Valuation Ratios for Investment Analysis - dummies

Valuation Ratios for Investment Analysis

By Peter J. Sander, Janet Haley

With valuation ratios, a company’s stock price enters your investment analysis. Valuation ratios include the ever-popular price to earnings (P/E) ratio, along with price to sales (P/S), price to book (P/B), and a couple of boutique P/E variations.

Price to earnings

Price to earnings (P/E) is just what it sounds like: the ratio of a price at a point in time to net earnings in a period, usually the trailing 12 months (TTM). Here’s the formula:

Price to earnings (P/E) = stock price / net earnings per share

A high P/E, say 20 or higher, indicates a relatively high valuation; a low P/E, say 15 or less, indicates a relatively low or more conservative one.

Earnings to price

Earnings to price, a deriviative of P/E, is simply the reciprocal of P/E, or 1 divided by the P/E. Why is this important? Earnings to price is the functional equivalent of a stock’s yield, comparable to an interest rate on a fixed income investment. Because we’re talking earnings and not dividends, this yield doesn’t usually come your way in the form of a check, but it’s useful just the same to determine how much return your dollar paid for a share is generating. Many people call this figure earnings yield.

Price/earnings to growth

When comparing businesses, one popular way to “normalize” P/Es is to compare them to their respective company’s growth rate. From this comparison, get to know another derivative of P/E, price/earnings to growth, or PEG:

Price/earnings to growth (PEG) = (P/E) / earnings growth rate

The lower the PEG, the better. But if the low PEG is driven by high growth rates, you’d better be confident in the growth rate assumption.

Price to sales

Per dollar of shareholder value, how much business does this company generate? Price to sales (P/S) is a straightforward way to answer this question. Here’s the formula:

Price to sales (P/S) = stock price (total market cap) / total sales (revenues)

P/S is a common-sense ratio: The lower the better, although there’s no specific rule or normalizing factor like growth. Somewhere around 1.0 is usually considered good.

Don’t read too much into the raw P/S number, especially when comparing companies in different industries. A company selling big-ticket items may have a very low P/S ratio. Ford Motor is an example, at 0.11. But low margins and high expenses reduce the profitability of those sales; Cisco, on the other hand, has much higher margins.

Price to book

The price to book (P/B) ratio is getting varying amounts of attention from investors in different sectors:

Price to book (P/B) = stock price (total market cap) / book value

Book value consists of the accounting value of assets less (real) liabilities — sort of an accounting net worth or owner’s equity of a corporation. This figure has greater meaning in financial services industries, where most assets are actual dollars, not factories, inventories, and other hard-to-value items.