Risk tolerance by stocks categorization using ratio analysis

There are so many investment instruments available in the market today that an investor faces difficulty in choosing the optimal one. This article focuses on considering the risk tolerance of investors using ratio analysis and then allocating stocks into different categories. Stocks categorization is the process wherein stocks are classified into three categories:

• growth,
• income, and
• value stocks.

Stocks categorization is done using different methods like Price-to-Earnings Ratio, Price-to-Book value Ratio, Beta, Price-to-Cash Flow ratio, Dividend yield rate, and dividend payout ratio.

Ratio analysis is an invaluable tool for stocks categorization

Investing in stocks requires careful examination of the financial data of the company in order to determine its true worth. Financial ratios are a source of valuable information like profitability, liquidity, debt repayment ability, or operational efficiency clearing the doubts of investors and aware them of the financial position of the company. The majority of investors consider ratio analysis as the optimal method for determining the position of the portfolio by having a valuation based on historical prices. Herein, in order to classify stocks into growth, income, and value stocks, the ratios considered are:

• Price-to-Earnings (P/E) ratio: P/E is the ratio representing the company’s current share price to its earnings per share. Depicting the willingness to pay by the market for the company’s earnings, the P/E ratio indicates the valuation of a stock in the market. A high P/E suggests the bullish nature of market participants on stocks wherein it is expected to have higher earnings growth in the future. It is also referred to as the over-valuation of the market.
• Price-to-Book (P/B) value ratio: P/B compares the capitalization of the market with its book value by dividing the company’s stock price per share by its book value per share. Representing the valuation of stocks, the P/B is mostly used by value investors for identifying undervalued company stocks. A stock with a low P/B value shows that there might be some issues that the company is bearing with its fundamentals and thus, the stocks are undervalued. There is a possibility of having a profit in the future.
• Dividend Yield Ratio: Dividend yield represents the percentage of the market price of a share that the company pays annually to its shareholders as dividends. It is referred to as the ratio of dividend per share to its market price per share. As dividend yield does not show the nature of the company but instead identifies the alignment of stocks, a low yield represents a growing company focusing on re-investment while high yield paying company is a mature company with fewer chances of future growth. Thus, a high yield ratio represents the more possibility of income for the investors.

As stated in the previous article, the criteria for the classification of 303 BSE listed stocks is

Growth stocks categorization

Growth stocks depict the stocks of the company with high risk and less stability, but more possibility of earning sustainable returns. Herein, for the BSE-500 listed 303 companies, the comparison of the P/E ratio for each stock is done with the stated level i.e. 20. The stocks with negative values or below the stated level are eliminated from the growth stocks categorization. The analysis of P/E, P/B, and the dividend yield values for the list of growth stocks is shown in the below table.

Value stock categorization

Value stocks are the undervalued stocks which though currently traded at price below the average market price but have the possibility of yielding high returns in the future. The stocks are mostly traded in the situation of distress thus there are very fewer investors who prefer these stocks. Herein, the listed BSE-500 companies are categorized on the basis of two ratios i.e. P/E and P/B. Stocks with a P/E value of less than 15 and P/B of less than 1.5 are regarded as the value stocks. Herein, the stocks with negative average values and the value with either P/E less than 15 and P/B greater than 1.5 or P/E greater than 15 and P/B less than 1.5 are eliminated. A list of identified value stocks is shown below.

Income stocks categorization

Income stocks are the kind of secured investment for investors wherein the portfolio is balanced against the volatility of the market by having a source of steady income. A larger portion of the profit is paid as a dividend the company issuing these stocks is more of the matured company with a slower future growth possibility. Mostly the dividend yield for these stocks is between 3-6% however, herein, the computation is done by comparing the rate with the average dividend yield of the market. The computed average market yield is 1.302%. Thus, the stocks having a value greater than the average market yield are referred to as income stocks. However, the growth and value stocks with a dividend yield greater than 1.302%, and the negative value are eliminated from the income stock. A list of the identified income stocks along with their P/E, P/B, and dividend yield is shown below:

BSE-500 listed categorized stocks

The examination of the 303 BSE-500 listed stocks with the ratio analysis i.e. P/E, P/B, and dividend yield has shown that most of the investors opt for investing in companies yielding sustainable returns and have more possibility of growth, thus, there are about 220 growth stocks in the market. With the availability of undervalued stocks, about 45 stocks were value stocks. Lastly, with less opportunity for growth and more stable earnings, only a few investors consider stocks as a medium to earn income. Therefore, 16 stocks are income stocks. Further, 22 stocks do not meet the threshold limit for stock categorization and thus are eliminated from further analysis.