Valuation is the process of using financial information to determine what a company is worth. Financial ratios put that valuation into the context of a company’s share price, which is then used to evaluate a company’s investment potential. Here is a list of ratios for value investing:
- Price to Earnings
- Price to Book Value
- Return on Equity
- Debt to Equity
- Price to Free Cash Flow
- Price to Earnings Growth
Ratios can be a quick and helpful way to help an investor value a company. Let’s take a deeper look into how the ratios are constructed and why these ratios are helpful
1. Price to Earnings Ratio
The most famous and most commonly used ratio to value a company is the Price to Earnings ratio, or PE ratio. The PE ratio shows the relationship between a company’s share price and its earnings per share. Earnings are defined as revenue minus the cost of sales, selling costs, interest, and taxes, or simply, after-tax net income. Earnings per share is just the earnings divided by the share price. The PE ratio shows the price the market is willing to pay for the company’s earnings and therefore what an investor would pay for those earnings if they were to purchase at that price.
For example, if a company’s share price is $100 and its earnings over the last 12 months are $5 per share, the PE ratio would be 20 ($100/$5). The average PE ratio for the S&P 500 has historically been around 15. In comparison to the average, a company with a higher PE ratio generally means investors have a strong sentiment that the company’s earnings are going to increase significantly in the future. Tesla, inc is a prime example. A lower PE ratio generally means investors think the company’s earnings will decline or continue to be meager.
The PE ratio should be used as a very rough estimation as it is not without its flaws. The PE ratio is a good starting point to quickly value a company and compare what people are paying for a company compared to other investment opportunities, especially ones that are in the same industry. It is an easy way to as the information that makes the ratio is readily available.
However, the PE ratio should be viewed with a certain level of skepticism. It can be easily manipulated by using different accounting methods to calculate earnings, not in an illegal way, just company preference. Also, the PE ratio does not include debt which could hurt earnings in the long run. The PE ratio is also based on past earnings and not future earnings. It is the future earnings of a company that counts, however, it can be an indication of how profitable a company can be.
2. Price to Book Ratio
Price to book ratio (PB ratio) is a ratio that shows the price the market is willing to pay for the book value of a company. Book value is defined as the balance sheet’s assets minus the balance sheet’s liabilities. It is calculated by dividing the share price by the book value per share (the company’s book value divided by the number of shares outstanding). It is an estimation of a company’s true value if it were to close today and sell everything off.
For example, if a company’s stock was trading at a price of $100 and had a book value of $80 per share it would have PB ratio of 1.25 ($100/$80). A ratio of 1 means that the market is willing to pay more than the liquidation value of a company, whereas a below 1 means the market is willing to pay less. The PB ratio is often compared to return on equity (ROE), a measurement of the ability of a company to generate profits from its shareholders investments in the company. A high PB ratio and a low ROE can mean a stock is overvalued; investors are paying above liquidation value without the company generating strong profits.
However, the PB ratio is more suited for companies that need a large amount of assets to generate profits, such as utility and industrial companies. In today’s economy where there is an increasing amount of companies that are less asset-heavy and more toward information-focused companies, such as technology, book value has become less applicable.
The greatest businesses actually do not require a book value. The best companies have cash flows that increase over time without the need to invest more and more into assets to generate that cash flow (which builds up book value over time). It is more important to focus on what a company can earn on invested assets and the ability to increase earnings per unit of invested asset. This is how a company that may appear overvalued based on book value can actually be undervalued when based on its ability to increase its cash flow per dollar invested.
3. Return on Equity ratio
Return on equity (ROE) is calculated by dividing the net income of a company by the shareholder’s equity (how much the shareholders of a company have invested in the business in the form of money or by retaining earnings).
ROE combines components from the income statement and the balance sheet. It shows the total return of equity and the company’s ability to generate a return on investment, i.e. how many dollars does the company return for each dollar invested. It is a simplistic way to measure investment returns. Also, it provides an easy way to compare the profitability of a company to others in the same industry and to discover the most competitive companies. A company that can generate above-average returns can indicate a suitable investment. The profitability is an indication that the company has the ability to generate earnings, preferably at an increasing rate each year. A steadily increasing ROE generally means the management can invest intelligently to increase profits. This increasing ROE raises the value of the company and should be reflected in the stock price over time.
ROE is expressed as a percentage and the higher the percentage the better the ROE. For example, if a company generates $10 million from a $40 million worth of shareholders’ equity it would have an ROE of 25% ($10m/$40m), which is excellent. However, if the shareholder’s equity was $400 million, then the ROE would be a measly 2.5%. As a rule of thumb, an ROE over 15% is good, however, it must be compared to other similar companies in the same industry to get a good gauge. It should also be noted that ROE can be skewed by share buybacks, and may exclude intangible assets which can play a role in a company’s ability to generate revenue.
4. Debt to Equity Ratio
The Debt to Equity ratio (DE ratio) is a measure of how much debt a company has compared to its equity. It helps investors understand how leveraged a company is and how it finances its investments. A low DE ratio means the company has little debt compared to its equity and does not need to borrow substantial amounts to operate. A DE ratio means the company has borrowed more money to operate and can pose a risk if they do not have the cash flow to meet its debt obligations. It can be an indication of the mentality of the management; some may be more aggressive in financing growth, and some may take a more conservative approach.
It should not be used as a stand-alone ratio and should be used to compare companies in the same industry. It may be necessary for companies in asset-heavy industries, such as construction, to need a lot of debt to buy equipment and materials to expand operations.This debt should be evaluated as to its profitability; if the financing can increase earnings more than the debt’s interest then it may be logical to take out the debt. However, if the interest on the loans is substantial the company could potentially generate more earnings without the debt. A DE ratio of .5 or below, i.e. for every $1 of equity the company has 50c of debt, is a sign that the company is not too leveraged and can cover its obligations.
5. Price to Free Cash Flow Ratio
Price to Free Cash Flow ratio (PCF ratio) compares the price of a company’s stock to the amount of operating free cash flow a company generates. It is most commonly calculated by dividing the company’s market cap by the cash flow generated in the past 12 months. It can be seen as a more accurate valuation ratio compared to the PE ratio because the PCF ratio is harder to manipulate as it measures the actual cash leftover in a reporting period.
For example, a company has a share price of $50 and 50 million shares outstanding and therefore a market cap of $2.5 billion. If you divide the market cap by its free cash flow of $500 million you would get a PCF ratio of 5. All else being equal, a PCF ratio of 5 means an investor would receive a 20% yield (the price of the stock divided by 5). The lower the ratio means the quicker an investor would get their money back. Generally, a PCF ratio of 15 or below is good. However, depending on the likelihood of the cash flow growing or declining in the future will greatly affect what an investor is willing to pay.
6. Price to Earnings Growth Ratio
The Price to Earnings Growth (PEG ratio) is the comparison between the PE ratio and the projected earnings of a company. It is similar to the PE ratio but also takes earnings growth into account in an attempt to calculate the company’s forecasted growth. It is calculated by dividing the PE ratio by the earnings per share growth (how much the earnings per share (EPS) has changed from year to year). For example, if a company’s PE ratio is 15 and its PEG is expected to be 12% over the next year, the PEG ratio would be 1.25 (15 PE ratio/12% earnings growth).
A stock with a PEG ratio less than 1 typically means the company is undervalued as its price is below its expected earnings growth, whereas a PEG ratio greater than 1 may be considered overvalued because it could indicate the share price is too expensive compared to the expected earnings growth. As always, the PEG ratio should be compared to other companies in its industry to be able to judge where the valuation sits in relation to other investment opportunities.
