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Valuation Ratios

Investors use valuation ratios to identify potentially undervalued stocks. You’ve probably heard of the more popular ratios such as price-to-earnings (P/E) or price-to-book (P/B).

Relative vs Absolute
A stock with one or more valuation ratios lower than the general market or stocks within the same sector is said to exhibit relative undervaluation. For example, a stock with an EV/EBITDA ratio of 10x vs the S&P 500 at 12x would be considered to be relatively undervalued. However, the same stock could have a higher P/B ratio than the market due to the nature of its business (e.g., a technology or consumer goods company), so it’s important to not only compare a stock’s valuation ratios against the market but against companies within the same industry.

A stock that has lower valuation ratios than the market or its peers cannot be said to be absolutely undervalued—a stock must be evaluated against its intrinsic value or fair market value to make this determination. To arrive at a stock’s intrinsic value, a discounted cash flow model (DCF) or alternative valuation model must be constructed. In a DCF model, estimated future cash flows are discounted back to the present. Such a model requires estimates about future growth, margins, capital expenditures, and other variables. A stock with a 21x P/E ratio growing at 10% per year could be undervalued whereas a stock with a 13x P/E ratio growing at only 1% per year could be overvalued.

Limitations
Investors using valuation ratios should be aware of the following limitations:

  • Income statement items like earnings or EBITDA can be easily manipulated by management.
  • Cyclical stocks typically record strong earnings near the peak of the economic cycle, resulting in low valuation ratios just as earnings are about to roll over as the economy enters into recession.
  • Looking strictly at valuation ratios ignores potential legal, environmental, pension, or other material liabilities that may not be captured in current earnings or on the balance sheet.
  • Valuation ratios using trailing financial data are based on past performance–future performance will be impacted by industry dynamics, competitive landscape, management execution, technological change, and numerous other factors.
  • In a bull market, all stocks could be overvalued. Stocks that look attractive when compared to the market or similar stocks may actually be expensive.

Using Valuation Ratios
Despite their limitations, numerous quantitative investment strategies, active fund managers, and smart beta ETFs utilize valuation ratios extensively. They’re an essential part of any investor’s toolkit.

Let’s look at some of the more popular valuation ratios:

Price-to-Earnings Ratio (P/E) | P/E = Price/Earnings per share (EPS)
Investors use the P/E ratio to look at the relationship between a company’s stock price and its earnings per share (EPS). EPS can be last fiscal year, trailing 12 months (TTM), or next year’s expected EPS. The higher the P/E, the more investors are willing to pay for the company’s stream of earnings, typically because growth expectations are high.

Price-to-Sales (P/S) | P/S = Price/Sales per share
The price-to-sales ratio (P/S) shows how much the market values every dollar of the company’s sales. Revenues are more stable than earnings so the P/S ratio can be used to get a more stable valuation picture.

Price-to-Book (P/B) | P/B = Price/Book value per share
The P/B ratio is most often used when looking at stocks within the financial sector such as banks and insurance companies. These types of businesses utilize their financial assets and liabilities to generate earnings. A financial stock with a high return on equity (earnings divided by the difference between assets and liabilities) will typically have a higher P/B ratio than its peers.

Price-to-Cash-Flow (P/CF) | P/CF = Price/Cash flow per share
At the end of the day, it’s all about cash flow. The price-to-cash flow ratio (P/CF) evaluates the price of a company’s stock relative to how much cash flow the company generates. Be careful: cash flow can refer to either cash flow from operations (CFO) or free cash flow (FCF). Free cash flow is net of capital expenditures so gives a much better picture of how much excess cash flow a company generates after necessary maintenance capital expenditures and investments for future growth.

Enterprise Multiple (EV/EBITDA) | EV/EBITDA = (Market Cap + Debt – Cash)/Earnings Before Interest, Taxes, Depreciation and Amortization
Unlike the ratios above, the EV/EBITDA ratio is unaffected by changing capital structures. The numerator incorporates net debt and the denominator (EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization) is a pre-interest earnings figure. Many investors believe the EV/EBITDA ratio offers a better comparison of companies with capital structures that differ.

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Valuation Ratios

Investors use valuation ratios to identify potentially undervalued stocks. You’ve probably heard of the more popular ratios such as price-to-earnings (P/E) or price-to-book (P/B).

Relative vs Absolute
A stock with one or more valuation ratios lower than the general market or stocks within the same sector is said to exhibit relative undervaluation. For example, a stock with an EV/EBITDA ratio of 10x vs the S&P 500 at 12x would be considered to be relatively undervalued. However, the same stock could have a higher P/B ratio than the market due to the nature of its business (e.g., a technology or consumer goods company), so it’s important to not only compare a stock’s valuation ratios against the market but against companies within the same industry.

A stock that has lower valuation ratios than the market or its peers cannot be said to be absolutely undervalued—a stock must be evaluated against its intrinsic value or fair market value to make this determination. To arrive at a stock’s intrinsic value, a discounted cash flow model (DCF) or alternative valuation model must be constructed. In a DCF model, estimated future cash flows are discounted back to the present. Such a model requires estimates about future growth, margins, capital expenditures, and other variables. A stock with a 21x P/E ratio growing at 10% per year could be undervalued whereas a stock with a 13x P/E ratio growing at only 1% per year could be overvalued.

Limitations
Investors using valuation ratios should be aware of the following limitations:

  • Income statement items like earnings or EBITDA can be easily manipulated by management.
  • Cyclical stocks typically record strong earnings near the peak of the economic cycle, resulting in low valuation ratios just as earnings are about to roll over as the economy enters into recession.
  • Looking strictly at valuation ratios ignores potential legal, environmental, pension, or other material liabilities that may not be captured in current earnings or on the balance sheet.
  • Valuation ratios using trailing financial data are based on past performance–future performance will be impacted by industry dynamics, competitive landscape, management execution, technological change, and numerous other factors.
  • In a bull market, all stocks could be overvalued. Stocks that look attractive when compared to the market or similar stocks may actually be expensive.

Using Valuation Ratios
Despite their limitations, numerous quantitative investment strategies, active fund managers, and smart beta ETFs utilize valuation ratios extensively. They’re an essential part of any investor’s toolkit.

Let’s look at some of the more popular valuation ratios:

Price-to-Earnings Ratio (P/E) | P/E = Price/Earnings per share (EPS)
Investors use the P/E ratio to look at the relationship between a company’s stock price and its earnings per share (EPS). EPS can be last fiscal year, trailing 12 months (TTM), or next year’s expected EPS. The higher the P/E, the more investors are willing to pay for the company’s stream of earnings, typically because growth expectations are high.

Price-to-Sales (P/S) | P/S = Price/Sales per share
The price-to-sales ratio (P/S) shows how much the market values every dollar of the company’s sales. Revenues are more stable than earnings so the P/S ratio can be used to get a more stable valuation picture.

Price-to-Book (P/B) | P/B = Price/Book value per share
The P/B ratio is most often used when looking at stocks within the financial sector such as banks and insurance companies. These types of businesses utilize their financial assets and liabilities to generate earnings. A financial stock with a high return on equity (earnings divided by the difference between assets and liabilities) will typically have a higher P/B ratio than its peers.

Price-to-Cash-Flow (P/CF) | P/CF = Price/Cash flow per share
At the end of the day, it’s all about cash flow. The price-to-cash flow ratio (P/CF) evaluates the price of a company’s stock relative to how much cash flow the company generates. Be careful: cash flow can refer to either cash flow from operations (CFO) or free cash flow (FCF). Free cash flow is net of capital expenditures so gives a much better picture of how much excess cash flow a company generates after necessary maintenance capital expenditures and investments for future growth.

Enterprise Multiple (EV/EBITDA) | EV/EBITDA = (Market Cap + Debt – Cash)/Earnings Before Interest, Taxes, Depreciation and Amortization
Unlike the ratios above, the EV/EBITDA ratio is unaffected by changing capital structures. The numerator incorporates net debt and the denominator (EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization) is a pre-interest earnings figure. Many investors believe the EV/EBITDA ratio offers a better comparison of companies with capital structures that differ.

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About tickrz
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