Understanding Investment Valuation Ratios
Researching investments can be tricky. There are a seemingly endless number of terms and figures being thrown around. Some of these might be familiar to you and some are probably not. Worse yet, some of the values are based on estimations and are only as good as the people providing the estimate. It’s important to know which values use estimated figures.
Understanding what these investment valuation ratios really represent will give you much more insight into the value of a company as an investment. The ratios are not difficult to understand, nor is it particularly difficult to interpret them.
Consider how you can use these 6 important investment valuation ratios:
- Price/Earnings Ratio (P/E Ratio): This is certainly the most well-known of the valuation indicators. It’s commonly referred to as the P/E ratio. The ratio is very simple. It’s merely the stock price per share divided by the earnings per share.
- The earnings per share value is often estimated into the future. This is where things can become misleading. During bear markets, the estimations tend to be low. During bull markets, estimations are high.
- The historical record of financial professionals’ accuracy in predicting anything has always been less than impressive.
- The market, as a whole, has averaged a price/earnings ratio of about 15. This can vary with market conditions. You’ll also find particular industries have different averages.
- Price/Earnings Ratio = ___Stock Price per Share____
Earnings per Share
- Stocks with higher P/E ratios are expected by investors to have more earnings growth moving forward than the overall market. Those with low ratios are expected to grow at a slower rate than the market.
- Remember the value of this ratio is dependent on the accuracy of the component numbers. If the estimations are poor, it’s easy to make a poor investment decision.
- Price/Earnings to Growth Ratio (PEG Ratio): This ratio is a refined version of the P/E ratio that also considers the stocks estimated growth of earnings.
- By comparing the P/E ratio and the PEG, investors can have some insight about the degree of overpricing or underpricing of a stock.
- If the PEG is 1, it’s generally considered to be priced accurately with regards to the estimated earnings per share growth expectations. A PEG of less than 1 is considered to be undervalued. A PEG greater than 1 means the company is likely to be overpriced.
- PEG Ratio = ____ Price/Earnings Ratio_____
Earnings per Share Growth
- The P/E ratio is the most widely used metric, but it’s lacking in one important way. Investors are willing to purchase high P/E stocks due to the high, expected growth prospects. The PEG ratio considers the validity of that growth expectation.
- Remember that the Earnings per Share Growth estimates are still exactly that, just estimates. The PEG ratio simply tells how well the P/E ratio is tracking with the earnings estimates of the analysts.
- Price/Sales Ratio (P/S Ratio): This is another valuation indicator that’s closely related to the P/E ratio. The Price/Sale (P/S) ratio uses the price of the stock vs. its sales figures, rather than earnings.
- The P/S ratio is an indication of what investors are willing to pay for each dollar of a company’s sales. Many investors consider sales figures to be a more reliable metric than earnings. Earnings are subject to the manipulations of management and accounting estimates.
- Price/Sales Ratio = _____Stock Price per Share____
Net Sales (Revenue) per Share
- Many investing experts highly tout the P/S ratio. The stocks with lower P/S ratios have been a better indication of stock price success than any other valuation ratio.
- No metric ought to be the sole basis for any decision. However, any investor really needs to take the P/S ratio seriously.
- Price/Cash Flow Ratio (P/CF Ratio): This metric is used to determine the value of a company based on its stock price and the amount of cash flow the company generates per share.
- It’s similar to the P/E ratio, but the P/CF is considered by many to be a more reliable way to determine the appropriateness of a stock’s price.
- Cash flow numbers aren’t as easily manipulated. But earnings can be manipulated and are also affected by depreciation.
- Price/Cash Flow Ratio = ____Stock Price per Share______
Operating Cash Flow per Share
- Many investors and financial professionals choose to focus on cash flow instead of earnings. Likewise, many people prefer the P/CF ratio over the P/E ratio.
- Price/Book Value Ratio (P/BV Ratio): This provides a comparison of a stock’s price to its book value (shareholders’ equity). This ratio is a multiple that shows how much an investor would be paying for the net assets of that company.
- The book value is the value of the company’s assets. This can be found on the balance sheet. To determine the book value, the liabilities on the balance sheet are subtracted from the assets. The remainder is the book value.
- Price/Book Value Ratio = ______Stock Price per Share______
Shareholders’ Equity per Share
- When a company’s stock price is lower than its book value, there are two possible scenarios. In one case the stock is being undervalued by investors for an illegitimate reason and the stock is a good buy. Otherwise, the under-valuation is correct and the stock is likely to be a poor investment choice in the foreseeable future.
- This metric is used most heavily in finance-related businesses, such as banks. Companies with a lot of intellectual property are difficult to assess in a meaningful way with the Price/Book Value Ratio.
- Dividend Yield (DY): This value is a percentage. It’s the company’s annual dividend paid to investors divided by the stock price at the time the dividend is paid. This value can normally be found as part of a company’s stock quote.
- Dividend Yield = __Annual Dividend per Share__
Stock Price per Share
- Dividend yields are attractive to income investors. Growth companies normally refrain from paying dividends, since they would prefer to pour the profits back into the company.
- The most common dividend-paying companies are utilities, which often have limited growth potential. Mature banking companies are another good example.
- If you’re into growth stocks, the dividend is unlikely to matter to you. If you prefer income producing investments, like most bonds, the dividend yield ought to be on your radar.
Investment valuation ratios are another set of numbers that provide investors with an additional method of determining the attractiveness of a company as an investment. Some ratios are more applicable to certain industries.
A great idea would be to look at your past investments and check out all of these ratios for those companies. Consider which companies were great investments, and then look at the duds. Do you see any trends that differentiate the good and the poor investments? Take the time to learn from your successes and mistakes. That’s what successful investors do.
These ratios are an invaluable resource for investors. However, other factors also need to be considered when deciding whether or not to invest in a company. If you add these ratios to your investment research arsenal, you’ll likely be rewarded handsomely. As always, give us a call if you have questions about this article or want recommendations on who you can talk to about your investment decisions.