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Value investing focuses on buying quality businesses at reasonable prices, supported by clear numbers rather than market hype. Financial ratios play a central role in this approach, as they help investors assess whether a stock is undervalued, fairly priced, or overpriced.
By analysing profitability, valuation, leverage, and cash flow ratios, investors can judge a company’s financial strength and long-term potential. However, ratios deliver meaningful insights only when compared with industry peers and historical trends.
In this article, we explore the top ratios used in value investing and explain how they help investors make informed, disciplined investment decisions.
How To Read Ratios?
A single ratio never tells the complete story of a company. To evaluate a stock properly, you must analyse a combination of valuation, profitability, leverage, and liquidity ratios together. Each ratio complements the other and helps confirm whether the business quality and stock price are aligned.
Value investing ratios become meaningful only when compared with companies from the same industry and tracked over multiple years to identify trends. Since manually checking metrics like P/E, P/B, ROE, and ROCE can be time-consuming, using reliable stock screeners simplifies the process by offering ready-made filters and updated financial data.
Now, let’s look at the key ratios used in value investing that every value investor should analyse.
P/E ratio shows how much investors are willing to pay for every rupee of a company’s earnings. It helps you understand whether a stock is expensive or reasonably priced relative to its profits. A lower P/E ratio may indicate better value, but only if the company’s earnings are stable and sustainable.
A high P/E does not always mean overvaluation, nor does a low P/E always indicate undervaluation. This depends on growth and industry factors and will be explained in a separate blog.
Formula:
P/E = Price per Share ÷ Earnings per Share (EPS)
P/E ratio becomes meaningful only when compared with industry peers. This comparison helps investors judge whether a stock is overvalued, undervalued, or fairly valued.
- Example
- Assume a company has total earnings of ₹1000 and 100 shares outstanding. Its Earnings Per Share (EPS) would be ₹10.
- If the current market price of the share is ₹100, then: P/E Ratio = 100 ÷ 10 = 10
- This means an investor is paying ₹10 to earn ₹1 from the company’s profits.
What Is an Ideal P/E Ratio?
There is no universal “ideal” P/E ratio. Every industry has its own benchmark based on growth potential, stability, and risk profile.
For example, in the FMCG sector, P/E ratios are usually higher due to steady demand and predictable earnings:
- HUL (P/E ratio): 46
- Britannia(P/E ratio): 53
If one company is trading at a higher P/E than its peer, it may be relatively overvalued, assuming similar growth prospects.
Now consider a different sector, such as metals or manufacturing:
- Tata Steel(P/E ratio): 24
Comparing this P/E directly with FMCG companies would lead to a misleading conclusion because industry dynamics are completely different.
P/B ratio compares a company’s market price with its book value, which represents the net value of assets recorded on the balance sheet. This ratio is useful for banks, insurance companies, and asset-heavy businesses, where asset quality plays a key role in valuation.
Book value reflects what shareholders may receive if a company shuts down operations, sells its assets, and repays all liabilities.
Formula:
P/B = Price per Share ÷ Book Value per Share
P/B ratio below 1 can indicate undervaluation, but only after confirming the quality of assets, profitability, and balance-sheet strength..
How to Interpret the P/B Ratio?
Traditionally, a lower P/B ratio is seen as undervalued and a higher P/B ratio as overvalued. However, this interpretation can be misleading if used in isolation. A low P/B may reflect poor asset quality or weak business fundamentals, while a high P/B may be justified by strong profitability and efficient capital use.
For example:
- Yes Bank(P/B ratio): 1.51
- Avenue Supermarts(P/B ratio): 10
Despite having a much higher P/B ratio, Avenue Supermarts is often considered fundamentally strong due to consistent earnings and high return ratios.
ROE measures how efficiently a company uses shareholders’ funds to generate profits. It is one of the most important indicators for assessing management quality and the overall strength of a business.
Formula:
ROE = Net Income ÷ Shareholders’ Equity
A higher ROE generally reflects strong operational efficiency and, in many cases, a competitive advantage or economic moat. However, a high ROE driven by excessive debt may not be sustainable over the long term.
How ROE Works?
- ROE shows how effectively equity capital is converted into profits. For example, if a company has total equity of ₹100 and generates a net income of ₹20, its ROE is 20%. Another company with the same equity but earning ₹40 would have an ROE of 40%, making it more efficient in using shareholder funds.
- ROE varies across industries, so comparing it with sector peers is essential. Additionally, a company can report a high ROE because it operates with low equity and high debt, which increases financial risk.
- A very high ROE does not make a company a good investment. Investors must analyse debt levels, capital structure, and consistency of returns before concluding.
ROCE measures how efficiently a company generates profits using all the capital at its disposal, including both equity and debt. Unlike ROE, which focuses only on shareholders’ funds, ROCE gives a broader view of overall capital efficiency and is especially useful when comparing companies with different leverage levels.
Formula:
ROCE = Profit Before Interest and Taxes (EBIT) ÷ (Total Debt + Shareholders’ Equity)
How ROCE Works?
ROCE shows how much operating profit a company earns for every rupee of capital employed in the business. For example, if a company uses ₹100 of total capital (debt + equity) and generates ₹20 as EBIT, its ROCE is 20%. A higher ROCE indicates better uzd stronger operational efficiency.
Debt to Equity ratio shows the proportion of debt and equity used to finance a company’s operations. It is a key financial leverage and risk indicator, helping investors understand how dependent a business is on borrowed funds compared to shareholders’ capital.
Formula:
D/E = Total Debt ÷ Shareholders’ Equity
A lower D/E ratio generally indicates lower financial risk and a healthier balance sheet. Investors often analyse this ratio along with the interest coverage ratio to assess whether the company’s earnings are sufficient to service its debt obligations.
How the D/E Ratio Works?
D/E ratio compares a company’s total liabilities with its shareholders’ equity. It shows how much of the business is funded through loans versus owned capital. A higher ratio means greater reliance on debt, while a lower ratio suggests conservative financing.
Is a High D/E Always Bad?
There is no universal ideal D/E ratio, as acceptable levels vary across industries. Capital-intensive sectors may naturally operate with higher debt. While excessive borrowing can increase interest costs and reduce cash flows, debt is not inherently negative.
When used efficiently and managed well, borrowed funds can support expansion and improve returns. Generally, a lower D/E ratio is preferred, as investors tend to favour companies with low debt or debt-free balance sheets.
Dividend Yield ratio shows how much cash a company returns to its shareholders in the form of dividends relative to its current stock price. This ratio is important for income-oriented investors who prefer steady cash flows over price appreciation.
Formula:
Dividend Yield = (Annual Dividend per Share ÷ Current Market Price) × 100
A higher dividend yield can be attractive, but it is sustainable only when supported by strong and consistent cash flows.
How Dividend Yield Works?
Dividend yield, also known as the dividend–price ratio, indicates the annual return an investor earns from dividends alone. For example, if a company pays an annual dividend of ₹20 on a share priced at ₹400, the dividend yield is 5%. However, investors must also evaluate dividend coverage and free cash flows to ensure the payout can be maintained.
Why Dividend Yield Matters?
Many stocks may not show price growth but still deliver consistent returns through dividends. A higher dividend yield increases earnings from the same investment amount compared to stocks with lower yields.
EBITDA Margin measures a company’s operating profitability before accounting for interest, taxes, depreciation, and amortisation. It helps investors understand how efficiently a business generates operating profits from its core activities, without the impact of financing and accounting decisions.
Formula:
EBITDA Margin = EBITDA ÷ Operating Revenue
Why EBITDA Margin Matters?
A higher or improving EBITDA margin indicates better cost control, operational efficiency, and pricing power. It shows that the company is able to convert a larger portion of its revenue into operating profit.
How to Use EBITDA Margin in Analysis?
EBITDA margins should always be analysed over multiple years to identify trends and compared with industry peers for context. A one-time spike may not be meaningful, but consistent improvement over time reflects strengthening business fundamentals.
Current Ratio measures a company’s ability to meet its short-term obligations using its short-term assets. It is a liquidity ratio that indicates how comfortably a business can manage its day-to-day financial commitments.
Formula:
Current Ratio = Current Assets ÷ Current Liabilities
How to Interpret the Current Ratio?
A current ratio between 1.5 and 3 is generally considered healthy, as it suggests the company has sufficient assets to cover its near-term liabilities. A ratio below 1 may indicate liquidity stress, while an excessively high ratio could signal inefficient use of working capital.
What to Look Beyond the Number?
The quality of current assets matters as much as the ratio itself. Slow-moving inventory or delayed receivables can weaken actual liquidity, even if the current ratio appears comfortable.
PEG ratio is a growth-adjusted version of P/E ratio. It helps investors avoid low P/E traps in slow-growing companies and identify stocks where the price is reasonable relative to future earnings growth.
Formula:
PEG = P/E ÷ Earnings Growth Rate
A PEG close to 1 is often considered fairly valued. However, investors should also evaluate the quality, sustainability, and cyclicality of growth before relying on this ratio alone.
Final Words
Ratios such as P/E, P/B, EV/EBITDA, PEG, dividend yield, ROE, ROCE, Debt-to-Equity, and current ratio to assess a stock’s price relative to its business quality. These value investing ratios help balance valuation with profitability, financial strength, and liquidity.
However, ratios are meaningful only when validated through peer comparisons and long-term trend analysis. All the ratios discussed are available on multiple financial websites, so you do not need to calculate them manually. Hope you understand what ratios used in Value Investing
FAQs on Ratios used in Value Investing
How are ROE and ROCE helpful in identifying quality companies?
ROE shows how efficiently shareholder capital is converted into profits, while ROCE evaluates how well total capital, including debt, is utilised to generate operating returns.
Which ratio is more important for value investors, P/E or P/B?
Both matter. P/E suits companies with stable earnings, while P/B works better for asset-heavy businesses. Using them together usually gives a clearer valuation picture.
Are ratios enough to make buy or sell decisions?
No. Ratios highlight opportunities and risks, but investors should also consider business quality, management, industry conditions, and long-term prospects before making decisions.
Happy investing and thank you for reading!
Disclaimer:
This website content is only for educational purposes, not investment advice. Before making any investment, it’s important to do your own research and be fully informed. Investing in the stock market includes risks, and you should carefully read the Risk Disclosure documents before proceeding. Please remember that past performance doesn’t guarantee future results, and due to market fluctuations, your investment goals may not always be achieved.
