How to Analyse Debt and Valuation of a Company?
We often come across a lot of different financial ratios with complex names and become confused about the kinds of metrics to use when analyzing different companies listed in the stock market. In this article, we will discuss how to analyse the debt and valuation of a company (by using Tata Steel as an example).
Understanding Debt and Valuation
Debt refers to the total amount of money that a company owes to external creditors or lenders. It can arise from various sources, including loans, bonds, lines of credit, and other forms of borrowing. When a company borrows money, it agrees to repay the borrowed funds over time, often with interest. Companies take in debt for financing operations, expanding their business, investing in new projects, acquiring assets, or managing cash flow fluctuations. Debt can be an important tool for companies to raise capital and achieve their growth objectives. However, it also comes with the responsibility of making regular interest payments and eventually repaying the principal amount borrowed.
Meanwhile, valuation means finding the real worth of a company. Market participants use it to determine the price they are willing to pay or accept when selling a business. Thus, value investing is based on the true value of a business compared to its market value.
- The market value of a business is the worth that the market assigns to it. To calculate the market value of a publicly traded company, multiply its share price by the number of outstanding shares.
- Intrinsic value is the true and accurate worth of a company. It is the anticipated or calculated value determined through fundamental analysis.
- If the market value of a company is higher than its intrinsic value, then the stock is currently overpriced or overvalued. On the other hand, if the intrinsic value of a company is lower than its market value, then the company is undervalued.
Debt Analysis Ratios (Leverage Ratios)
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.
The following are the different types of leverage ratios:
1. 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 0.76X in FY23, which means that for every ₹1 equity in the company, there exists ₹0.76 as debt. A higher Debt-to-Equity ratio indicates a higher amount of debt compared to equity.
From the graph shown above, we can conclude that Tata Steel has been able to reduce its debts, although it has increased slightly this year. 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.
2. Interest Coverage Ratio
The interest coverage ratio helps us to know how much the company can earn with respect to its interest payment. It is also known as the debt service coverage ratio.
Interest Coverage Ratio = Earnings Before Interest & Tax (EBIT) / Finance Cost
To calculate EBIT, we add Finance Cost (listed as an expense) to the Profit Before Tax (PBT). For Tata Steel, the Interest Coverage Ratio stands at 5.29, which means for every ₹1 paid as interest, the company can generate ₹2.29 as revenue. A decreasing interest coverage ratio tells us that the company does not generate enough revenue to service its debt.
In the graph above, Tata Steel’s interest coverage ratio was higher than peers in FY22 but fell to the industry average in FY23.
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.
1. Price-to-Earnings (P/E) Ratio
The Price-earnings ratio gives you an insight into how much the stock market participants are willing to pay for the stock for every ₹1 profit generated by the company.
Price-to-Earnings Ratio = Current Market Price/Earnings Per Share (EPS)
To calculate EPS, we divide the net profit of a firm by the total number of its shares. Tata Steel's P/E stands at 14.57, meaning that for every ₹1 profit generated by the company, investors are ready to pay ₹14.57.
Tata Steel is slightly undervalued compared to peer companies. Meanwhile, JSW Steel is valued at a P/E of 39.89, making it a more expensive option.
Every industry/sector has a different range of valuation. Thus, we cannot define a standard P/E range for all stocks. Therefore, we must compare the valuation to its industry averages.
2. Price to Sales (P/S) Ratio
We used Earnings Per Share (EPS) for calculating the P/E ratio. However, changes in tax slabs, new accounting rules, one-time payments, etc. can influence EPS. To overcome this, we can consider the total sales of a company to find its valuation. A low price-to-sales ratio (P/S) means that the company is relatively undervalued.
Price-to-Sales (P/S) ratio = Current Market Price/ Sales Per Share
To calculate Price-to-Sales ratio, we divide a company's revenue from operations by the total number of shares. The P/S of Tata Steel stands at 0.52, which means that for every ₹1 earned as revenue, the company's investors value it 0.52 times.
Tata Steel has a low P/S ratio.
3. 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 amount 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 1.24, meaning that the stock is trading at 1.24 times its book value.
Here, JSW Steel has a P/B ratio of 3.15, 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.
Using Debt and Valuation Analysis for Investing
In the world of finance and investment, making informed decisions is key to success. Two essential tools that play an important role in this process are debt analysis and valuation analysis. Let's explore why these tools are vital for investors seeking to make smart investment choices:
- Risk Mitigation: Debt analysis allows investors to assess a company's financial health by examining its debt levels. This helps in understanding the risk associated with an investment. High debt can be a red flag, indicating potential financial distress, while low or manageable debt levels can instil confidence in an investment's stability.
- Valuation Analysis: It involves estimating the intrinsic value of an asset or company. By comparing this value to the current market price, investors can determine whether an investment is overvalued or undervalued. Making decisions based on valuation analysis can prevent overpaying for assets and enhance long-term returns.
- Portfolio Diversification: Understanding the debt and valuation metrics of different investments enables investors to build a diversified portfolio. A well-diversified portfolio spreads risk, reducing the impact of poor-performing assets and increasing the potential for overall returns.
- Long-Term Success: Debt and valuation analysis provide the foundation for a disciplined investment strategy that considers both short-term fluctuations and long-term growth prospects.
- Finding Opportunities: Valuation analysis can uncover undervalued assets or companies with growth potential. These opportunities might not be apparent without a systematic assessment of valuation metrics.
- Enhanced Returns: Making investments based on thorough analysis can lead to improved returns over time. By buying undervalued assets and avoiding overvalued ones, investors increase their chances of profiting from market inefficiencies.
Limitations of Debt and Valuation Analysis
While debt and valuation analysis are valuable tools for investors, it's essential to acknowledge their limitations to make well-rounded investment decisions. Here are some key limitations to consider:
- Incomplete Information: Financial statements can sometimes lack crucial information, and companies may use accounting methods that make their financial health appear better than it actually is. This can lead to inaccuracies in debt and valuation analysis.
- Market Sentiment: Market sentiment and investor behaviour can heavily influence stock prices and valuations. These factors may not always align with a company's fundamentals, making it challenging to predict short-term market movements.
- Economic Factors: Economic conditions (such as recessions or economic booms) can significantly impact the performance of companies and their debt obligations. Debt analysis may not fully account for these external factors.
- Industry Specifics: Different industries have varying debt norms and valuation metrics. What's considered acceptable in one industry might not apply to another. Ignoring industry-specific dynamics can lead to inaccurate conclusions.
- Future Uncertainty: Debt and valuation analysis rely on historical data and assumptions about the future. Unexpected events, changes in market conditions, or shifts in a company's strategy can disrupt these assumptions and render analyses obsolete.
- Limited Scope: Debt and valuation analysis often focus on quantitative aspects, overlooking qualitative factors like company management, industry trends, and competitive dynamics. These qualitative factors can significantly impact a company's performance.
Note: Never try to analyse 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.