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Researching investments can be tricky. There are a seemingly endless number of terms and figures being thrown around. Some of these might be familiar to you and some are probably not. Worse yet, some of the values are based on estimations and are only as good as the people providing the estimate. It’s important to know which values use estimated figures.
Understanding what these investment valuation ratios really represent will give you much more insight into the value of a company as an investment. The ratios are not difficult to understand, nor is it particularly difficult to interpret them.
Consider how you can use these 6 important investment valuation ratios:
1. Price/Earnings Ratio (P/E Ratio): This is certainly the most well-known of the valuation indicators. It’s commonly referred to as the P/E ratio. The ratio is very simple. It’s merely the stock price per share divided by the earnings per share. This ratio is a reasonable method of comparing stocks based on their relative expense.
? The earnings per share value is often estimated into the future. This is where things can become misleading. During bear markets, the estimations tend to be low. During bull markets, estimations are high.
? The historical record of financial professional’s accuracy in predicting anything has always been less than impressive.
? Price/Earnings Ratio = Stock Price per Share/ Earnings per Share
? Different industries lean toward different P/E ratios. But P/E ratios within industries can be compared. A company with a P/E ratio of 25 is trading at 25 times earnings.
? Stocks with higher P/E ratios are expected by investors to have more earnings growth moving forward than the overall market. These same companies may just be overpriced, however, so it’s important to research other factors about the company too.
? Those with low ratios are expected to grow at a slower rate than the market. Lower P/E companies may be undervalued! Many investors scour the low P/E companies looking for deals.
? Remember the value of this ratio is dependent on the accuracy of the component numbers. If the estimations are poor, it’s easy to make a poor investment decision.
2. Price/Earnings to Growth Ratio (PEG Ratio): This ratio is a refined version of the P/E ratio that also considers the stock’s estimated growth of earnings. It’s a common tool to make a quick evaluation.
? By comparing the P/E ratio and the PEG ratio, you can have some insight about the degree of overpricing or underpricing of a stock.
? If the PEG is 1, it’s generally considered to be priced accurately with regards to the estimated earnings per share growth expectations. A PEG of less than 1 is considered to be undervalued. A PEG greater than 2 typically means the company is likely overpriced.
? PEG Ratio = (Price/Earnings Ratio)/ Earnings Growth Rate
? The P/E ratio is the most widely used metric, but it’s lacking in one important way. Investors are willing to purchase high P/E stocks due to the high, expected growth prospects. The PEG ratio considers the validity of that growth expectation.
? Remember that the Earnings per Share Growth estimates are still exactly that: just estimates. The PEG ratio simply tells how well the P/E ratio is tracking with the earnings estimates of the analysts.
3. Price/Sales Ratio (P/S Ratio): If the company doesn’t have any current earnings, this ratio can be used. The lack of current earnings information can be due to the young age of the company. This is another valuation indicator that’s closely related to the P/E ratio. The Price/ Sale (P/S) ratio uses the price of the stock vs. its sales figures, rather than earnings.
? Profitable companies may also appear to have no earnings due to accounting write-offs.
? The P/S ratio is an indication of what investors are willing to pay for each dollar of a company’s sales. Many investors consider sales figures to be a more reliable metric than earnings. Earnings are subject to the manipulations of management and accounting estimates.
? Price/Sales Ratio = Stock Price per Share x Outstanding Shares/ Revenue
? No metric ought to be the sole basis for any decision. However, any investor needs to take the P/S ratio seriously.
4. Price/Cash Flow Ratio (P/CF Ratio): This metric is used to determine the value of a company based on its stock price and the amount of cash flow the company generates per share. It can be considered a ratio that falls between the P/E and the P/S ratios. ? Cash flow numbers aren’t as easily manipulated. But earnings can be manipulated and are also affected by depreciation.
? Price/Cash Flow Ratio = Stock Price per Share/Operating Cash Flow per Share
? Many investors and financial professionals choose to focus on cash flow instead of earnings. Likewise, many people prefer the P/CF ratio over the P/E ratio.
5. Price/Book Value Ratio (P/BV Ratio): This provides a comparison of a stock’s price to its book value (shareholders’ equity). It is essentially the liquidation value of the firm.
? The book value is the value of the company’s assets. This can be found on the balance sheet. To determine the book value, the liabilities on the balance sheet are subtracted from the assets. The remainder is the book value.
? Price/Book Value Ratio = Stock Price per Share/ Book Value per Share
? It’s worth noting that companies value assets in different ways. Some use the actual cost or some other value that has little to do with the actual value on the open market.
? When a company’s stock price is lower than its book value, there are two possible scenarios. Either investors, for an illegitimate reason, undervalue the stock and the stock is a good buy, or the under-valuation is correct and the stock is likely to be a poor investment choice in the foreseeable future.
? This metric is used most heavily in finance-related businesses, such as banks. Companies with a lot of intellectual property are difficult to assess in a meaningful way with the Price/Book Value Ratio.
6. Dividend Yield (DY): This value is a percentage. It’s the company’s annual dividend paid to investors divided by the stock price at the time the dividend is paid. This value can normally be found as part of a company’s stock quote.
? Dividend Yield = Annual Dividend per Share/ Stock Price per Share
? Dividend yields are attractive to income investors. Growth companies normally refrain from paying dividends, since they would prefer to pour the profits back into the company.
? The most common dividend-paying companies are utilities, which often have limited growth potential. Mature banking companies are another good example.
? If you’re into growth stocks, the dividend is unlikely to matter to you. If you prefer income producing investments, like most bonds, the dividend yield ought to be on your radar.
Investment valuation ratios are another set of numbers that provide investors with an additional method of determining the attractiveness of a company as an investment. Some ratios are more applicable to certain industries.
A great idea would be to look at your past investments and check out all of these ratios for those companies. Consider which companies were great investments, and then look at the duds. Do you see any trends that differentiate the good and the poor investments? Take the time to learn from your successes and mistakes. That’s what successful investors do.
These ratios are an invaluable resource for investors. However, other factors also need to be considered when deciding whether or not to invest in a company. If you add these ratios to your investment research arsenal, you’ll likely be rewarded handsomely.
Leroy Ross