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4 Valuation Ratios To Help Your Investments
Education | 09 October 2015
By: Louis Kent Lee
Articles (199) Profile
By: Tan Jia Hui
Articles (82) Profile

Valuation, one of the most exciting things ever to circulate in investment language. More often than not, this is one of the building blocks that form the final decision of whether or not you might even consider that stock/company into your portfolio.

Now, many of you might have heard of the most famous Price to Earnings ratio (P/E), or even Price to Book ratio (P/B), but many of us might not know when to put these wonders into action when you rationalise your investment thoughts.

With that, we present to you the four valuation ratios that are most commonly talked about.

P/E Ratio

Perhaps one of the best known valuation ratios, the P/E is a multiple that relates current market price of a company to its earnings.

Formula: P/E = Current Share Price / Earnings Per Share (EPS)

The interpretation is fairly easy, if investors buy into a company with a P/E of say 5.5 it means that the investor is paying $5.50 for every dollar of its earnings.

A stock with a high P/E (common for tech companies) suggests that investors expect higher earnings growth, as compared with a stock with low P/E and thus are willing to pay a higher price for the current earnings. Investors who buy into a high P/E stock are essentially buying into the growth story of the company.

There are two variants of the P/E – trailing (current) P/E and leading (forward) P/E, calculated using historical EPS and future earnings guidance/estimations respectively.

For a normal investor, the trailing P/E would be more useful too as it is often difficult to project accurately a company’s future earnings, even for analysts.

The P/E of a company can be used to compare with P/E of companies relative to its industry or industry average, and a relatively low P/E may present a bargain (though investors should be wary of underlying issues that could depress P/E).

While being relatively to use, P/E as a valuation as its own limitations. For one, the P/E does not reflect net cash or net debt and secondly, earnings are more easily subjected to manipulations to say cash flows.

EV/EBITDA

A common follow up choice to use when one does not want to consider P/E, because it does not reflect net debt or net cash of the company.

Enterprise value (EV), is calculated: “Market capitalisation of the company + debt, minority interests and preferred shares – total cash and cash equivalents”.

It takes into account of the net debt or net cash position of the company rather than just a market capitalisation figure. EV tells you how much you have to pay off the equity and debt owners, so that you can acquire the company at a clean slate without owing anyone anything.

Also, Earnings before interests, taxes, depreciation and amortisation (EBITDA) is used here rather than just earnings as an indicator of the profitability of the company, that is used as a base for P/E calculation.

EBITDA is a much stronger indicator of ongoing operation strength of the firm. It gives the true picture of a company’s earnings without the influence of capital structure.

EV/EBITDA is preferred when you are looking at the company from the perspective of owning and controlling.

Using the EV/EBITDA to deck your selected company against all shortlisted companies for comparison within the SAME industry is a good reflection on which company has a better position, as essentially, they are now capital structure neutral and this comparison will not be impacted by the different debt levels carried across the companies.

It is important to note that comparing EV/EBITDA to companies within the same cluster, business, will make more sense rather than judging the company based on whether or not the EV/EBITDA is high or low.

A general range that EV/EBITDA is commonly seen for companies are between 6x to 18x.

EV/SALES

What if a company has negative profits? Earnings multiples like P/E, EV/EBITDA will essentially be rendered meaningless. Hence, revenue multiples will be more insightful.

EV/Sales is commonly used in the valuation of companies whose operating costs still exceed revenues. This is very much apparent in internet firms, and fast growth companies that are slightly in the red and on the verge of a breakthrough in EBITDA.

Since the company is generally exhibiting little to no profits, with fast growth in sales, EV/Sales gives you a fair idea as to how much it costs to buy the company’s sales, and whether or not it’s too expensive.

Generally, EV/Sales multiples for companies range between 1x to 3x.

Like the other valuation multiples, it is best to compare directly with the closest peers of the company instead of relying on the range given above.

For special instances where EV/Sales is negative, it could mean that the liquid cash/bank balance of the company is more than its market capitalisation as well as debt. This indicates that the company can essentially be bought with its own cash.

P/B Ratio

P/B – a multiple that reflects the current market price of a company (share price) to its book value – provides a gauge on how much shareholders are paying for the net assets of a firm.

Formula: P/B = Current Share Price / Book Value Per Share (BVS)

Book value (BV), the difference between the balance sheet assets and liabilities is a proxy to how much shareholders will receive in the event of a liquidation of the firm’s assets.

Book value per share (BVS) can be obtained by simply dividing the book value by the number of shares outstanding in the company.

P/B provides a simplistic approach to see if a stock is undervalued (P/B <1), overvalued (P/B > 1), or fairly valued (P/B).

That said, a company’s stock trading below book value is not necessarily cheap.

Firstly, book value is affected by different accounting measures and might not be a true reflection of liquidation value.

Furthermore, a stock trading at a discount to book value may be “punished” by investors for poor performance of dim future prospects.

Additionally, the justified P/B calculation based on company fundamentals may also shed more light on why it could be trading above, below or at valuation.

As a general rule of thumb, if a firm’s return on equity (ROE) is greater (smaller) than cost of equity, justified P/B would be greater (smaller) than 1 (based on Gordon growth model).

P/B is preferred when looking at capital-intensive businesses (example: property developers) or finance businesses with plenty of assets and less suitable for services based companies with few tangible assets.

The bottom line: P/B provides a good starting point for investors to filter out stocks however, given the shortfalls, it should be combined with deeper examination of a company’s business and perhaps also in conjunction to other valuation metric.

Conclusion

In short, the above valuation ratios all works best when it is decked against the targeted company’s closest competitors, checked against its historical ranges for each valuation ratio, and also, comparability to that of the industry’s average valuation ratio the target company is in.

This is a co-written article of Shares Investment, which lays out the analytical ideas and thoughts of the authors, who are well versed in investments and market concepts.


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