Valuation: Ratio Valuation
Ratio valuation is much faster and much easier than DCF analysis, but it is generally not considered to be as accurate. The reason why it is not as accurate is that these ratios have a built-in emotional component that doesn’t exist in DCF. This emotional bias comes from the fact that these ratios use the stock market price.
Using ratio valuation gives you a relative value, meaning that it allows you to see whether a company is undervalued or overvalued in comparison to other companies. The problem is that if your comparison companies are also overvalued, then the relative valuation won’t be helpful because your benchmark for value will be too high. A stock that looks cheap relative to a stock that is overpriced could also be overpriced. Using ratio valuations in that situation would give you an inaccurate target price. In general, it is best to combine ratio valuation with other metrics for company performance.
You should already have an understanding of how each of these ratios is calculated and what they mean. This section describes how you can use them to evaluate your potential investments. The most commonly used valuation ratios are the Price/Earnings Ratio, the Price/Book Value Ratio, the Dividend Yield, the Price/Cash Flow Ratio, the Price to Sales Ratio, and the Price/Earnings to Growth Ratio.
i. Price/Earnings Ratio
The Price/Earnings Ratio (P/E) is the most commonly used valuation ratio. There are four basic ways to evaluate this ratio: compare against the same company’s past ratios, compare against ratios of companies in the same industry or sector, and compare against ratios for the market average as a whole.
In absolute terms, it’s hard to say whether a company is worth a P/E 10 or a P/E of 20. Below 10 is generally considered to be a low P/E, between 10 and 20 is moderate, and above 20 is considered high. The higher the P/E ratio, the faster the company is expected to grow.
Comparing a Company’s P/E ratio is very easy to do. If the ratio is lower than its historical average, the company’s average industry or sector P/E, or the average market P/E, then the company is considered to be cheap. The long-term U.S. average P/E is about 15.
Sometimes there is confusion about the difference between P/E and forward P/E. P/E is not the same as the Forward Price/Earnings Ratio. The Forward Price/Earnings Ratio is the P/E based on the company’s expected future earnings. You should never use the forecasted numbers because they are easily manipulated and they are wrong nearly 100% of the time.
ii. Price/Book Value
Price/Book Value (P/B) is another common valuation ratio. It is used in the same way as the P/E ratio, but not as extensively. The same basic comparisons apply the company’s historical P/B, the industry or sector’s P/B, and the market’s average P/B.
When the company’s current P/B is lower than any of those comparisons, it is considered to be “cheap,” but this can still be misleading because of what gets included in book value. For example, book value includes intangible items, such as goodwill, that are easy to manipulate. One way to overcome this problem is to only include tangible assets as part of book value. However the number is compared, it is not very useful without considering other valuation metrics.
On an absolute value, high P/B numbers do not have much significance without further investigation. The most significant key number for P/B is one, meaning that the current market price of the company is the same as the company’s asset value. If P/B drops below one, this means that the market believes the company will have negative returns and may be a buying opportunity.
iii. Dividend Yield
Dividend yield comparisons are only possible for companies that pay a dividend, and the relevant comparisons are usually between individual companies. Because investors looking at dividends are looking to get regular cash payments from their investments, dividend yields can also be compared to bond yields.
The basic rule for dividends is that the higher the dividend yield, the more attractive the investment. However, this is not always true. When looking at dividend yield, you will get the best result by combining this with the dividend payout ratio, which is the percentage of the company’s profits that are being used to pay dividends.
If the payout ratio is above 100%, the company’s dividends are unsustainable because more money is being sent out as dividends than what is being made as profits. Payout Ratios generally increase with the age and size of the company as the management has a more difficult time finding other uses for the company’s profits. Companies with slower growth will also tend to have higher payout ratios. These are all factors to consider when using dividend yield comparisons.
Dividend yield also relies on the stock price of the company. If the price of the company’s stock goes up significantly, its dividend yield will go down.
iv. Price/Cash Flow
The Price/Cash Flow (P/CF) is very similar to the P/E ratio and is used in the same ways. It can be compared against the company’s historical P/CF, its industry or sector P/CF, and the overall market P/CF.
Similar to the P/E ratio, a company is considered cheap if the P/CF is lower than its comparison.
Price/Sales Ratios (P/S) are also used in the same way as P/E and P/CF. The relevant comparisons are with the company’s historical P/S ratio, it’s industry or sector P/S, and the overall market P/S. Like the other metrics, the lower P/S is considered a cheaper buy.
The best times to use P/S valuation is when the company does not have any earnings (and therefore no P/E ratio), or during a recession, because a recession will often change profit numbers more than sales.
vi. Price/Earnings to Growth
The P/E to Growth Ratio (PEG) is the P/E ratio with an adjustment made for the growth of the company. It is calculated by dividing the P/E ratio by the (expected) Annual EPS Growth. It provides a way to numerically compare any company to any other company, even if they are in different industries.
The PEG ratio compares what the market believes the company’s future growth will be with what analysts have forecasted for future growth. Ideally, every stock with has a PEG ratio of 1, meaning that the market’s expectations are the same as the analysts.
Evaluating the PEG is simple: If the PEG ratio is above 1, then the stock is either overvalued or the market’s expectation is higher than analyst expectations. If the PEG ratio is below 1, then the stock is either undervalued or the market’s expectation is lower than analyst expectations.
The trouble with using the PEG ratio is that is assuming the analyst expectations are always rational, and that the market’s expectations will eventually converge with analyst expectations. While the PEG ratio can be a useful tool for comparing across industries, the human element of its calculation can make it an unreliable valuation tool.