Top 5 Helpful Financial Ratios in IPO Investing

May 9, 2023

Initial Public Offering (IPO) – the first public sale of shares of a company – is a closely watched and much-anticipated event in the lives of investors as well as company insiders. However, identifying good IPOs can be a daunting task, as investors need to carefully analyze the financials of the company to make an informed decision about valuation. To make things easier, we at IPO Central have compiled a list of the 5 most important financial ratios in IPO investing.

#1 Price-to-Earnings (P/E) Ratio – Among Most Popular Ratios in IPO Investing

The P/E ratio is a measure of a company’s stock price relative to its earnings per share (EPS). It is calculated by dividing the current stock price by the EPS. A high P/E ratio indicates that the stock is overvalued, while a low P/E ratio indicates that the stock is undervalued.

For example, if a company has a P/E ratio of 20, it means that investors are willing to pay INR 20 for every INR 1 of earnings. On the other hand, if a company has a P/E ratio of 10, it means that investors are willing to pay only INR 10 for every INR 1 of earnings.

P/E ratio is very easy to understand and intuitively makes sense. It is for this reason that it is among the most used ratios in IPO investing. However, it is not uniform across industries and a figure of 20 may be too high for some industries and too low for others. Generally speaking, companies from mature industries with low growth rates tend to have lower P/E ratios than their counterparts from high-growth sectors. In addition, several other factors such as corporate governance are also at play in deciding valuation.

#2 Price-to-Sales (P/S) Ratio

The P/S ratio is a measure of a company’s stock price relative to its revenue per share. It is calculated by dividing the current stock price by the revenue per share. A high P/S ratio indicates that the stock is overvalued, while a low P/S ratio indicates that the stock is undervalued.

For example, if a company has a P/S ratio of 3, it means that investors are willing to pay INR 3 for every INR 1 of revenue. On the other hand, if a company has a P/S ratio of 0.5, it means that investors are willing to pay only INR 0.5 for every INR 1 of revenue.

Similar to P/E ratio, P/S ratio is also subject to vary a lot across industries. Value investors tend to place a lot of emphasis on this metric as it offers a bird’s eye view regarding the valuations of companies in an industry.

#3 Debt-to-Equity (D/E) Ratio – IPO Investing Made Easy

The D/E ratio is a measure of a company’s debt relative to its equity. It is calculated by dividing the company’s total debt by its total equity. A high D/E ratio indicates that the company has a high level of debt, which can be risky for investors as the company has to pay interest on the debt which eventually reduces profits for shareholders.

As an example, a company with a D/E ratio of 2 simply has twice as much debt as equity. On the other hand, if a company has a D/E ratio of 0.5, it means that the company has half as much debt as equity.

While low debt is always preferred, it may be indispensable in capital-intensive industries such as capital goods and EPC. In a similar vein, high-debt companies tend to post higher profits than their debt-free counterparts in low-interest regimes but fare worse otherwise. Simply put, as long as a company is able to generate higher returns than its cost of debt, debt isn’t bad for its balance sheet.

#4 Return on Equity (ROE)

The ROE is a measure of a company’s profitability relative to its equity. It is calculated by dividing the company’s net income (net profit) by its total equity. A high ROE indicates that the company is generating a high level of profits relative to its equity.

Unlike the earlier ratios, this metric is calculated as a percentage figure and works well across industries. As a rule of thumb, any business that consistently generates ROE above 15% is considered investment worthy.

#5 Return on Capital Employed (ROCE)

Like ROE, ROCE is also used to assess a company’s profitability and capital efficiency. However, it differs from ROE in the sense that it also takes into account debt capital. It is calculated by dividing the company’s Earnings Before Interest and Tax (EBIT) by Capital Employed which is defined as the difference between Total Assets and Current Liabilities.

As mentioned earlier, debt isn’t necessarily a bad component on the balance sheet and thus, ROCE is a comprehensive indicator regarding the effective use of capital. A higher figure is better and it can also be denominated in percentage. Since it provides a comprehensive view of capital efficiency, ROCE is among the most valuable ratios used in IPO investing.

In addition, there are some ratios which can be helpful in specific cases.

#6 Price to book (PBV) Ratio

The Price to Book Ratio (PBV) is calculated by dividing the stock’s current price by its book value per share. In this case, book value might be defined as a company’s net asset value, which is computed as total assets minus intangible assets and liabilities.

Formula for PBV ratio:

Price to Book Ratio = (Price per Share)/(Book Value per Share)

The PBV ratio indicates how much shareholders pay for a company’s net assets. In general, a lower PBV ratio may indicate that the stock is undervalued.

However, once again, the definition of lower differs per industry. When examining the PBV ratio, an apple-to-apple comparison should be made. An IT company’s price to book value ratio should only be compared to the PBV of another IT company, not any other industry.

#7 Current Ratio

The current ratio is an important financial indicator for assessing a company’s liquidity. It calculates the proportion of current assets that can be used to cover current liabilities.

This ratio indicates the company’s ability to pay short-term liabilities with short-term assets. If the ratio is greater than one, the company has more short-term assets than short-term obligations. However, if the current ratio is less than 1.0, the inverse is true, and the corporation may be vulnerable.

The current ratio can be calculated as:

Current Ratio = (Current Assets)/(Current Liabilities)

This financial ratio indicates the company’s ability to pay short-term liabilities with short-term assets. If the ratio is greater than 1.0, the company has more short-term assets than short-term debts. However, if the current ratio is less than 1.0, the inverse is true, and the corporation may be vulnerable. As a general guideline, invest in a company with a current ratio higher than 1.

Conclusion

There is no dearth of ratios and financial figures that can be analyzed to gain a better understanding of a company’s financial performance. However, these five ratios in IPO investing can do the heavy lifting for you and help in building an initial impression that wouldn’t be very far from reality.

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