Valuation Ratios

Keys to Valuation

  • A valuation ratio shows the relationship between the market value of a company or its equity and some fundamental financial metric (e.g., earnings).

  • The point of a valuation ratio is to show the price you are paying for some stream of earnings, revenue, or cash flow (or other financial metric).

Valuation Ratios, Metrics and Formulas

There are many ways to establish the value of a stock. A number of financial ratios and metrics can be used to find and compare the relative value of stocks.

Price-To Earnings Ratio

 

The price-to-earnings ratio is one of the most important investing metrics to know. It is a quick way to broadly gauge the sentiment around a stock.

The higher the price-to-earnings ratio, the more you must pay for $1 of a company’s earnings. All other things being equal, a high price-to-earnings ratio signals the market expects rapid growth from a company while a low price-to-earnings ratio signals expected low or negative growth.

At a price-to-earnings ratio of 20, you must pay $20 for every $1 of annual earnings from the company. The price-to-earnings ratio is calculated as share price divided by earnings.

 

Enterprise Value to EBITDA

 

There is significant evidence that the Enterprise Value to EBITDA ratio is one of the two best valuation metrics. It appears that using enterprise value in the denominator of value ratios improves results. This is likely because enterprise value takes into account total capital structure, including debt and cash. Enterprise value is calculated as follows:

Businesses with large amounts of cash on their balance sheet and no debt score better with enterprise value than they do with market capitalization.

EBITDA is perhaps the best measure of showing how much cash a business is generating irrespective of capital structure, taxation, and depreciation.

The downside to EBITDA is that it does not account for depreciation.. Using EBIT in place of EBITDA is preferable from a conceptual standpoint.

Enterprise Value to EBIT

 

For investors looking for a single valuation metric, Enterprise Value to EBIT is likely the best.

Enterprise Value to Free Cash Flow

 

Instead of using EBIT or EBITDA in the denominator, it uses free cash flow. Free cash flow comes from the statement of cash flows rather than from the income statement and is preferable when one believes a company may not be correctly stating earnings.

Price to Sales

 

The price to sales metric uses the very first item on the income statement – sales. The advantage the price to sales ratio has over others is that it works for virtually all businesses. Not all businesses are profitable, but nearly all have sales.

The price to sales ratio helps to compare businesses that may not be profitable currently, or that are experiencing a temporary decline in profit margins.

Price to Book Value

 

The price to book ratio compares the price of a stock to its book value. This ratio works well for businesses that rely on assets or equity to produce cash flows. It is not well suited for franchises, and does not work at all on businesses with negative equity. Here is the Price to Book Value ratio:

Price to Tangible Book Value

 

Tangible book value is book value minus intangible assets and goodwill. It looks only at ‘real’ assets. The price to tangible book value ratio can be used if you feel a company’s intangible assets are hiding the true value of assets. Here is the Price to Tangible Book Value ratio:

Forward Price to Earnings Ratio

 

The forward price to earnings ratio divides the current price by next year’s expected earnings. The ratio is useful when a business’s current year earnings are significantly understated or overstated by large one time events.

Price to Earnings to Growth Ratio (abbreviated PEG)

 

The PEG ratio was popularized by Peter Lynch. It is calculated as follows:

 

The PEG ratio takes into account growth rate when considering valuation. This is intuitive. A company growing at 10% a year should have a higher price-to-earnings ratio than a company growing at 2% a year. The PEG ratio takes this into account.

A PEG ratio value of 1 establishes a relationship or connection between the company's market value and its projected earnings growth. PEG ratios higher than 1 are generally considered unfavorable, as a stock may be overvalued and ratio of less than 1 indicates a stock might be undervalued.

Modified Price to Earnings to Growth Ratio

 

This ratio adds dividend payments to calculation of what price to value a stock. Dividends can be a large part of total returns. The formula for the modified PEG is below:

 

Shiller Price to Earnings Ratio

The cyclically adjusted price-to-earnings ratio, known as the Shiller P/E ratio is a valuation measure applied to the S&P 500  that uses real earnings per share, adjusted for inflation, over a 10-year period. The Shiller price to earnings ratio (also called PE10) uses average earnings over the last 10 years instead of trailing twelve months earnings in the denominator.

 

The ratio was popularized by Yale University professor Robert Shiller.

 
 
 
Discount to Net Current Asset Value

Net current asset value is calculated as current assets minus total liabilities.

Net current asset value or NCAV.

Benjamin Graham invested in a diversified portfolio trading at 67% or less of their NCAV.and generated returns of around 20% a year over several decades.

The idea behind NCAV is if a business is trading for less than the value of its current assets less all liabilities, it is very certainly undervalued. Benjamin Graham wanted a large margin of safety (hence the 67% of NCAV) on this type of investment.

In today’s market, there are very few NCAV stocks available. NCAV stocks become more common during deep bear markets.

Discounted Cash Flow

Discounted cash flow analysis is a method of finding the ‘fair value’ of a business. Discounted cash flow analysis is the correct way to value an investment if you have 100% perfect information on the future.

Discounted cash flow analysis discounts the sum of all future cash flows of a business back to present value using an appropriate discount rate.

Assuming you have misplaced your crystal ball and your psychic powers have stopped working, discounted cash flow analysis has serious flaws because it requires so many assumptions.

Discounted cash flow analysis makes several assumptions:

  • Discount rate

  • Growth rate

  • When earnings stream will start and stop

 

Because of this the fair value derived from discounted cash flow analysis. With that said, the metric does have utility in bringing to forth the assumptions you are making in your valuation, and how it effects the total value of a stocks.

Earnings Yield

The earnings yield is the inverse of the price-to-earnings ratio. It shows what percentage of money would be returned to you by a company at a current price if you owned the business and distributed 100% of net profit.

Magic Formula

 

Hedge Fund manager Joel Greenblatt popularized The magic formula in  his The Little Book That Beats the Market.

The Magic Formula ranks stocks on 2 metrics:

  • Rank based on EBIT/Enterprise Value

  • Rank based on EBIT/(net fixed assets + working capital)

 

The first ranking signal in the magic formula works very well. The second signal ads no value and actually decreases returns from the first signal as evidenced in the book Quantitative Value.

The idea behind the Magic Formula is to find:

  1. Undervalued businesses

  2. Businesses with strong competitive advantages

 

The EBIT/Enterprise Value metric works well to find undervalued businesses.

The other metric (which Greenblatt refers to as Return on Capital) does not work well in identifying businesses with strong and durable competitive advantages.

Any “magic formula” is an illusion.  There will never be a simple, foolproof, and low-risk way to beat the market.

It is also important to note that Greenblatt’s claims of 30% annual returns from the magic formula are disputed and cannot be independently verified by other historical studies.

Shareholder Yield

The shareholder yield is a ratio that shows how much money the company is sending back to shareholders in the form of cash dividends, net stock repurchases, and debt reduction.

 

Shareholder yield (in its most basic form) is calculated as:

Businesses with high shareholder yields show that the company is:

  1. Trading at a low price relative to cash returned to shareholders

  2. Has a shareholder friendly management that looks to reward shareholders with cash.

Fair Value

 

Fair Value looks to find the maximum acceptable price for a well-established business.  This is core to the idea of value investing made popular by Bejamin Granham. The Fair Value is calculated as:

 

The Fair Value finds the maximum fair value to pay for a business. As an example, if a company has $1 in earnings-per-share and $5 in book-value-per-share, the fair value would be $10.61. If the stock was trading for under $10.61 a share it would be a buy (but as an investor you might look for a margin of safety on top of this).
 

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