How to compare Ratio with another ratio?

Q&A: Questions & Answers Investing Basics Q&A
1

Hi,

  • How do you compare one ratio by another?
  • How do I know If I can compare RoE and PE. Suppose, two companies are all same and I see PE = 15 for one company but RoE = 25 and 2nd company with PE = 8 but RoE = 6. Which one to choose?
  • Is there any relationship I can establish among ratios? If one is good and another is bad then how to analyse! Which one is comparable or I can establish a relation and which one cannot with a particular one!

Any book exists!

2

As per my understanding PE is the variable that determines es how much you are paying for the earnings per year. And roe is the actual return given by the company.

E.g PE of 15 means that you are paying 15 rs for 1 rupee of earnings of the company. Inverting this it means you expect company to give you 6.66 rs for every 100 rs invested by you.But in actual if RoE is 25 it means company is generating 25rs for every 100 rupees invested by you.

The things are always not so simple and the reason that the PE valuation is so low is that market is foreseeing some risk in future due to which such roe might not be sustainable.
Generally you can see that PE is the price market assigns to the company

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3

If ROE is 6, don’t even bother to look at it. It means that company is making 6 rs per year for every 100 rs from equity. Even fixed deposit will give more than 6%, not worth running a business for making 6% annually. .
While comparing make sure you’re not comparing businesses in different sector.

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4

It is always tricky to choose between companies when one is better in one ratio and other is better in some other ratio.

If you want to be very objective, you can give points to each criteria and compare companies by each of your chosen criteria and then add up the points to see which one is better.

I ended up creating InvestR just to answer those type of questions.

Here is an example of HDFC Bank vs Yes Bank.

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5

For a more comparable indicator, PEG ratio can be much better indicator as it factors in the future growth in earnings with PE multiple. It would otherwise be difficult to assess whether paying 15 times the EPS is a reasonable premium to pay or not.

6

Ratio comparisons without understanding the business is a dangerous road in my opinion. I have seen more mistakes made due to this than due to anything else

Comparing ratios without the following is meaningless -

  1. Product & customer profile
  2. Operating utilization and efficiency
  3. Risks inherent in the business model
  4. Predictability & sustainability of earnings
  5. Current asset base and future investment needed

amongst many other important points…if you already have a hang of most of these, ratio analysis may add some value but not too much in my opinion

Going by pure ratio comparison and analysis one might end up making mistakes like buying a low P/E story just because it looks optically undervalued, buying a story with the lowest valuation in its peer group

Please tread cautiously on ratio analysis and comparison if your business analysis skills aren’t up to speed

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