What’s it: A valuation ratio is a financial ratio in which we relate a company’s financial soundness to its market value. We use it to determine how attractive a company’s stock is.
To calculate a valuation ratio, we compare a company’s market value with basic financial metrics such as cash flow, revenue, and net income (net profit). Commonly used ratios are:
- Price-to-earnings ratio.
- Price-to-book ratio.
- Price-to-sales ratio.
- Price-to-cash-flow ratio.
Why are valuation ratios important?
When investing in the stock market, we have several stock alternatives to choose from. Valuation ratio metrics help us to select them and make investment decisions.
We use valuation metrics to determine whether a stock is overvalued, undervalued, or fair. For example, some stocks may have been more expensive than others based on certain metrics. Thus, they are no longer worthy of being collected or held because the potential for prices to rise is minimal. On the contrary, the price may correct downwards in the future.
Valuation ratios are popular among investors because they are easy to calculate. In fact, we no longer have to calculate it manually. Most financial websites or apps have this available.
As I’ve mentioned, we judge how valuable a company’s stock is by comparing its share price against several financial metrics. Revenue, net income, book value, cash from operations are commonly used company performance metrics.
Then, stock investors look at valuation ratios based on their expectations for the future. Why? The increase or decrease in stock prices does not occur now but in the future. Moreover, they invest money not to be resold on the same day. They are not like traders. They buy and hold it, hoping the price goes up, and sell it for profit in the future.
For example, let’s compare the market price of a company’s stock with its ability to make money, as measured by cash from operations (CFO). Say, a company recently acquired a distributor to expand its marketing. So, the company has the potential to make big money in the future.
But, now, the market does not appreciate it, as reflected in the undervalued price-to-cash-flow ratio. So, by buying it, we expect the stock to rise in the future as the CFO increases.
What are the key valuation ratios?
Several metrics are available for valuing stocks. The price-to-earnings ratio (P/E ratio) is a popular example. The alternatives are:
- Price-to-book value ratio
- Price-to-sales ratio
- Price-to-cash-flow ratio
- Dividend yield
Here, I also present several other ratios: dividend payout ratio, retention rate, and sustainable growth rate. Although they do not link the company’s stock price, they are useful for valuing its stock.
The price-to-earnings ratio (P/E ratio) relates a company’s shares to its net income. We calculate it by dividing the share price by earnings per share. The formula for earnings per share is net income over the last 12 months divided by the number of common shares outstanding.
- P/E ratio = Share price / Earnings per share
High P/E ratio
- Investors appreciated the company’s shares positively. They are willing to buy at a high price for any net profit generated by the company. They expect profits to grow even higher in the future. Thus, they bid the company’s shares at a higher price.
- Alternatively, it could also signal an overpriced stock. So, it’s hard to climb. And, if the realized net income in the future is below expectations, it can lead to a downward correction in the share price.
Low P/E ratio
- Investors are not sure about the company’s prospects in the future. They doubt the company will generate higher profits. Thus, they are reluctant to buy shares at a higher price.
- Or the market is undervaluing the company’s stock. If true, the company’s stock is worth collecting because the price has the potential to rise in the future.
Which one is true? And which P/E ratio is good?
- It depends on the company’s performance. And, to provide a more objective valuation, you have to look at aspects such as the company’s strategy, its market position, and the industry and economic prospects in the future.
- The P/E ratio also varies across industries. So, it depends on the industry in which the company operates. Some industries have higher average P/E ratios than others.
Two drawbacks of the P/E ratio. First, it is susceptible to manipulation because we use net income, which is not the same as money made under accrual accounting.
Second, it does not take into account financial leverage. So the company may take on too much debt to grow the business. However, the investment does not yield a higher return than the cost of taking on additional debt. In the end, more expenses are added than the money is made.
We calculate earnings yield by dividing earnings per share (EPS) by the share price. Alternatively, we divide 1 by the P/E ratio to get it.
- Earning yield = 1 / (P/E ratio)
- Earning yield = EPS / Share price
As the above equation, earning yield is inversely related to the P/E ratio. So, to read it, we contrast it with when we read the P/E ratio. So, for example, a high earning yield means a low P/E ratio, indicating:
- Investors doubt the company’s prospects in generating net income. Thus, they are reluctant to pay a higher price.
- Or, the stock is undervalued, so it has the potential to rise in the future. Success in posting a higher net profit than the market had expected could boost the company’s stock price.
The P/E growth ratio or PEG ratio helps us evaluate whether a company’s P/E ratio is overvalued or undervalued. To calculate it, we divide the forward P/E ratio by EPS growth, usually the average over the next five years.
- PEG ratio = (Forward P/E ratio) / (EPS Growth)
A higher PEG ratio indicates a relatively more expensive price. If it is more than 1.0, the company’s stock is considered overvalued. Conversely, a ratio of 1.0 or lower indicates a fair or undervalued price.
The price-to-book ratio (P/B ratio) relates a company’s stock price to its book value (shareholder equity). We calculate it by dividing the price by the book value per share. Alternatively, we divide market capitalization by book value.
- P/B ratio = Price per share / Book value per share
- P/B ratio = Market capitalization / Book value
When the P/B ratio is higher than one, the market is trading the company’s stock at a premium above its book value. The reasons may be:
- The market appreciates the company’s stock because it has significant intangible assets. Strong brand equity, patents, and dominant market share support the company’s advantage over competitors. They allow the company to make more money. Unfortunately, they are not reflected in the book value.
- The company posted a higher ROE compared to the comparison companies (peers). And the company maintains it from time to time. Thus, the market likes and is willing to trade the company’s shares at a premium.
The price-to-sales ratio (P/S ratio) relates the stock price to the company’s sales. Two data we need to calculate it. The first is the stock price. The second is sales per share. To get sales per share, we divide the company’s revenue over the last 12 months by the number of shares outstanding. Thus, the ratio tells us how much investors paid for the stock compared to the sales the company made.
- P/S ratio = Share price / Sales per share
The way to read the P/S ratio is similar to the P/E ratio.
A high P/S ratio reflects the market’s willingness to pay more for the company’s stock. Investors expect future price increases to be associated with the company’s success in posting revenue performance.
- Or the market overestimates the company’s stock. So, the price is too expensive. It likely can’t go any higher in the future. When realized revenue is below expectations, it can lead to a stock price correction.
Conversely, a lower ratio could indicate investor pessimism. They doubt the prospects for the company’s sales in the future. So, they only buy shares at a low price.
- Or, it could also be an undervalued company stock. So, it can be an attractive investment choice and alternative because of the potential to increase in the future.
Unlike the P/E ratio, the P/S ratio is less susceptible to accounting manipulation. In addition, it is also more stable because revenue is generally less volatile compared to net income.
However, because it only uses revenue, the P/S ratio does not accommodate the company’s profitability. Thus, it does not contain information about how efficiently the company generates profits.
The price-to-cash-flow ratio (P/CF ratio) relates the stock price to how much money the company makes from operations. Unlike the P/E ratio, the P/CF ratio uses a realistic metric, namely cash from operations (CFO) as the divisor, not net income. Thus, it is less susceptible to manipulation as net income under accrual accounting.
We calculate the P/CF ratio by dividing the stock price by the CFO per share. Meanwhile, the last one we calculate by dividing CFO by the number of common shares outstanding.
- P/CF ratio = Price per share / CFO per share
Like the P/E ratio, a higher P/CF ratio indicates the market expects the company to make more money in the future. Or, it could also indicate the stock is overpriced. Conversely, the opposite conclusion applies if the P/CF ratio is low.
Although CFO is not easy to manipulate, its calculation is relatively more complex. Thus, variations in calculating CFO between companies can result in inconsistent P/CF ratio comparisons.
Earnings per share
Earnings per share (EPS) shows how much profit is available to owners (or stock investors) for each share held. We calculate this by dividing net income by the weighted average number of common shares outstanding during the year. We must adjust net income if the company has preferred stock. The basic EPS formula is as follows:
- EPS = (Net income – Preferred dividend) / Weighted average number of common shares outstanding
The formula does not consider the effect if diluted securities are exercised. Converting diluted securities can affect the number of shares outstanding. So, it will also affect the EPS value.
For this reason, we must also calculate diluted EPS, showing how much profit is available to owners when all diluted securities have been exercised. Here’s the formula:
- Diluted EPS = (Net income – Preferred dividend) / (Weighted average number of common shares outstanding + New common shares issued on conversion)
Higher EPS is considered better because more profit is available to the owner. However, the opposite conclusion holds if it is low.
Dividend per share
Dividend per share shows how much dividend is available for each share held. We calculate it by dividing the cash dividend – adjusted for the preferred dividend – by the number of shares outstanding.
- Dividend per share = (Cash dividend – Preferred dividend) / Number of common shares outstanding
When investing in stocks, dividends are another source of income for investors besides capital gains. Thus, investors usually prefer companies with increased dividends per share. It shows management’s positive expectation of its future earnings and believes its profit increase can be sustained. Thus, they decide to pay higher dividends from year to year.
Dividend payout ratio
The dividend payout ratio measures what percentage of net income is distributed as dividends. We calculate it by dividing cash dividends by net income.
- Dividend payout ratio = Dividends / Net income
A high ratio is preferred because it shows the company distributes most of its net income as dividends. And, on the other hand, less is left for internal capital (retained earnings). Thus, there is a trade-off between paying large dividends and strengthening internal capital.
For example, the company consistently distributes large dividends. Investors then expect the company to maintain an equal payout ratio in the future. It can make it difficult for management to raise internal capital because it is difficult to cut dividends without disappointing shareholders. And a lack of internal capital could undermine future business growth.
Dividend yield relates the stock price to the dividends distributed. We calculate it by dividing the company’s annual dividend per share divided by its share price per share.
- Dividend yield = Dividend per share / Share price
Not all companies pay regular dividends. Those who do usually have a stable net income. They may operate in defensive sectors such as utilities. Or, they are mature companies with few growth opportunities.
Such companies are usually underpinned by not only relatively stable businesses. But, they also usually have a strong cash flow. So, buying shares from companies with stable dividend yields is a wise choice.
The retention rate shows the portion of net profit retained by the company as internal capital. Again, it’s easy to calculate; we just divide retained earnings by net income.
- Retention rate = Retained earnings / Net profit = (Net profit – Dividend) / Net profit = 1 – Dividend payout ratio
A higher ratio indicates more retained earnings as internal capital. And less is distributed as dividends. As a result, the company can use it to grow its business. But, if it doesn’t result in higher earnings in the future, the market views it negatively.
Sustainable growth rate
The sustainable growth rate shows how high the company can maintain dividend growth from time to time. We assume a certain return on equity, a constant capital structure, and no-issuance of additional common stock when calculating it.
- Sustainable growth rate = Retention rate × ROE
This metric usually represents the company’s maximum growth rate over the long term by relying on internal capital. It assumes no new capital injections, neither equity nor debt.
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