InvestorQ : Can you tell me what is meant by company valuation ratios and how are the used to take a view on a stock or sector?
Arti Chavan made post

Can you tell me what is meant by company valuation ratios and how are the used to take a view on a stock or sector?

3 years ago

Financial ratios are relationships based on a company's financial information and they can serve as useful tools to evaluate a company's investment potential. But then what exactly is valuation? To cut a long story short, valuation is the financial process of determining what a company is worth. A company can be valuable because of the assets it owns or due to the future cash flows. Either way, it has some advantage that makes the company valuable to begin with. Valuation ratios put that insight into the context of a company’s share price, where they serve as useful tools for evaluating investment potential. Here you can take a quick peek at some of the principle valuation ratios.

Price-to-earnings ratio or the P/E ratio

Price-to-earnings ratio (P/E) looks at the relationship between a company's stock price and its earnings. The P/E ratio gives investors an idea of what the market is willing to pay for the company's earnings. The ratio is determined by dividing a company's current share price by its earnings per share. For example, if a company is currently trading at Rs.50 a share and its earnings over the last 12 months is Rs.2.50 per share, then the P/E ratio for the stock would be 20 (50 / 2.50). As the P/E goes up, it shows that current investor sentiment is favorable. A dropping P/E is an indication that the company is out of favour with investors. Normally, the P/E ratio tends to be the independent variable and the price is the consequence. Some sectors like FMCG enjoy a high P/E while commodity stocks typically have a lower P/E ratio.

Price-to-book value or the P/BV ratio

The price to book is not normally used as a standalone measure but more as an adjunct to the P/E ratio. In fact, in certain sectors like banks, the P/BV is more popular than the P/E ratio and it is a better gauge for comparing the companies within the financial sector. Price-to-book value (P/B) is a measurement that looks at the value the market places on the book value of the company. It is calculated by taking the current price per share and dividing by the book value per share. The book value of a company is the difference between the balance sheet assets and balance sheet liabilities. It is an estimation of the value of the company if it were to be liquidated. For example, a company with a share price of Rs.100 has a book value of Rs.40 per share then the company would have a P/B ratio of 2.5. A ratio over 1 generally implies that the market is willing to pay more than the equity per share, while a ratio under 1 implies that the market is willing to pay less. However, there are no common benchmarks and one need to tweak the benchmark P/BV ratio based on the unique conditions of the industry in the particular market.

Price-to-sales ratio or the P/S ratio

Price to sales is more popular when you have a loss making company and hence the only reliable metrics is the P/S ratio. The price-to-sales ratio (P/S) shows how much the market assigns value to every dollar of the company's sales. To calculate it, take the company's market capitalization and divide it by the company's total sales over the past 12 months. A company's market cap is the number of shares issued multiplied by the share price. The P/S ratio can be used in place of the P/E ratio in situations where the company has a net loss. The P/S ratio is quite common among the high gestation sectors like telecom, power and ecommerce where huge upfront investments ensure that it takes a long time to be able to make profits. One of the advantages of using the P/S ratio is that sales are much harder to manipulate than earnings. Since a company's sales are generally more stable than its earnings level, any large changes in the P/S ratio are often more likely to indicate a departure from the intrinsic value of the company (either up or down).

Price-to-cash flow ratio or the P/CF ratio

This ratio is not a very popular in terms of general usage and the previous three valuation ratios are more widely used. Price-to-cash flow ratio (P/CF) evaluates the price of a company's stock relative to how much cash flow the company generates. It is calculated by dividing the company's market cap by its operating cash flow in the most recent 12 months. It can also be calculated by dividing the per-share stock price by the per-share operating cash flow. P/CF ratio is an alternative method to P/E ratio. Many investors prefer to use a P/CF metric because it is considered harder to manipulate cash tallies than it would be to massage earnings reports under generally accepted accounting principles, which could make the cash-based benchmark a more reliable indicator. The only problem with the P/CF ratio is that it is meaningful only when it is historic and not prospective. But being historical defeats the very purpose of valuation which is forward looking by default. Therein lies the complexity.

Price/earnings-to-growth or the (PEG) ratio

This is not a new ratio but just an extension of the P/E ratio. The problem with P/E is that it is not usable across industries as they have different rates of growth, different levels of intangible assets and different level of margins at an operating level. Price/earnings-to-growth ratio is the relationship between the P/E ratio and the projected earnings growth of a company. It is calculated by dividing the P/E ratio by the earnings-per-share growth. For example, if a company’s P/E ratio is 20 and its earnings-per-share growth over the next 3 years is expected to be 10%, then its PEG ratio would be 2. A PEG of 1 or less is typically taken to indicate that the company is undervalued. A PEG of more than 1 is typically taken to indicate that the company is overvalued. To get a clearer picture of value, the PEG of the company should also be compared with the PEG of the market and with the industry that the company competes in. The fact about PEG being greater than 1 or lesser than one is just indicative and not a hard and fast rule. You need to use your discretion to arrive at an acceptable cut off in such cases.