Last Updated on Jul 4, 2022 by Anjali Chourasiya
This article is written by Sonam Srivastava, the Founder and CEO of Wright Research. Sonam has more than 9 yrs of professional experience in systematic portfolio management and quantitative trading.
“The tech IPOs are overvalued!”, “Major large-cap stocks have their lowest valuations”, financial news is filled with these statements daily! With valuation ratios, we evaluate the right price to pay for a company’s income stream or revenues by comparing these ratios to comparable stocks. A particular value investing class relies on valuation ratios, and evaluating stocks based on these ratios is called relative valuation.
Value investing is the opposite of growth or momentum investing, where we invest in the company’s growth potential. A value investor looks at the price-to-value ratios to identify undervalued stocks. In contrast, a growth investor seeks to invest in stocks with growing earnings.
Table of Contents
Performing relative valuation
Several accounting nuances are needed to perform relative valuation:
- First, we need to identify comparable companies.
- We must standardise the valuation ratio across the universe, and make sure to not include outliers.
- We also have to make sure that we compare apple to apple by accounting for the market conditions and other explainable differences.
A value investor can look at tens of nuanced valuation ratios. But five important ones are essential to know. It is also vital to know the pros and cons and when to use these ratios.
Price-to-Earnings ratio
The price-to-earnings ratio is possibly the most popular valuation ratio where we compare the price of a stock to its earnings. The idea is that the price of any stock should be a multiple of earnings.
Benefit of the price-to-earnings ratio
- It is easy to calculate.
Shortcomings of price-to-earnings
- Companies can manipulate earnings.
- It does not account for the growth premium.
- It does not consider debt.
When to use?
- As a starting point for quickly comparing valuations.
- Suitable for stable companies with consistent earnings.
Price-to-book ratio
Price-to-book is the ratio of price to book value per share. The book value is a company’s net worth calculated as assets minus liabilities. Investors pay a premium over the book value as it is expected to generate earnings in the future.
Benefit of the price-to-book ratio
- Book value is relatively stable, so this ratio doesn’t vary much.
Shortcomings of price-to-book ratio
- Book value can differ for companies with different debt structures and accounting practices. In addition, other sectors might have a different model for net worth.
When to use the price-to-book ratio?
- Most suitable for valuing for banks where earnings can be volatile.
- It can be used for companies that have negative earnings.
Price-to-cash-flow ratio
The price-to-cash-flow uses cash instead of earnings. Cash flow is a good idea as they are less susceptible to manipulation and creative accounting than earnings.
Benefit of price-to-cash-flow
- Cash flow cannot be easily manipulated.
Shortcomings of price-to-cash-flow
- Cash flows are difficult to forecast.
- Cash flows can also differ based on sector or company structure.
When to use price-to-cash-flow?
- Useful for stocks that have cash flow but are not profitable.
Price-to-sales ratio
Price-to-sales is the stock price divided by sales per share. The price-to-sales valuation ratio is often used for companies that don’t have a positive net income. You will see a lot of IPO valuations using this ratio.
Pros of price-to-sales ratio
- Revenue is less susceptible to accounting manipulation compared to earnings.
- Revenue is (generally) more stable than earnings.
Shortcomings of price-to-sales ratio
- It doesn’t take profitability into account.
When to use the price-to-sales ratio?
- They are used for companies that don’t have earnings or are going through periods of negative earnings.
EV-to-EBITDA
EV-to-EBITDA is the ratio of the enterprise value of a company to its EBIDTA. EV is simply defined as equity value plus debt less cash, and EBITDA is earnings before interest, tax, depreciation and amortisation.
Pros of EV-to-EBITDA
- Incorporates the enterprise value from the balance sheet.
Shortcomings of EV-to-EBITDA
- It is challenging to compute.
When to use EV-to-EBITDA?
- Suitable for capital-intensive industries where balance sheets hide a lot of information – airlines, railroads, etc.
Bottom line
Valuation ratios are an essential tool for analysing stocks. A specific valuation ratio might be suitable for any particular use case. To make the most of valuation ratios, you must dig deep into your use case.
A company could be showing a better valuation. Still, the debt could be higher, or the margins could be lower than the comparable business. The most prominent valuation proponents use forensic accounting and valuation ratios to make the most of these numbers.
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