Valuation ratios associate stock price to a performance metric.
Some of the commonly used valuation ratios are cash flow per share, EBITDA per share, dividend per share, price to earnings ratio, price to cash flow ratio, price to sales ratio, and price to book value.
When looking at financial ratios, analysts should: apply their prior experience in evaluating firms and industries; consider the company’s publicly stated objectives; and determine industry norms, as the nuances of economic differences across industries can be reflected in their ratios.
Earnings Per Share (EPS)
Earnings per share (EPS) is considered to be one of the best measures to summarize the performance of a company. The EPS for a company is reported only for common stock.
A company can have simple capital structure or complex capital structure.
- A company with a simple capital structure can only have common stock, nonconvertible debt and non-convertible preferred stock. It cannot have any potentially dilutive securities (i.e., stock options, warrants, convertible bonds, and convertible preferred stock). For companies with simple capital structure, we calculate the Basic EPS.
- A company with a complex capital structure also includes convertible securities, stock options and warrants. For these companies, we calculate both Basic EPS and Diluted EPS. The diluted ESP considers the impact of potentially dilutive securities.
The basic EPS is calculated as follows:
Companies with complex capital structures are required to present both basic and diluted earnings per share.
In computing diluted EPS, the potential impact (i.e., the assumed conversion) of potentially dilutive securities is considered in addition to the weighted average shares.
The calculation of Basic EPS and Diluted EPS is explained in detail under Reading: Understanding Income Statement.
Price to Earnings Ratio
The Price to Earnings ratio refers to the price of the stock to profit (or net income). It is also known as multiple. Typically a stocks market capitalization to its total annual earnings will give its PE ratio.
PE ratio = Price per share/ Earning per share
Say the price of the share is $32 and its earning per share is $8, then its PE ratio would be 4. This is assuming inflation stays constant as does the time value of money. It would take 4 years for the share to pay back its purchase price. The PE ratio is used to value stocks in the same sector. Companies with stronger earnings generally attract better valuation as compared to riskier lower expected earning stocks.
Price to Book Value Ratio
Price to Book ratio measures the price of the share to the book value of the share.
PB ratio= Stock Price/(Total Assets – Intangible Assets and Liabilities)
This ratio helps assess if investors are paying too much for the stock, should the company go bankrupt tomorrow. This ratio does not value brand value or other intellectual property, on which companies are valued. In that sense this ratio has limited scope.
Price to Earning Growth Ratio
Price to Earning Growth ratio is arrived at by dividing the PE ratio by the growth on earnings per share. This ratio is preferred by investors as it factors in growth in earnings. This ratio can be used in say comparing stocks of supposedly high expected growth companies (e.g. technology) with perhaps a more traditional company (e.g. Book publishing). This will help us understand if a particular stock is overvalued.
Assume that the technology company has a high PE ratio of 50 and an annual expected growth of 25%. The book publishing company has a PE ratio of 20, and expected growth of 5%.
The PEG ratio for the technology company is 2, while that of the book publishing company stands at 4. Despite better expected rate of growth, the book publishing company seems a better bet and the technology firm overvalued.
Dividend Yield is the inverse of the PE ratio. This ratio helps understand how much cash you will get for the money you have invested in the stock. A company that has a steady and high dividend is preferred by investors. A high dividend yield could mean the company has reached its peak as far as payouts are considered or that it is undervalued. Low dividend yields mean one can expect better payouts in the future or that the stock is overvalued.
These ratios used together can help a beginner seek his way better through all the stocks in the market that vie for their attention.
Price to Sales (P/S) Ratio
Price to Sales ratio is calculated by dividing Market price per share by Sales per share.
P/S = Market Price per Share / Sales per Share
Price to Sales is a useful measure because sales can be more difficult for management to manipulate than earnings or book value. While earnings can be negative, sales are never negative. Sales can be more consistent than earnings. P/S can be useful for analyzing companies with no earnings, are cyclical, or have reached maturity. Stock return trends can be analyzed within the context of differences in P/S values.
P/S ratio also has some drawbacks. Unprofitable companies can still show sales growth. P/S ratio does not reflect cost structure. Different companies may have different revenue recognition policies.
Price to Cash Flow Ratio
Analysts may choose to value stocks based on price to cash flow ratios.
The cash flow applied could be: Net Income plus Non-cash Charges (which is not correct); Cash Flow from Operations; Adjusted CFO; or Free Cash Flow to Equity.
Cash flows are more objective than earnings. When earnings are volatile, cash flow ratios will be more stable than the P/E ratio. Stock return trends can be analyzed within the context of differences in price to cash flow values.
A drawback is that if Free Cash Flow to Equity is negative, then the P/FCFE metric cannot be used to value a stock. FCFE can be volatile. Cash flow approximation metrics can be misapplied by the analyst.