Chapter 9 of 15
Key Financial Ratios Every Investor Must Know
P/E, P/B, ROE, D/E - ratios that reveal true value.
Rahul's coach used to break down opposition batsmen using data. Balls faced outside off stump. Strike rate against pace vs spin. Conversion rate from 50 to 100.
Single numbers meant nothing. Combinations told the story.
Rahul realised stock analysis works the same way. A company's P/E ratio alone is meaningless. Its ROE alone is incomplete. But put five or six ratios together, and you start to see whether a business is genuinely strong, or just good at looking strong.
Here are the ratios that actually matter, and how to use them without becoming an accountant.
Valuation Ratios: Is the Stock Cheap or Expensive?
P/E Ratio: The Most Common (and Most Misused)
P/E = Current Share Price ÷ Earnings Per Share (EPS). It tells you how much you're paying for every ₹1 of annual profit the company earns. A P/E of 25 means you're paying ₹25 for every ₹1 of current earnings.
The P/E ratio is useful for comparing companies within the same industry. It's nearly useless for cross-sector comparisons. IT companies trade at 30× PE, PSU banks at 8× PE, and both can be fairly valued.
Rules of thumb (for India, 2025):
- Market (Nifty 50) P/E: typically 18–24× in normal conditions
- A stock trading below sector P/E: potentially undervalued (or declining)
- A stock trading at 2–3× sector P/E: needs very high growth to justify it
Watch out for: P/E calculated on last year's earnings vs forward earnings. A company with 30× trailing P/E but 15× forward P/E (because earnings are expected to double) is a very different story.
P/B Ratio: Book Value Check
P/B = Market Price ÷ Book Value Per Share. Book value is the company's net assets (assets minus liabilities) per share. P/B tells you how much premium the market pays over the company's accounting worth.
- Banks and NBFCs are typically valued using P/B rather than P/E (their "book" = loan portfolio quality)
- P/B below 1 = stock trading below book value (could be a bargain, or assets are overvalued)
- P/B of 3–6× is typical for profitable, high-ROE companies
- P/B of 10×+ suggests the market expects extraordinary future returns: or is overpricing the stock
For banks and insurance companies, P/B is the go-to metric. A well-run private bank like HDFC Bank might trade at 4–5× P/B. A PSU bank struggling with NPAs might trade at 0.8× P/B. The discount reflects lower quality of the loan book, not necessarily a bargain.
Profitability Ratios: How Well Is It Running?
ROE: Return on Equity
ROE = Net Profit ÷ Shareholder Equity × 100. It measures how efficiently the company generates profit from the money shareholders have invested.
Think of it this way: if you invest ₹100 in a business and it generates ₹18 profit, your ROE is 18%.
In India, a consistently high ROE is a hallmark of a great business:
- ROE below 10%: Poor capital efficiency. Look elsewhere.
- ROE 12–18%: Decent. Watch for improvement trend.
- ROE 20%+: Excellent. Companies like Asian Paints, HDFC Bank maintain 18–25%+ ROE over decades.
Important: High ROE achieved by taking on lots of debt is dangerous. A company can pump ROE by borrowing heavily. Check the debt-to-equity ratio alongside ROE.
ROCE: Return on Capital Employed
ROCE = EBIT ÷ (Total Assets − Current Liabilities) × 100. Unlike ROE, ROCE measures returns on ALL capital used, equity plus debt. It's a better measure for capital-intensive businesses.
ROCE is especially useful for manufacturing, infrastructure, and capital-intensive companies. A company with ROCE > its cost of borrowing is genuinely creating value. One with ROCE < cost of debt is destroying it.
| Metric | What It Measures | Good Range (India) | Best Used For |
|---|---|---|---|
| ROE | Profit vs shareholder equity | 15–25%+ | Asset-light businesses, consumer brands |
| ROCE | Profit vs all capital (equity + debt) | 15–20%+ | Capital-intensive: manufacturing, infra |
| ROA | Profit vs total assets | 8–15%+ | Banks and financial companies |
Company A: ROE 22%, ROCE 19%, D/E 0.3. Company B: ROE 24%, ROCE 11%, D/E 1.8. Company A's ROE is slightly lower but its ROCE is far stronger, and it carries very little debt. Company B has a higher ROE, but achieved by heavy borrowing (D/E 1.8). Its ROCE of 11% barely exceeds the typical cost of debt in India (~9–10%). Company A is the genuinely stronger business. This is exactly the kind of insight Rahul's cricket data training prepared him for: one stat doesn't tell the story, combinations do.
Leverage Ratios: How Much Debt?
Debt-to-Equity Ratio
D/E = Total Debt ÷ Shareholder Equity. It shows how much a company relies on borrowed money relative to its own money. A D/E of 1 means ₹1 of debt for every ₹1 of equity.
Context matters enormously here:
- A manufacturing company with D/E of 1 might be fine if its business generates stable cash flows
- A software company with D/E of 1 is worrying: IT companies should have minimal debt
- An NBFC with D/E of 5–7 is normal (they borrow to lend: that's the business model)
General rule for non-financial companies: D/E above 2 deserves scrutiny. D/E above 3 is a red flag unless cash flows are extremely stable.
If a company's debt is increasing but revenue growth is flat or declining, the borrowed money isn't generating returns. This is how businesses get into trouble, borrow to fund operations, profits don't materialise, interest costs eat further into margins. Always track whether debt is rising or falling over 3–5 years.
Liquidity Ratios: Can It Pay Its Bills?
Current Ratio
Current Ratio = Current Assets ÷ Current Liabilities. Current assets include cash, receivables, and inventory. Current liabilities are bills due within 12 months. This measures the company's ability to meet short-term obligations.
- Current Ratio below 1: The company can't cover its short-term bills from liquid assets: potential cash crunch
- Current Ratio 1.5–3: Healthy. Comfortable buffer.
- Current Ratio above 4–5: Could signal poor capital management (too much idle cash or inventory)
Revenue Quality Ratios
Dividend Payout Ratio
Dividend Payout Ratio = Dividend Per Share ÷ EPS × 100. Shows what percentage of profits are returned to shareholders vs reinvested.
High payout (60–80%): Mature, slow-growth company returning cash. Good for income investors. Low payout (5–20%): Growth company reinvesting in expansion. Good if ROCE is high. 100%+ payout: Red flag, paying more in dividends than it earns. Unsustainable.
Putting It All Together: Rahul's Checklist
When Rahul evaluates any stock, he runs through six numbers quickly:
- P/E: Is it reasonable vs sector peers?
- P/B: Is it in line with quality of the business?
- ROE: 15%+ consistently over 5 years?
- ROCE: Is it above cost of debt?
- D/E: Is debt manageable and trending down?
- Current Ratio: Can it pay its short-term bills?
No single ratio passes or fails a stock. He's looking for a pattern. A high-quality business with good management usually shows: reasonable valuation, high ROE and ROCE, low debt, and healthy liquidity.
You don't need to calculate these ratios manually. Screener.in and Tickertape.in provide all these ratios for every listed Indian company, with 5–10 year history and industry comparisons. Rahul's first stop before any stock analysis is Screener.in.
Key Takeaways
- P/E compares price to earnings: only meaningful when comparing companies within the same sector
- P/B compares price to book value: most useful for financial companies (banks, NBFCs)
- ROE (return on equity) and ROCE (return on all capital) measure business efficiency: aim for 15%+ consistently
- High ROE achieved through heavy debt is dangerous: always check D/E alongside ROE
- D/E above 2 for non-financial companies deserves scrutiny; rising debt in a slow-growth business is a red flag
- Use Screener.in to get all these ratios with historical data: don't calculate manually
Ready to go deeper? Learn how to read a balance sheet or understand stock valuation and DCF analysis.
Company A has ROE of 28% with D/E of 3.5. Company B has ROE of 19% with D/E of 0.2. Which shows stronger underlying business quality?
Disclaimer: This article is for educational purposes only and does not constitute personalized financial advice. Investments are subject to market risks. Past performance does not guarantee future returns. Please consult a SEBI-registered investment adviser before making investment decisions.