*LOOKING* to buy stocks but you are not sure how to select them? Don't fret.

We have, here, eight ratios that would make your life easier, and of course,

enable you to make the best possible stock selection.

*1*. *Ploughback or Reserves*

Every year, the company divides its net profit (profits in hand after

subtracting various expenses including taxes) in two portions: ploughback

and dividends.

While dividends are handed out to the shareholders, ploughback is kept by

the company for its future use and is included in its reserves. Ploughback

is essential because, besides boosting the company’s reserves, it is a

source of funds for the company’s expansion plans. Hence, if you are looking

for a company with good growth prospects, check its ploughback figures.

Reserves are also known as shareholders’ funds, since they belong to the

shareholders. If a company’s reserves are twice its equity capital, the

company can reward its shareholders with a generous bonus. Also any increase

in reserves will push the share price of your share.

*2*. *Book value per share

*This ratio shows the worth of each share of a company as per the company's

accounting books. It is calculated as:

Shareholders' funds

------------------------------------------------ = Book Value per share

Total quantity of equity shares issued

Shareholders' funds can be computed as such:

Total assets *(*equity capital to the company's reserves) *less *total

liabilities (money owed to creditors).

Book value is an old record that uses the original purchase prices of the

assets.

However, it doesn't show the present market price of the company’s assets.

As a result, this ratio has a restricted use when it comes to estimating the

market price of the shares, but can give you an estimate of the minimum

price of the company’s shares. It will also help you judge if the share

price is overpriced or under-priced.

*3*. *Earnings per share (EPS)

*One of the most popular investment ratios, it can be computed as:

Profit Post Tax

------------------------------------------------ = EPS

Total quantity of equity shares issued

This ratio computes the company's earnings on a per share basis. Say, you

own 100 shares of ABC Co., each having a face value of Rs 10. Assume the

earnings per share is Rs 10 and the dividend declared is 30 per cent, or Rs

3 per share. This implies that on every share of ABC Co., you earn Rs 6 each

year, but you actually get Rs 3 via dividend. The balance of Rs 4 per share
goes into the ploughback (retained earnings). Had you purchased these shares

at par, it implies a return of 60 per cent.

This example shows that instead of looking at the dividends received from to

company as the base of investment returns, always look at earnings per

share, as it is the actual indicator of the returns earned by your shares.

*4*. *Price Earnings Ratio (P/E)*

This ratio highlights the connection between the market price of a share and

its EPS.

Price of the share

------------------------ = P/E

Earnings per share

It shows the degree to which earnings of a share are protected by its price.

Say, the P/E is 40, it means the share price is 40 times its earnings. So if

the company's EPS is constant, it will need about 40 years to make up for

the purchase price of the share, after taking into account the dividends and

the capital appreciation. Hence, low P/E means you will recover your money

quickly.

P/E ratio shows what the market thinks about the earnings potential and

future business forecast of a company. Companies with high P/E ratios are

the darlings of the investors and thus enjoy a higher market rating. In
order to use the P/E ratio properly, take into account the future earnings

and growth projections of the company. If the current P/E ratio is low, as

against the future prospects of a company, then the shares make an

attractive investment option. But if the company is saddled with losses and

falling sales, stay away from it, despite the low P/E ratio.

5*. *Dividend and yield

*Dividend is the portion of the profit that is distributed amongst

shareholders. Companies offering high dividends, normally don’t have much of

growth to talk about. This is because the ploughback required to finance

future development is insufficient. Similarly, those companies in high

growth sector don’t give any dividend. Instead here they give sharp capital

appreciation, which ultimately will lead to higher dividends.

So it makes much more sense to invest for capital appreciation instead of

dividends. Rather it makes more sense to invest for yield, which is nothing

but the association between the dividends and the market price of the

shares. Yield (dividend yield) can be calculated as:

Dividend per share

----------------------------- x 100 = Yield

Market price of a share

Yield shows the returns in percentage that you can expect via dividends

earned by your investment at the current market price. It is more useful

than simply focusing on the dividends.

*6*. *Return of capital employed (ROCE)*

ROCE is the ratio that is calculated as:

Operating profit

----------------------------------------

Capital employed (net value + debt)

To get operating profit, add old taxes paid, depreciation, special one-off

expenses, and special one-off income and miscellaneous income to get the net

profit. The operating profit is a far better indicator of the profits earned

by the company instead of the net profit. Hence this ratio is the better

indicator of the general performance of the company and the company’s

operational efficiency. It is one of the most useful ratio that lets you

compare amongst the companies.

*7*.* Return on net worth (RONW)*

RONW is calculated as

Net Profit

-----------------

Net Worth

This ratio gives you an idea of the returns generated by investing in the

company. While ROCE is an effective measure to get a general overview of the

profitability of the company’s business operations, RONW lets you gauge the

returns you can earn on your investment. When used along with ROCE, you get

an overview of the company’s competence, financial standing and its capacity

to generate returns on shareholders’ finances and capital employed.

*8*.* PEG ratio*

PEG is an essential and extensively used ratio for calculating the inbuilt

worth of a share. It helps you decide whether the share is under-priced,

totally priced or overpriced. To derive the ratio, you have to associate the

P/E ratio with the expected growth rate of the company. It assumes that

higher the growth rate of the company, higher the P/E ratio of the company’s

shares. Vice versa also holds true.

P/E

----------------------------------

Expected growth rate of the EPS of the company

In general, a PEG lesser than 0.5 is a lucrative investment opportunity.

However if the PEG exceeds 1.5, it is time to sell.

These are some of the most critical ratios that must be considered when

purchasing a share. Extensive reading of the financial performance of the

company in newspapers and magazines will help you get all the relevant

information to arrive at the correct decision.

Under debt
*THE* power of debt is tremendous. On one hand, it can helps you achieve
your goals. On the other, it can destroy you.

Unfortunately for Aman, a 42-year old college lecturer who is married and
has a child, his loans did him more harm than good. He earns Rs 19,000 per
month and is in deep debt, today.

*wealth* chronicles Aman's route to debt and suggests a way out.

November 2005: He took a personal loan of Rs 1,50,000, to furnish a new

house he was about to acquire.

December 2005: He took a home loan of Rs 4,87,679 to buy a property in Pune,

where he now lives with his family.

September 2006: He took a motorcycle loan of Rs 50,000 and bought a new

bike.

July 2007: Aman took a personal loan of Rs 5, 00,000 to buy shares, and gave
power of attorney to a brokerage firm, to invest his money as they saw fit.
When the stock market crashed, he lost all his savings and was left with no
savings.

September 2007: He took a personal loan of Rs 4,60,000 (secured against his

home), to pay off the remaining Equated Monthly Installments (EMIs) on his
personal loan of Rs 1, 50,000, thereby closing the loan. He also utilised it
to pay EMIs on other loans.

*Loan watch*:

*When**Type of loan
**Purpose* *Loan amount
(in Rs)* *EMI
(in Rs)
**Remaining EMIs
*November 2005PersonalFurnishing the flat150,000 5,424
Closed
December 2005
Home
Buying the flat
487,679
4,947
162
September 2006
MotorcycleCommute
50,000
1,150
43
July 2007
Personal
Buy shares
500,000
15,080
39
September 2007
Personal (against home)
To close the first loan and pay EMI of Rs 15,080
460,000 6,049
175

Not surprisingly, Aman is unable to pay the EMI of Rs 15,080, which

obviously, did not go down well with the bank. It’s been six months since he
paid his last instalment, and the bank is threatening him , so he clears
pending dues.

*Top mistakes

*The personal loan of Rs 5, 00,000 to invest in stocks was uncalled for,

considering that he was already paying off three EMIs. In fact, he should
have used the loan of Rs 4, 60,000 to prepay his other loans and bring down
the EMI amount rather than pay more EMIs.

*Tough decisions
*
Aman has choices but none that are pleasant. Yogin Sabnis, Director, VSK
Financial Consultancy Services advices him.

- First, Aman could sell his motorcycle and close the motorcycle loan.
- Next, he could opt to stay in a rented house, and sell of his property
(worth Rs 25,00,000, now). He will be able to get rid of all his loans, and
he may even be left with some surplus.
- He must invest the surplus amount equally, between fixed income
instruments and diversified equity instruments.

*
Life insurance, yet?*

Should Aman consider buying an insurance policy despite his financial

situation? Yes. "It's important for him to buy a term policy in his name
after he has paid off his loans. After all, he must be worried sick and
that's not good for his health. And there’s his family to think of,"
explains Sabnis.

*Mantras for borrowers

* 1. According to financial planners, the EMI amount should not exceed 30 to

35 per cent of your monthly income. In Aman's case, it was way over 100 per
cent!

2. Aman should have taken a home improvement loan instead of a personal

loan. The interest on a home improvement loan is 13 to 15 per cent. The
interest on a personal loan is between 13 to 30 per cent.

3. Remember the maxim: Do not borrow to invest. Aman borrowed from a bank to
speculate and that landed him in trouble.

4. Power of attorney must not be given to anyone. Aman blindly trusted the
brokerage firm and gave them the authority to invest his money.
Unfortunately for him, they lost all his money, and worse still, he has no
recourse.
*Moral of the story
*
Though some purchases merit borrowing, know where to draw the line. Get your
priorities, right and you will always be ‘indebted’ to yourself for this!