InvestorQ : What are valuation ratios in the equity market and how to use these ratios to evaluate the attractiveness of companies and stocks?
Rutuja Nigam made post

What are valuation ratios in the equity market and how to use these ratios to evaluate the attractiveness of companies and stocks?

Arti Chavan answered.
2 years ago

Valuations pertain to the valuations that markets attach to the stock. There is an interesting point here. When it comes to valuations, P/E ratio is the input not the output. It gives an idea of how much the market is willing to pay for every rupee earned by the company as EPS. The P/E is higher based on factors like higher growth, better ROE, efficient management, corporate governance, brands etc. Understanding this is at the core of understanding valuation ratios.

What do we understand by valuation? In simple terms, valuation is the financial process of determining what a company is worth. Valuation ratios put valuation in the context of a company’s share price, where they serve as tools for evaluating whether to buy the stock, hold the stock or to sell the stock. However, different sectors and different companies have some unique features. For example, you do you use P/E Ratio for a loss making company? How do you use dividend yield for a company that is reinvesting all its cash flows into the business? These are the questions that will get better answered as we delve deep into the concept of valuation ratios.

P/E Ratio or the Price to Earnings Ratio

The P/E ratio tells you what the market is willing to pay for every rupee earned by the company. Obviously, this can only be useful if the company is making stable profits and not erratic or volatile profits. P/E ratio is determined by dividing a company's current share price by its earnings per share. Alternatively, you can also divide the market cap of the company by its total net profits and the results will be the same. For example, if a company is currently trading at Rs.25 a share and its earnings over the last 12 months are Rs.1.25 per share, the P/E ratio for the stock would be 20 (Rs.25/Rs.1.25). There are two ways to look at P/E ratio. A rising P/E ratio shows that the stock is in favour in the market but it also shows that the stock is getting expensive. Similarly, a falling P/E ratio means that the stock is getting cheaper but it also shows that the stock is going out of favour in the market.

P/BV or the Price to Book ratio

Did you know that P/BV is more popular for banks and financials than for industrial companies? In fact, the idea of P/BV has its own utility too. 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.60 and a book value of Rs.65 per share would have a P/B ratio of 0.9. 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.

P/S or the Price to Sales Ratio

When should be using the P/S ratio. What does it indicate? The price-to-sales ratio (P/S) shows how much the markets value every dollar of the company's sales. The company's market capitalization is divided by the company's total sales over the past 12 months to arrive at the P/S ratio. 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. 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). Normally, P/S ratio is used more as a ratification tool to P/E ratio rather than as a standalone tool to value companies.

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

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.

An improvement to the P/E in the form of the PEG ratio

PEG is the P/E Ratio divided by growth. Standalone P/E can be quite misleading. To be meaningful it needs to be looked at in conjunction with the growth rate or the sustainable growth rate. 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 16.5 and its earnings-per-share growth over the next 3 years is expected to be 10.8%, its PEG ratio would be 1.5. 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.

Quite often a mix of the above ratios is used in conjunction rather than in isolation to get dual ratification of your analysis about the company. That is a safer bet than relying on just one ratio.