Home : Introduction to stock markets

# Valuation Ratios

Learn the process of determining a company's worth using different valuation ratios and the implications of using the ratios.

The process of determining the worth of a company as a whole or on a unit basis, through assessment of its current and future prospects with respect to its financials is termed as Valuation. Valuations are usually expressed as a ratio of a company's current market price to a particular parameter of its financial performance. Valuation ratios are used by investors to determine whether the current share price of a company is high or low in relation to its true value.

Valuation ratios also help us assess if a company is cheap or expensive relative to earnings, growth prospects and dividend distributions. Some of the commonly used valuation ratios are:

1. Price to Earnings

2. Price to Sales

3. Price to Book Value

4. Price to Cash Flow

5. Price/Earnings to Growth

6. Dividend Yield

### Price to Earnings (P/E) Ratio

Also termed as the price-earnings multiple, Price to Earnings is a valuation ratio which defines the amount of money an investor is willing to pay, for every rupee worth of earnings of that particular company. P.E. ratio is measured by dividing the current price of the share by the earnings per share.

Price to Earnings ratio is calculated as:

P/E Ratio = Current market price of the share / Earnings per share

The P.E. ratio is one of the widely used parameters for stock selection. It is based on the notion that low P.E. ratio is as an indicator of good, low priced stocks, whose growth potential is not yet factored into the current price. Similarly, stocks with high P.E. ratio are interpreted as overvalued stocks.

However, it is important to remember that P.E. is not a definitive and reliable indicator due to various reasons.

• Interpretation of PE ratio is heavily dependent on a comparison of the company with its peers. In the same sector, a company with better growth prospects might have a higher P.E. as compared to other companies. Investors might be willing to pay a higher price for a company that has better growth prospects rather than invest in low P.E. companies which exhibit poor growth outlook.

• Also, P.E. can be very high in certain sectors and very low in other sectors. Comparing P.E. of companies in different sectors is not appropriate, as a company in a growth sector might have a higher P.E. as compared to a company in another sector with normalized growth prospects.

Traditionally, cyclical sectors like sugar, paper, fertilizers command a low PE ratio, while growth sectors like Financials, FMCG, Consumer Durables normally have a higher PE. So the PE ratio of a company should either be compared with its peers, having similar business activity, and of similar size, or with its historical PE, to evaluate whether a stock is undervalued or overvalued.

### Price to Sales (P/S) Ratio

Similar to the P.E. ratio, Price to Sales ratio measures the current market price of a company against its sales, instead of earnings. It compares the market price per share against the net sales per share. It is also calculated by dividing the company's market capitalization by the total sales over the trailing twelve months (TTM).

Price to Sales ratio is calculated as:

P/S Ratio = Current Market Price of the Share / Net Sales per Share, or

Total Market Capitalization / Total Net Sales

A company with a lower price/sales ratio is usually considered to be better indicating undervaluation of the company. It implies that the investors have to pay less money for each unit of sales. James O'Shaughnessy, an American investor describes the P/S ratio as the king of the value factors in his famous book, ‘What Works on Wall Street’. One of the major drawbacks of the price to sales ratio is that it doesn’t give any idea about the profitability of a company and hence, it should not be used on a standalone basis.

### Price to Book Value (P/BV) Ratio

Price to Book Value is also a valuation ratio, which indicates the market price of a share in terms of the book value of equity. It is the rupee amount an investor has to pay for each rupee of book value. This ratio is useful for value comparison between similar companies within the same sector, assuming that both the companies follow a uniform accounting method for asset valuation.

Price to Book Value ratio is calculated as:

P/BV = Current Market Price per Share / Book Value per Share

The P/BV ratio may not be a valid valuation methodology when comparing companies from different sectors and industries, as some companies may record their assets at historical costs and other companies might mark their assets based on market value. As a result, a high P/BV ratio would not necessarily be a sign of premium valuation, and conversely, a low P/BV ratio would not automatically be a representation of a discounted valuation.

### Price to Cash Flow (P/CF) Ratio

The Price to Cash Flow ratio measures the value of the current market price of a company to the cash generated per share. This ratio is useful in identifying companies which are undervalued in comparison to their cash flows. The price to cash flow ratio is calculated by dividing the share price by the operating cash flow per share of the company. Operating cash flow of the trailing twelve months is considered for calculation.

Price to Cash Flow ratio is calculated as:

P/CF = Current Market Price Per Share / Operating Cash Flow per Share

PCF ratio can also be calculated by dividing the company's market capitalization by its operating cash flow in the trailing twelve months. A lower ratio indicates undervaluation of the stock and vice versa.

### Price to Earnings/Growth (PEG) Ratio

A ratio measuring the relationship between a company’s price to earnings ratio and the earnings growth rate is termed as the Price to Earnings to Growth ratio or PEG ratio. PEG ratio is the PE ratio divided by the EPS growth figure for the last year.

Price / Earnings to Growth ratio is calculated as:

PEG = Price / Earnings ÷ Annual EPS Growth

The PEG ratio should be considered for growth stocks where the PE ratio is above the industry average, in order to assess whether the premium price paid is justified given the current level of earnings growth. A value of less than one implies that a stock may be undervalued with further potential for share price appreciation. A value of more than one implies the stock is overvalued at current prices. The PEG ratio was first developed by Mario Farina in the year 1969 and made famous in 1989 by Peter Lynch in his book, ‘One up On Wall Street’.

### Dividend Yield Ratio

Always expressed as a percentage, Dividend Yield is a financial ratio measuring the amount of dividends paid to the shareholders relative to the share price of the company. Dividend Yield is calculated by dividing the sum total of the dividend per share paid in the financial year by the current stock price of the company.

Dividend Yield is calculated as:

Dvd. Yield (%) = Total Dividend per Share / Current Market Price of the share

A higher dividend yield is assumed to imply that the share price is undervalued and vice versa. Many investors prefer high dividend paying companies to be included in their portfolio, as they are more predictable in the estimation of the returns from a company as compared to capital gains. These type of stocks are called as income stocks, as they provide a secondary source of income to long term investors.

But at the same time, it also indicates that the company is not able to find sufficient avenues of growth to deploy the profits and hence, is returning the amount to the shareholders in the form of dividends.

### Enterprise Value (EV)

Many times, market participants use market capitalization as the value assigned to any company. While this is acceptable as a rough gauge, when it comes to actually value a company, Enterprise Value is the appropriate valuation metric, as it incorporates the debt as well as available cash to arrive at the right value. Enterprise value of a company is arrived at by considering the market capitalization along with debt, preferred shares as well as cash & cash equivalents.

Enterprise Value is calculated as:

EV = Market Capitalization + Market Value of Debt – Cash and Equivalents

Companies with the same market cap can also have different enterprise values. Hence, for a comparative analysis between two companies, enterprise value is often used for multiples such as EV/EBITDA, EV/EBIT, EV/FCF or EV/Sales, as debt and cash are included in all the calculations. This is a reliable valuation metric, providing the best information for any investor from a holistic perspective.

## Next Chapter

### Altman Z Score Financial Models

4 Lessons

It's a combination of ratios which helps to understand a company's health, creditworthiness and the likelihood of it's bankruptcy.

### Introduction to Economic Factors

15 Lessons

This chapter explains the external micro and macro economic factors which have direct and indirect consequences on companies.

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