Common Valuation Ratios

The theory of buying low and selling high makes investing seem all too easy. For many, it is difficult to truly know when prices are cheap or expensive. In theory, the value of an investment is equal to the sum of its earnings or cash flows, which are discounted by some expected rate of return. From this general theory, many different short-hand methods have evolved to assist investors in making a quick determination as to a company's investment value using valuation ratios.

Before continuing, it is important to note some special considerations regarding ratios. In many instances, a low ratio is considered a sign of an undervalued security, while a high ratio is considered an overvalued security. However, one major problem is that ratios typically do not take into account the future expected growth of the company itself. It is the prospects for the company's future growth combined with these estimated valuations that help you reach reasonable conclusions.

Price/Earnings Ratio

The price/earnings ratio, commonly referred to as the P/E ratio, is a standard method for comparing stocks based on their relative expense. A company's P/E is calculated by dividing its current price per share by its earnings per share.

With the P/E ratio, investors can evaluate the difference between what they are paying for the stock and its earning power. A company with a P/E of 40 is trading at a level 40 times higher than its earnings, while a company with a P/E of 20 is trading at a level 20 times its earnings.

A high P/E ratio may signify that the company is overvalued, which means that eventually market forces will drive the price down. On the other hand, a high P/E could indicate great earning power and the possibility that profitability will increase over time, justifying the higher price.

A low P/E may indicate the potential for strong future performance. Companies with low P/Es may be undervalued, or trading at a price lower than the company's fundamentals merit. In that case, earnings may increase dramatically in future weeks and years. Or, a low P/E could just as easily denote a faltering company that would be an inadvisable investment.

The bottom line is that while P/E is a valuable tool, it doesn't provide all the information you need to make an informed decision.

Price/Earnings Growth (PEG) Ratio

One ratio that was developed to help counter the shortfalls of the traditional P/E ratio is the PEG Ratio. Growth in earnings is what helps determine whether a high or low P/E is justified. So, the formula for determining a PEG ratio is:

PEG Ratio = (price/earnings) / earnings growth rate

By taking into consideration growth of the company's earnings, we can see that a low PEG ratio means that the company is trading at a low price relative to its earnings growth potential. A high PEG ratio means that the company's stock is trading at a high price relative to its earnings growth potential.

As with any ratio, there are potential pitfalls. As an example, when you calculate a PEG ratio, should you use historical growth rates of earnings or estimated earnings? Historical growth rates do not always indicate a reasonable future growth rate for earnings and projected future earnings growth rates can be over or understated.

Even with the mentioned pitfalls, the PEG ratio has become a common tool used for a quick measure of valuation. While no exact value for the ratio is considered good or bad, many have determined general rules. In some theories, a ratio of 2 or higher is considered overvalued, with PEG ratios of around 1 or lower considered to signal an undervalued investment.

Price to Sales (P/S) Ratio

In some cases, a company that you are seeking to value does not have any current earnings. In other cases the company is very young or might be experiencing a cyclical low in their earnings cycle. Additionally, a variety of accounting rules can make a profitable company appear to have no earnings due to special write-offs specific to that industry. For all of the above-mentioned reasons, some prefer to use a ratio of current price to sales of the company. The ratio is calculated as:

P/S Ratio = (current price per share x shares outstanding) / revenue

As with most ratios, the lower the ratio the better the expected value of those companies' shares. However, much like the P/E ratio, it fails to account for future growth and therefore can give you misleading results if used alone.

Price to Cash Flow Ratio

A middle ground between the Price to Sales and P/E Ratio is the Price to Cash Flow Ratio. Price to cash flow takes into consideration the many accounting rules that can hide a company's earnings while also focusing on the company's ability to be profitable. The purpose of the Statement of Cash Flows produced by companies is to show the actual cash generated by the company by removing non-cash related expenses and determining the actual uses and sources of cash of the company being evaluated. One of the end results of those calculations is the company's reported cash flow from operations. The calculation for price to cash flow is:

Price to Cash Flow Ratio = current price / cash flow from operations per share

or

Price to Cash Flow Ratio = market capitalization / cash flow from operations

As mentioned before, a lower ratio is generally considered desirable if other factors lead you to believe the company has bright future prospects.

Additionally, some analysts will remove from cash flows from operations the capital expenditures of the company in order to calculate Free Cash Flow. Capital expenditures are the expenses considered to be the minimum amount of reinvestment needed to keep the company operational. Therefore, Free Cash Flow would be the funds that the company has in excess of what is necessary to run the firm. At this point, the firm could choose to reinvest those funds or pay them as a dividend to shareholders. It is calculated using the same methods as price to cash flows and is interpreted in the same fashion.

Price to Book Value (P/B Ratio)

One final ratio comes to us from the balance sheet. The balance sheet is designed to tell us the book value or equity of a company as of a specific reporting period. The equity value of the company represents the firm's worth in the case of liquidation. It is calculated by dividing the current price of the company by the reported book value per share. As with other ratios, a high ratio could indicate the firm is overvalued relative to the equity of the company. A low ratio could indicate the firm is undervalued relative to the equity of the company.

Unfortunately, because of the way accounting rules work, the assets reported on the balance sheet might be held at cost or some other value that would not accurately reflect what the firm could get for them today. Additionally, the balance sheet is not always able to accurately represent the true earning power of those assets. Therefore, the ratio itself might be misleading without some form of additional analysis and modifications to balance sheet accounts.

Applying Ratios

In discussing the actual ratios themselves we have reviewed the primary use, which is to measure the value based on a general perception. However, we can apply these ratios in a few other ways.

First, we can look back historically to see the general range that the market has applied to that particular company in the past. As an example, suppose a stock historically trades at a P/E ratio of between 10 - 15. By that standard, a P/E ratio below 10 would be considered low while a P/E above 15 might be considered high.

A second method is to compare ratios of peer companies or to the market in general. In this fashion, you can determine how expensive the stock is relative to the market or one of its competitors. However, the discussion would not be complete without one additional warning about ratio analysis. If the market or an industry sector itself is over or undervalued, then peer comparison by itself might lead you to incorrect conclusions.

Growth & Value

Growth stocks are companies that generally reinvest their earnings instead of paying out dividends. Because of their current placement within the typical business cycle, their goal is to produce higher than normal rates of return on reinvested earnings into the foreseeable future. As this growth translates into higher expected future earnings, the stock prices tend to rise to reflect the market's expectations. One of the common pitfalls of buying into growth stocks is buying into a company's stock where the expectations have gotten too high. When a company's stock is said to be 'priced for perfection', there is no room for the company to miss estimates, and the company runs the risk of the market revaluing the shares at a much lower price.

Value stocks are typically defined as companies trading at a low multiple to earnings potential or some other form of valuation. In many cases, they might be recent growth stories that have lost favor in the marketplace, obscure companies that have been overlooked by the general investing public or companies facing financial difficulty but that may still have a reasonable probability of recovering from the burdens of debt or difficult economic times.

A typical pitfall often encountered by value investors is called a 'value trap'. A value trap is identified as a business that shows great promise for the future and is trading at a reasonable price relative to some measure of valuation. However, the future expected growth fails to materialize or even deteriorates further, leading to a loss of principal on the investment.