When you’re investing in stocks, in order to ensure that you buy and sell at a fair and reasonable price you need to have some basis of valuation, and also know how to apply that valuation to make a great investment decision.
Many traders, especially day traders, pay a deal of attention to technical analysis, examining charts and trading patterns and seeking to exploit those patterns to buy and sell shares for profit. Other traders, especially when trading or investing for a longer period than generally associated with day traders will use fundamental analysis.
Fundamental analysis examines balance sheets, earnings, assets, and other items associated with a business. The problem with this approach is how then to easily identify whether the shares represent good value or not. To do this, the fundamental numbers of a company can be expressed as ratios. These ratios can then be compared to historic ratio values, or the ratios of other similar companies to identify the value of a stock at any given time.
Here we look at a few of the most commonly used valuation ratios, and how you can use them to identify possible buy and sell opportunities.
Price to Earnings Ratio
The price to earnings ratio (P/E) tells an investor how many years it will take to return his investment were the company earnings maintained at a constant level, and were all those earnings to be paid to the shareholder.
For example, if a company earns 10 cents per share per year, and the stock price is $1.00, then it would take 10 years to return the shareholder his investment
The formula to calculate the P/E of a stock is as follows:
Share price/ annual net earnings per share = P/E
The P/E is not only easy to calculate, but it is an accurate way of valuing a stock, and can be easily compared to the P/E’s of other similar companies.
The downside of a P/E is that it is based on historic earnings, and that those earnings could be low for a specific and not-to-be-repeated event (for example, a bank taking bad debt provision, or san oil company paying compensation for environmental issues). If this were to happen, and the earnings be lower because of such a blip, then the P/E ratio would look high and possibly lead to consideration that the shares are overvalued.
So when you are considering a stock based on its P/E value, then it’s always wise to look at other bases of valuation, too.
Forward Price to Earnings Ratio
A derivative of the P/E ratio, the Forward P/E ratio is calculated using forecast earnings instead of historic earnings. In this case, the formula is:
Share Price/ Estimated Earnings Next Year = Forward P/E
Whilst being an easily calculated and forward looking valuation ratio, the Forward P/E does depend upon earnings estimates being up to date. Many investors consider the Forward P/E and the (historic) P/E together when looking at stock valuations.
Another derivative of the P/E is the Earnings Yield. This is the reciprocal of the P/E (1 divided by the P/E), and tells you what return your investment is making by way of company earnings. This is a great yield based ratio, particularly for stocks that pay no dividend.
Price to Earnings Growth
Different companies trade at different P/E ratios, even when those companies are very similar in their business perspective. To normalize differing P/E’s, another derivative of the P/E ratio is the Price to Earnings Growth (PEG).
The PEG is more dynamic than the P/E ratio, and it includes the estimated growth rate of earnings of a company: the lower the PEG, the better. The formula to calculate the PEG is:
P/E/ estimated earnings growth rate = PEG
Once more, the drawback of this ratio is that it relies on the accuracy of estimated numbers, in this case the rate of growth of earnings.
Price to Sales
This is a valuation ratio that seeks to put a number on the value of the business that a company generates, rather than the earnings it makes: the lower the ratio, the better. The formula for calculating the Price to Sales ratio (P/S) is:
Total Market Capitalization/ Total Sales = P/S
The P/S doesn’t take debt into account, nor company expenses. This fact limits the usefulness of the P/S. Companies that sell big ticket items, like cars or houses, may have a low P/S, but expenses will eat into the profitability of such companies. Hence, this is a ratio strictly for comparison of companies trading in the same business sector.
One of the most looked at valuation ratios, the dividend yield is the stock market equivalent of the interest rate on cash deposit accounts.
Quite simply, it is the rate of payback that a shareholder receives on his investment by way of the dividend that a company pays. The dividend yield is calculated as follows:
Annual Dividend/ Share Price = Dividend Yield
It is usual that dividends are paid by more mature companies, rather than less mature, higher growth companies. The dividend yield is very important for those investors that need income rather than growth (for example when investing for income in retirement).
Using Valuation Ratios
While valuation ratios are a quick and easy way to value stocks, there are some basic rules that you should follow.
Firstly, companies in different sectors of the economy are valued differently. For example, an internet based company would be generally considered to have a higher growth potential than, say, a food manufacturer. It would be normal to assume that the internet company will have a higher P/E ratio than the food manufacturer. So, when you are looking at relative valuations, always compare like-for-like and look at valuations of stocks that operate in the same economic sector.
Secondly, even though one valuation ratio indicates that a stock may be undervalued (or overvalued) at any given time, always look at other valuation ratios to back this up. One off abnormalities in results or earnings, for example, can temporarily skew valuation ratios.
Thirdly, always back up the valuation values with other research. The share of a large car manufacturer, for example, may trade on a low P/E ratio, and have a great Dividend Yield, but if it has a pile of debt repayable next year then the low share price might be valid.
When all other things are equal, valuation ratios are a good way to quickly compare the relative value of a stock against others, as well as to look at the relative value of a stock over time. If you then combine the use of such ratios with other research, and possibly technical analysis too, then you will have a real basis for your investment and trading decisions, and your trading profitability will improve.