An Easy Guide to Investment Valuation Ratios
Financial news coverage can be a dizzying array of information, which flies past before you can even grasp the significance. The world of finance is filled with complicated-sounding ratios and grandeur terms, which leaves you awestruck and puzzled at the same time. Investment valuation ratios are no exception (there are plenty of them) as each has a distinct calculation method, applicability, and interpretation.
In the following article, I'll explain the definition of investment valuation ratios and their significance. We will cover each valuation ratio along with their calculations; thus, you can gain essential insight into the company you want to invest in.
What is investment valuation?
Valuation is a quantitative process that determines the fair value of an asset or a firm. A company can be evaluated on an absolute basis on its own or a relative basis by comparing it to competitors. There are several methods and techniques to arrive at a valuation value and the most commonly used among them are ratios.
Investment valuation ratios highlight the relationship of a company or its equity's market value with some fundamental financial metrics, such as earnings. Valuation ratios show the price you pay for some financial metrics such as earning streams, cash flow, and revenues.
Why do you need investment valuation ratios?
Imagine buying a company at a cheap price; it seems to be a profitable deal for you. But, if the company is loss-making, all your investments will go at a loss. This is where investment valuation ratios are used to determine the worth of any company. Valuation ratios are the most commonly quoted and easily interpreted ratios that analyze the attractiveness of an investment in a company. These ratios provide an understanding of a company's value to investors as it integrates the company's publicly traded stock price with the company's financial information. Also, keep in mind that the attractiveness of a company is inversely proportional to the ratio levels.
Principle investment valuation ratios
Now we know that valuation is a financial process that determines a company's worth, and that investment valuation ratios provide that insight into the context of the company's financial share price, thus serving as a tool for evaluating investment potential. I hear you asking, “what are the ratios and how do you calculate them?”. Here are the central investment valuation ratios you need to understand before making your investments. As always with financial ratios, do not look at them in isolation. Compare ratio calculations with industry averages and other firms in the industry.
Price to Earnings ratio
Price to Earnings (P/E) ratio, also known as price multiple or earnings multiple, is a valuing ratio that measures the firm's current share price relative to its per-share earnings. It is employed by investors to determine the value of a firm's share with an apple to apple comparison. If the P/E ratio is large, it indicates that investors expect earnings to increase in the future hence the company's stock is overvalued. On the contrary, a low P/E ratio indicates that the current earnings are high compared with the current share price therefore the stock could be considered as undervalued. It is worth noting that a company without earnings or making a loss doesn't have a P/E ratio, as there is nothing for the denominator.
P/E ratio = market value per share/ earnings per share
Price/earnings to growth ratio
PEG ratio is derived by dividing a stock's price to earnings ratio to the growth rate of its earnings for a specific period. Thus PEG enhances the P/E ratio by adding the expected growth earnings factor into the calculations. Like P/E ratio PEG is also used to determine the actual stock's value. A lower PEG indicates that the company is undervalued. Keep in mind that one reported source's PEG value can be highly differentiated from others as it depends on the growth estimate employed in calculation.
PEG ratio = (price/ earnings per share) / earnings per share growth
Price to sales ratio
Price to sales ratio, also known as a sales multiple or revenue multiple, is a valuation ratio that compares a company's stock value to its revenues. It is an analysis and valuation tool that shows how much a person can willingly spend per dollar sale of a company's stock. The ratio is either derived by dividing a company's market capitalization to the total sales within a specific time or by dividing stock price to the sales per share on a per-share basis. A lower ratio implies that stocks are undervalued and vice versa. One drawback of this ratio is that it doesn’t give any indication of whether the company is actually making earnings.
Price to sales ratio= market value per share/ sales per share
Price to Sales Ratio = Market Capitalization / Sales
Price to book value ratio
This ratio compares the company's stock price or market value to the book value per share. In contrast, book value is the net asset value of any company in the intangible assets and liabilities. The ratio shows the amount that shareholders are paying for the net assets of any company. Remember that market value is generally higher than the book value. A p/b ratio of 1 is considered as a stable ratio.
P/B Ratio = Market price per share/ Book value per share.
Book value per share = (Total Common Shareholders Equity - Preferred Stock) / # Common Shares
Investment valuation ratios are important for investors because they can accurately estimate a company's worth. All of them are like pieces of puzzles, and you can have a holistic understanding by deriving them. In short, valuation ratios are of great importance for stock evaluations, especially for comparing across rates, companies, and industries.