Financial news coverage can be a dizzying array of information, flying past before you can grab onto their significance. This is especially true with valuation ratios, since there are a large number of them with differences in applicability, calculation method, and interpretation.
What are valuation ratios? They are fractions calculated to express the true value of a company's stock and allow for comparison to other companies, especially in the same field. Generally, it's a price or worth divided by a separate set of data regarding the company's operation or finances. Many ratios measure perceived worth vs. financial soundness. Some common examples:
- Price-to-Earnings ratio (P/E) – The most common measure, defined as the common stock price per share divided by the post-tax earnings per share. When comparing, make sure P/E ratios are calculated in the same way – some P/E's are "forward,” based on earnings estimates, and there are multiple ways to calculate earnings per share.
A high P/E means prices are disproportionately high compared to earnings, suggesting the market thinks performance will improve. Is there any reason for this? If so, it may be worth the risk. Conversely, low P/E stocks have low expectations – and may be a great value, or just a sluggish stock. Your investing philosophy determines what you think of P/E ratios. In general, if you are looking for growth, can accept higher risk, and are confident in your analysis of the company's health, you prefer high P/E growth stocks. If you are looking more for undervalued stocks and lesser risk, you prefer low P/E stocks.
- Price/Earnings-to-Growth Ratio (PEG) – This expands on the P/E ratio, to help determine whether a stock with a high P/E is really overvalued or not. The PEG ratio is the P/E ratio divided by the estimated growth in earnings per share. The key word is "estimated.” PEG ratios are only as good as the source of the estimates.
- Price-to-Sales Ratio (P/S) – The P/S ratio is the common stock price per share divided by the net sales revenue per share. Some analysts prefer the P/S ratio, claiming it's harder for company accountants to manipulate. It's best in evaluating companies with operating losses (therefore no P/E ratio) and spotting promising recovering companies.
- Price-to-Book Ratio (P/B) – The book value (also known as shareholder's equity) equals a company's assets minus their liabilities. The P/B ratio is the common stock price per share divided by the book value per share. Similar to the P/E discussion above, you may look at a low P/B and see an undervalued company to buy, or an underperforming company to avoid. P/B ratios can have a blind spot in the proper assessment of intangibles such as goodwill or patents (think Microsoft).
The ratios discussed so far focus on stock price. It is also wise to check measures of liquidity, profitability, and debt. Some examples:
- Cash Ratio – Total cash and securities divided by liabilities, which tells you whether a company can handle short-term liabilities.
- Return on Equity – After-tax income divided by book value, which tells you how well a company did generating earnings through reinvestment.
- Debt-to-Equity Ratio – The long-term debt divided by the book value, which tells you how overextended a company may be.
None of these ratios are perfectly reliable ways to evaluate a company. They all have blind spots and assumptions, and are best used for relative comparisons of companies within the same sector. Different analysts can reach different conclusions with the same ratios. The point is not to buy blindly based on a ratio or multiple ratios – do your due diligence to find the reasoning behind the numbers.