How to Analyse Debt and Valuation of a Company
We often come across a lot of different financial ratios with complex names. We also get confused about the kinds of metrics one must use in a particular condition. In this jargon series, we shall discuss two kinds of financial ratios— Leverage Ratios & Valuation Ratios. Let’s get started!
Let us take Tata Steel as an example for the analysis, along with JSW Steel and Jindal steel for peer competition.
Note: Never try to analyze a company with only one kind of ratio. Using multiple ratios and comparing them with metrics of peer players across a specific time period will give us a comprehensive insight into a company.
For a company, debt (leverage) is like a double-edged sword. They can scale their business and improve sales with the help of debt funds. However, if not used wisely, the interest to be paid for these borrowings can eat up the company’s profits. It could also lead to a crunch in the cash reserved for future operations.
Leverage ratios can be furthered classified as:
- Debt to Equity Ratio
- Debt to Asset Ratio
- Financial Leverage
- Interest Coverage Ratio
Debt to Equity Ratio
Equity is the value attributable to the shareholders of a company. It is calculated by subtracting liabilities from the value of the assets. The Debt to Equity ratio tells us how much borrowings are present in a company compared to its equity.
Debt to Equity Ratio = Total Debt/Total Equity
We can find the total equity of a company in its balance sheet. By adding the borrowings from the current and non-current liabilities, we get debt. For Tata Steel, the ratio stood at 1.05 in FY21, which means that for every Rs 1 equity in the company, there exists Rs 1.05 as debt. A higher Debt to Equity ratio indicates a higher amount of debt.
From the graph shown above, we can conclude that Tata Steel has been able to reduce its debts. The company's Debt to Equity ratio is also aligned with the industry average. We can also conclude that the steel sector is capital intensive, and each manufacturer has to raise funds through debt to conduct its operations.
Debt to Asset Ratio
In this ratio, we replace total equity from the previous ratio with the total assets of the company.
Debt to Asset = Total Debt/Total Asset
By converting the result into percentage terms, we can analyse how much of the company's assets are assisted by debt. For Tata Steel, the ratio stands at 0.33 or 33%. It means that for every Rs 100 worth of assets in the company, Rs 33 is financed by debt.
By going through the two ratios, we can see that Jindal Steel has been able to reduce its leverage.
Financial Leverage gives another dimension to analyse a company's debt. The formula is:
Financial leverage = Total Assets/Total Equity
Even though the formula does not include debt, it resembles assets that are present for every single unit of equity. For Tata Steel, the ratio stands at 3.17, which means that for every equity of Rs 1, it holds assets worth Rs 3.17. The ratio increases when total assets are raised with the help of debt.
JSW Steel has a Financial Leverage of 3.21, and Jindal Steel has a relatively good figure of 2.52.
Interest Coverage Ratio
The interest coverage ratio helps us to know how much the company is able to earn with respect to its interest payment. It is also known as the debt service ratio.
Interest Coverage Ratio = Earnings Before Interest & Tax (EBIT) / Finance Cost
EBIT is calculated by adding Finance Cost (listed as an expense) to the Profit Before Tax (PBT). For Tata Steel, the Interest Coverage Ratio stands at 2.8, which means for every Rs 1 paid as interest, the company can generate Rs 2.8 as revenue. A decreasing interest coverage ratio tells us that the company cannot efficiently manage its debt to generate more revenue.
As we can see, Tata Steel's interest coverage ratio has fallen over time and has ended up the last among its peers.
As stock market investors, it is always ideal to buy shares of a company when it has a cheaper valuation. Valuation is the process of determining the true value of an asset or company. For example, the real estate prices of a particular plot surge when there is an announcement of a new township or tourism project. The ones who bought the plot earlier at a cheaper rate tend to enjoy the higher valuation of the property.
Similarly, investors can measure the valuation of each stock they invest in.
Price to Earnings (P/E) Ratio
The Price to Earnings ratio gives you an insight into how much the stock market participants are willing to pay for the stock for every Rs 1 profit generated by the company.
Price to Earnings Ratio = Current Market Price/Earnings Per Share (EPS)
EPS can be easily calculated by dividing the net profit of a firm by the total number of shares. Tata Steel's P/E stands at 21.5, meaning that for every Rs 1 profit generated by the company, investors are ready to pay Rs 21.5.
Compared to peer companies, Tata Steel is slightly overvalued. Meanwhile, Jindal Steel is valued at a P/E of 8.6, making it a cheaper option.
Every industry/sector has a different range of valuation. Thus, a standard P/E range cannot be defined for all stocks.
Price to Sales (P/S) Ratio
We used Earnings Per Share (EPS) for calculating the P/E ratio. However, EPS can be influenced by factors such as a change in tax slabs, new accounting rules, one-time payments, etc. To overcome this, we can consider the total sales of a company to find its valuation.
Price to Sales (P/S) ratio = Current Market Price/ Sales Per Share
Sales per share can be calculated by dividing a company's revenue from operations by the total number of shares. The P/S of Tata Steel stands at 1.06, which means that for every Rs 1 earned as revenue, the company's investors value it 1.06 times.
Surprisingly, Tata Steel (which has a higher P/E ratio) has a low P/S ratio.
Price to Book (P/B) Ratio
Suppose a company ends its operations after liquidating assets and settling all debts. Any final amount remaining within the firm has to be distributed amongst its investors. This value is known as the book value of a company.
The sum of the total equity and cash reserve from a company's balance sheet is its book value. By dividing the book value by the total number of shares, we get the book value per share.
Price to Book Ratio = Current Market Price/Book Value Per Share
For Tata Steel, the P/B ratio stands at 2.13, meaning that the stock is trading 2.13 times its book value.
Here, JSW Steel has a P/B ratio of 3.62, which means it has a higher valuation. Conservative investors can consider stocks whose P/B ratio is close to 1. For modern and asset-light businesses, P/B will always be on the higher side.