There are numerous methods to value a stock. The well-known discounted cash flow (DCF) method involves calculating profits received by the shareholder in the future, estimating a final value on disposal and discounting both at an appropriate interest rate to determine current value. Unfortunately, this method relies heavily on unknown future profits and values that must be estimated.
Fortunately, there are other methods to value a stock. A common method is to compare valuation of fundamental characteristics of a stock with other companies. Comparisons could be made between peer companies, companies within the same industry or sector, versus the entire stock market, versus a company’s own history or versus a company’s growth rate. If an investor is interested in using stock valuations as a guide to their investments, there are five common ratios they should know. Generally, companies with lower valuation ratios are cheaper and therefore more attractive.
1. Price-to-Earnings Ratio (P/E Ratio)
Price-to-earnings ratio is the most popular valuation metric. A P/E ratio is simply the current market price divided by the earnings per share, giving an indication as to how much investors are willing to pay per dollar of earnings. Earnings per share can be trailing 12 months, expected next 12 months or normalized over some time period. Although commonly used, this ratio, in some cases, may not allow for accurate comparisons due to variations between companies’ accounting policies. If earnings are distorted, then the ratio will also be distorted.
2. Price-to-Book Ratio (P/B Ratio)
This ratio is the current market price divided by the book value per share. Book value is the value of the company's assets documented on their balance sheet. The calculated ratio represents its total assets minus any intangible assets or liabilities. This ratio measures how much investors are willing to pay for each dollar of a company’s assets. However, it can be distorted for companies that have significant intangible assets and may be misleadingly high.
3. Enterprise Value-to-EBITDA (EV/EBITDA)
The Enterprise Value measures a company’s total value less cash (market capitalization plus debt, minority interest, and preferred shares minus total cash and equivalents). EBITDA is earnings before interest, taxes and depreciation and amortization. EV/EBITDA ratio is less subject to distortion from differences in accounting policies and is sometimes preferred as a way to compare the operations of different companies. This ratio is commonly used to compare companies within the same industry.
4. Price-to-Sales Ratio (P/S Ratio)
Price-to-sales is the current stock price divided by the annual sales per share. Investors can utilize this tool to understand how company profits are valued per dollar of sales. This is another ratio less subject to distortion from differing accounting policies, however, it may be less informative because it doesn’t evaluate the operations or earning capacity of the company. Again, this ratio may be more appropriately used to compare companies within the same industry.
5. Price-to-Free Cash Flow Ratio
One of the best valuation ratios is price-to-free cash flow, because free cash flow is the company’s ability to generate cash from operations after allowing for capital expenditures. A measure of a company’s free cash flow can be significant to investors because it indicates the amount of cash left over to pay dividends, buy back stock, pay down debt or accumulate on the balance sheet. This ratio is less subject to distortion from accounting policies. Unfortunately, this ratio cannot be used for companies that do not generate free cash flow. Many rapidly growing or expanding companies need extra cash to grow and often rely on the financial markets to access this extra cash, thereby generating no free cash flow.
These valuation tools can be beneficial to investors, however, there is no single ratio that applies in all situations. Many investors use multiple ratios to better compare companies versus other investment opportunities. Although valuation ratios may be compared to a company’s history, industry, sector, peers, market or growth rate, they must be interpreted very carefully, due to potential differences in accounting and tax policies.
Valuation ratios are only one factor in fundamentally analyzing a company or index. In addition to utilizing stock valuations, an investor should consider other factors before making any investment decisions. Investors can ask themselves a few simple questions to determine whether or not an investment is suited for them:
- What are my goals and objectives? Even an attractively valued investment may not be appropriate when considering the purpose of the money.
- What is my time horizon for this investment – is it for a week, month, a year, or long term for retirement?
- What is my risk tolerance? Am I willing to hold this stock even if it drops in value?
- Does this investment sound too good? Investors should use prudence when making an investment decision – if it sounds too good to be true, then it likely is.
Many excellent resources exist for those interested in learning more about investing. Investors should consider using a financial advisor or expert who will invest their money in professionally managed investment vehicles if they don’t have the time, motivation or knowledge to properly evaluate investment opportunities.
The decision-making process does not always have to be daunting. By understanding how a stock’s value is determined and the role it plays in a portfolio, investors can begin to make better, more informed choices.
Aash M. Shah, CFA is a senior portfolio manager at Summit Global Investments, an SEC registered investment adviser specializing in low volatility investment strategies. Learn more at www.summitglobalinvestments.com.
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