Capital Markets of India - Stock Exchanges of India - Commonly Referred Terms & Ratios in the Stock Market

The following technical terms and ratios are commonly referred in the stock market while explaining the futures of specific securities. It is necessary to know in more detail about them

EPS: refers to earnings per share. It is calculated after deducting interest and taxes payable from the operating profit (EBIT), as also dividend, if any, on preference shares. The residual amount represents the earning available to common shareholders. If this amount is divided by the number of shares of equity outstanding, EPS is calculated. It is the objective of a business to maximize earnings per share, through the process of financial leverage or trading on equity. This brings in the maximum return to the shareholders and makes the stocks of the company high-valued. Financial leverage involves the use of fixed-cost financing. Favourable financial leverage is said to occur when the company uses funds obtained at a fixed cost (funds obtained by issuing debt with a fixed interest or preferred stock with a constant dividend rate) to earn more than fixed financing costs paid. Any profits left after meeting fixed financing costs then belong to the common shareholders. Unfavourable or negative leverage occurs when the firm dos not earn as much as the fixed financing costs. Thus if a company raised Rs.20 Lacs of debt capital and incurs capital cost of Rs.5 Lacs on the same, but is able to earn an incremental profit of Rs.15 Lacs therefrom, it is having favourable financial leverage of Rs.10 Lacs. But if it incurs a cost of Rs.10 Lacs and earns only Rs.8 Lacs incrementally therefrom, it is a case of unfavourable financial leverage

P/E ratio: Price-earnings Ratio is an important valuation ratio. These ratios indicate how the equity stock of the company is assessed in the capital market. Since the market value of equity reflects the combined influence of risk and return, valuation ratios are the most comprehensive measures of a firm's performance.

P/E Ratio is calculated by the formulae

Market Price per share
Earnings per share

The market price per share may be the price prevailing on a certain day, or preferably the average price over a period of time. The earnings per share are simply: profit after tax divided by number of outstanding equity shares.

The price earning ratio or (price earning multiple as it is commonly referred to) is a summary measure, which primarily reflects the following factors:

• Growth prospects,

• Risk characteristics,

• Shareholder orientation,

• Corporate image, and

• Degree of liquidity.

E.B.I.T: refers to earnings before interest and taxes and represent the operating profits generated by a business. Since interest and taxes represent not operating expense, but financial charges, these expenses are excluded in calculating operating profit. A business can improve its operating profits or EBIT through operating leverage. Leverage refers to the use of fixed costs in an attempt to increase profitability. Operating leverage arises due to fixed operating costs in the production of goods and services. Fixed costs are those, which do not vary with sales volume. They are a function of time and are typically contractual (e.g. rent paid for factory premises). Operating leverage occurs any time a firm has costs that has to be met any time regardless of sales volume. In other words with fixed costs remain constant the percentage of change in profits accompanying a change in volume is greater than the percentage of change in volume. The occurrence of operating leverage maximises EBIT.

Example: A firm sells its products for Rs.100 per unit, has a variable cost of Rs.50/- per unit and fixed operating cost of Rs.50,000/- per year. When its sales level is 2000 units its EBIT is Rs.50,000/- (sales revenue minus variable & fixed costs). If the products sold is increased to 3000 from 2000, there is no increase in the fixed cost, and there is increase of Rs.50,000 only in variable costs against incremental sales of Rs.100,000. Thus the operating profits increases to Rs.1 Lacs (from Rs.50,000/-). This is a case of favourable operating leverage. On the other hand if the sales revenue is reduced to 1000 units from 2000 units, sales revenue is reduced by Rs.1 Lac, against reduction of variable cost by Rs.50,000/- and hence it makes neither profit or loss. This is a case of negative operating leverage.

Debt: Equity: - Debt-equity ratio is an important leverage ratio. Financial leverage refers to the use of debt finance. While debt capital is a cheaper source of finance, it is also a riskier source. Leverage ratio helps in assessing the risk arising from the use of debt capital. One type of leverage ratio is structural ratio, which are based on the proportion of debt and equity in the financial stricture of the firm. (The type is coverage ratio). Debt-equity ratio is an important structural ratio.

Debt-equity ratio is expressed as

Long term Debt
Equity Preference capital

The numerator consists of long term liabilities and denominator consists of net worth plus preference capital. In general the lower the debt/equity ratio, the higher the degree of protection enjoyed by the creditors, due to higher stake of the promoters in the venture

Net Asset Value (NAV)

"Net asset value," or "NAV," of an investment company is the company's total assets minus its total liabilities. For example, if an investment company has securities and other assets worth $100 million and has liabilities of $10 million, the Investment Company's NAV will be $90 million. Because an investment company's assets and liabilities change daily, NAV will also change daily. NAV might be $90 million one day, $100 million the next, and $80 million the day after.

Mutual Fund and Unit Trust of India generally must calculate their NAV at least once every business day. A closed-end fund, whose shares generally are not "redeemable"-that is, not required to be repurchased by the fund-is not subject to this requirement.

An investment company calculates the NAV of a single share (or the "per share NAV") by dividing its NAV by the number of shares that are outstanding. For example, if a mutual fund has an NAV of Rs.10 Crore, and investors own Rs.1,00,00,000 of the fund's shares, the fund's per share NAV will be Rs.10. Because per share NAV is based on NAV, which changes daily, and on the number of shares held by investors, which also changes daily, per share NAV also will change daily. Most mutual funds publish their per share NAVs in the daily newspapers.

The share price of mutual funds is based on their NAV. That is, the price that investors pay to purchase mutual fund and most UIT shares is the approximate per share NAV, plus any fees that the fund imposes at purchase (such as sales load or purchase fees). The price that investors receive on redemption is the approximate per share NAV at redemption, minus any fees that the fund deducts at that time (such as deferred sales load or redemption fees). The NAV is usually below the market price because the current value of the fund's assets is higher than the historical financial statements used in the NAV calculation.

SEBI has defined NAV in respect of Mutual Funds -

"The performance of a particular scheme of a mutual fund is denoted by Net Asset Value (NAV). Mutual funds invest the money collected from the investors in securities markets. In simple words, Net Asset Value is the market value of the securities held by the scheme. Since market value of securities changes every day, NAV of a scheme also varies on day to day basis. The NAV per unit is the market value of securities of a scheme divided by the total number of scheme on any particular date. For example, if the market value of securities of a mutual fund scheme is Rs 200 lakhs and the mutual fund has issued 10 lakhs units of Rs. 10 each to the investors, then the NAV per unit of the fund is Rs.20. NAV is required to be disclosed by the mutual funds on a regular basis - daily or weekly - depending on the type of scheme."