvency and possibly the investment opportunities available. The combination of ratios offering P/E, P/B, ROE, and others is an in-depth analysis of a stock’s value.

If you wish to have more knowledge, you can go for our guide on Introduction to Fundamental Analysis: The Key to Long-Term Investing. With these tools in hand, you’re set to make smarter, well-informed investment decisions. Happy investing!