What it is: The ratio valuation (valuation ratios) is a financial ratio in which we connect financial health ( financial soundness) company by market value. We use it to determine how attractive a company’s stock is.
To calculate a valuation ratio, we compare a company’s market value with some basic financial metrics such as cash flow, revenue and net income . Commonly used ratios are price-to-earnings ratio, price-to-book ratio, price-to-sales ratio, and price-to-cash-flow ratio.
Why are valuation ratios important?
When investing in the stock market, we have several stock alternatives to choose from. Valuation ratio metrics help us to select them and make investment decisions.
We use valuation metrics to determine whether a stock is overvalued, undervalued or fair. For example, some stocks may have been more expensive than others based on certain metrics. Thus, they are no longer worthy to be collected or held because the potential for prices to rise is very small. On the contrary, the price may correct downwards in the future.
Valuation ratios are popular among investors because they are easy to calculate. In fact, we no longer have to calculate it manually. Most financial websites or apps have this provided.
As I mentioned, we judge how valuable a company’s stock is by comparing its share price against several financial metrics. Revenue, net income, book value, cash from operations are commonly used company performance metrics.
Then, stock investors look at valuation ratios based on their expectations for the future. Why? The increase or decrease in stock prices does not occur now but in the future. Moreover, they invest money not to be resold on the same day. They are not like traders. They buy and hold it, hoping the price will rise and be able to sell it at a profit in the future.
For example, let’s compare the market price of a company’s stock with its ability to make money, as measured by cash from operations (CFO). Say, a company recently acquired a distributor to expand its marketing. So, the company has the potential to make big money in the future.
But, now, the market does not appreciate it, as reflected in the undervalued price-to-cash-flow ratio. So, by buying it, we expect the stock to rise in the future as the CFO increases.
What are the key valuation ratios?
Several metrics are available for valuing stocks. The price-to-earnings ratio (P/E ratio) is a popular example. Some of the alternatives are:
- Price-to-book value ratio
- Price-to-sales ratio
- Price-to-cash-flow ratio
- Dividend yield
Here, I also present several other ratios such as dividend payout ratio, retention rate and sustainable growth rate. They do not relate to the company’s stock price, but are useful for valuing the company’s stock.
The price-to-earnings ratio (P/E ratio) relates a company’s shares to its net income. We calculate it by dividing the share price by earnings per share. The formula for earnings per share is net income over the last 12 months divided by the number of common shares outstanding.
- P/E ratio = Share price / Earnings per share
High P/E ratio
- Investors appreciated the company’s shares positively. They are willing to buy at a high price for any net profit generated by the company. They expect profits to grow even higher in the future. Thus, they bid the company’s stock at a higher price.
- Alternatively, it could also signal an overpriced stock. So, it’s hard to climb. And, if realized net income in the future is below expectations, it can lead to a downward correction in the share price.
Low P/E ratio
- Investors are not too sure about the company’s prospects in the future. They doubt the company will generate higher profits. Thus, they are reluctant to buy shares at a higher price.
- Or, the market is undervaluing the company’s stock. If true, the company’s stock is worth collecting because the price has the potential to rise in the future.
Which one is true? And which P/E ratio is good?
- It depends on the company’s performance. And, to provide a more objective valuation, you have to look at aspects such as the company’s strategy, its market position, and the prospects for the industry and economy in the future.
- The P/E ratio also varies across industries. So, it depends on the industry in which the company operates. Some industries have higher average P/E ratios than others.
Two drawbacks of the P/E ratio. First, it is susceptible to manipulation because we use net income, which is not the same as money made under accrual accounting.
Second, it does not take into account financial leverage. So the company may take on too much debt to grow the business. However, these investments do not yield returns that are higher than the costs of taking on additional debt. In the end, more expenses are added than the money is made.
We calculate earnings yield by dividing earnings per share (EPS) by the share price. Alternatively, we divide 1 by the P/E ratio to get it.
- Earning yield = 1 / (P/E ratio)
- Earning yield = EPS / Share price
As in the above equation, earning yield is inversely related to the P/E ratio. So, to read it, we contrast it with when we read the P/E ratio. For example, a high earning yield means a low P/E ratio, indicating:
- Investors doubt the company’s prospects in generating net income. Thus, they are reluctant to pay a higher price.
- Or, the stock is undervalued, so it has the potential to rise in the future. The success in posting a higher net profit than expected by the market could boost the company’s stock price.
P/E growth ratio or PEG ratio helps us to evaluate whether a company’s P/E ratio is overvalued or undervalued. To calculate it, we divide the forward P/E ratio by the growth in EPS, usually the average over the next five years.
- PEG ratio = (Forward P/E ratio) / (EPS Growth)
A higher PEG ratio indicates a relatively more expensive price. If it is more than 1.0,the company’s stock is considered overvalued. Conversely, a ratio of 1.0 or lower indicates a fair or undervalued price.
The price-to-book ratio (P/B ratio) relates a company’s stock price to its book value (shareholder equity). We calculate it by dividing the price by the book value per share. Alternatively, we divide market capitalization by book value.
- P/B ratio = Price per share / Book value per share
- P/B ratio = Market capitalization / Book value
When the P/B ratio is greater than one, the market is trading the company’s stock at a premium, above its book value. The reasons may be:
- The market appreciates the company’s stock because it has significant intangible assets. Strong brand equity, patents and dominant market share support the company’s advantage over competitors. They allow the company to make more money. Unfortunately, they are not reflected in the book value.
- The company posted a higher ROE compared to comparison companies (peers). And, the company maintains it from time to time. Thus, the market likes and is willing to trade the company’s shares at a premium.
The price-to-sales ratio (P/S ratio) relates the stock price to the company’s sales. Two data we need to calculate it. First is the stock price. The second is sales per share. To get sales per share, we divide the company’s earnings over the last 12 months by the number of shares outstanding. The ratio tells us how much investors paid for the stock compared to the sales the company made.
- P/S ratio = Share price / Sales per share
The way to read the P/S ratio is similar to the P/E ratio.
A high P/S ratio reflects the market’s willingness to pay more for the company’s stock. Investors expect future price increases to be associated with the company’s success in posting earnings performance.
- Or, the market overestimates the company’s stock. So, the price is too expensive. It likely can’t go any higher in the future. When realized earnings are below expectations, it can lead to a stock price correction.
Conversely, a lower ratio could indicate investor pessimism. They are doubtful about the prospects for the company’s sales in the future. So, they only buy shares at a low price.
- Or, it could also be an undervalued company stock. So, it can be an attractive investment choice and alternative because of the potential to increase in the future.
Unlike the P/E ratio, the P/S ratio is less susceptible to accounting manipulation. In addition, it is also more stable because earnings are generally less volatile compared to net income.
However, because it only uses revenue, the P/S ratio does not accommodate the company’s profitability. Thus, it does not contain information about how efficiently the company generates profits.
The price-to-cash-flow ratio (P/CF ratio) relates the stock price to how much money the company makes from operations. Unlike the P/E ratio, the P/CF ratio uses a realistic metric, namely cash from operations (CFO) as the divisor, not net income. Thus, it is less susceptible to manipulation as net income under accrual accounting.
We calculate the P/CF ratio by dividing the stock price by the CFO per share. Meanwhile, the latter is calculated by dividing CFO by the number of ordinary shares outstanding.
- P/CF ratio = Price per share / CFO per share
Like the P/E ratio, a higher P/CF ratio indicates the market expects the company to make more money in the future. Or, it could also indicate the stock is overpriced. The opposite conclusion applies if the P/CF ratio is low.
Although CFO is not easy to manipulate, the calculation is relatively more complex. Thus, variations in calculating CFO between companies can result in inconsistent P/CF ratio comparisons.
Earnings per share
Earnings per share (earnings per share or EPS) shows how much profit is available to owners (or stock investors) for each share held. We calculate this by dividing net income by the weighted average number of common shares outstanding during the year. We must adjust net income if the company has preferred stock. The basic EPS formula is as follows:
- EPS = (Net income – Preferred dividend) / Weighted average number of ordinary shares outstanding
The above formula does not consider the effect if diluted securities are exercised. Converting diluted securities can affect the number of shares outstanding. So, it will also affect the EPS value.
For this reason, we must also calculate diluted EPS, showing how much profit is available to owners when all diluted securities have been exercised. Here’s the formula:
- Diluted EPS = (Net income – Preferred dividend) / (Weighted average number of ordinary shares outstanding + New ordinary shares issued on conversion)
Higher EPS is considered better because more profit is available to the owner. The opposite conclusion holds if it is low.
Dividend per share
Dividend per share (dividend per share) shows how much dividend is available for each share held. We calculate it by dividing the cash dividend – adjusted for the preferred dividend – by the number of shares outstanding.
- Dividend per share = (Cash dividend – Preferred dividend) / Number of common shares outstanding
When investing in stocks, dividends are another source of income for investors besides capital gains. Thus, investors usually prefer companies with increased dividends per share. It shows management’s positive expectation of its future earnings and believes the company’s profit increase can be maintained. Thus, they decide to pay higher dividends from year to year.
Dividend payout ratio
The dividend payout ratio shows what percentage of net income is distributed as dividends. We calculate it by dividing cash dividends by net income.
- Dividend payout ratio = Dividends / Net income
A high ratio is preferred because it shows the company distributes most of its net income as dividends. And, on the other hand, less is left for internal capital (retained earnings). Thus, there is a trade-off between paying large dividends and strengthening internal capital.
For example, the company consistently distributes large dividends. Investors then expect the company to maintain an equal payout ratio in the future. It can make it difficult for management to raise internal capital because it is difficult to cut dividends without disappointing shareholders. And, a lack of internal capital could undermine future business growth.
Dividend yield relates the stock price to the dividends distributed. We calculate it by dividing the company’s annual dividend per share divided by its share price per share.
- Dividend yield = Dividend per share / Share price
Not all companies pay regular dividends. Those who do usually have a stable net income. They may operate in defensive sectors such as utilities. Or, they are mature companies with few growth opportunities.
Such companies are usually underpinned by not only relatively stable businesses. But, they also usually have a strong cash flow. So, buying shares from companies with stable dividend yields is a wise choice.
Retention rate shows the portion of net profit retained by the company as internal capital. It’s easy to calculate, we just divide retained earnings by net income.
- Retention rate = Retained earnings / Net income = (Net profit – Dividends) / Net profit = 1 Dividend payout ratio
A higher ratio indicates more retained earnings as internal capital. And, less is distributed as dividends. Companies can use it to grow their business. But, if it doesn’t lead to higher earnings in the future, the market views it negatively.
Sustainable growth rate
The sustainable growth rate shows how high the dividend growth can be maintained by the company from time to time. When calculating it, we assume a certain rate of return on equity, a constant capital structure and no issuance of additional common stock.
- Sustainable growth rate = Retention rate × ROE
This metric is usually used to represent the company’s maximum growth rate over the long term by relying on internal capital. It assumes no new capital injections, neither equity nor debt.