If I offered to sell you my company for $5, would you buy it? Is it worth it? Even though it seems cheap at just $5, if I’m currently a loss-making business, you’re actually paying to lose money. Maybe not a great deal.
That’s why valuation ratios are so important in determining a company’s worth. 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). So if I pay $10 for a company that expects to earn $20 every year for the next 10 years, that’s empirically a pretty good deal. Side note: This is an insanely cheap company and likely has never existed - this would imply a P/E ratio of 0.5x (10/20) vs. the current S&P 500 index of ~18x.
Considerations like time value of money are important as well - a dollar today is worth more than one 10 years from now. So generally, investors look at valuation ratios based on estimates of future earnings (or cash flow or revenue or community adjusted magic).
There are zillions of valuation ratios out there. Weird ones that subtract all sorts of issues. There are also the broader commonplace ratios that help you speak the same language as other investors. I will first mention the five “must-know” ratios that will help you speak the native tongue, and then I’ll touch upon a few esoteric gems in a followup post.
A quick data note before we dive in. Valuation metrics are most useful when thinking about the future, and therefore, the ratios financial metrics we choose for valuation should be based on what the consensus expects in terms of earnings, cash flow, etc. While your view of earnings potential may differ, it’s good to know what the market expects so you can understand what is built into the price. If you don’t have access to a $50k Bloomberg terminal, you can find consensus estimates at Yahoo Finance, Zacks (for revenue and earnings at least), and Koyfin (revenue, earnings, and EBITDA).
The price-to-earnings ratio shows the relationship between the price per share and the earnings (also known as the net income or profit, essentially the revenue minus cost of sales, operating expenses, and taxes) per share. This is the amount a common stock investor pays for a single dollar of earnings.
The price-to-cash flow (P/CF) ratio measures how much cash a company is generating relative to its market value.
Price-to-cash-flow or P/CF is a good alternative to P/E as cash flows are less susceptible to manipulation than earnings. Cash flow does not incorporate non-cash expense items like depreciation or amortization (income statement metrics), which can be subject to various accounting rules.
A company with a share price of $20 and cash flow per share of $5 equates to a P/CF of $4 ($20/5). In other words, investors currently pay $4 for every future dollar of expected cash flow.
Price-to-Sales or P/S is the stock price divided by sales per share. While earnings and book value ratios are generally more appropriate for large companies with positive earnings, the price-to-sales valuation ratio is often used as a comparative price metric for companies that don’t have positive net income - often young companies or those in trouble. Revenue relies less heavily on accounting practices than earnings and book value measures.
EV-to-EBITDA is the ratio of enterprise value to earnings before interest, taxes, depreciation, and amortization. Enterprise value (EV) is market capitalization + preferred shares + minority interest + debt - total cash. Essentially, the ratio tells you how many multiples of EBITDA (generally considered to be an easy-to-obtain proxy for cash flow, although there is some debate on that) someone needs to pay to acquire the business (EV is essentially equity value plus its debt less cash).
Price-to-book or P/B is the ratio of price to book value per share. Book value is the value of an asset according to its balance sheet account - in other words, it is a company’s value if it liquidated its assets and paid back all its liabilities.
P/B is an indicator of market sentiment regarding the relationship between a company’s required rate of return and its actual rate of return. A ratio >1 means that the market thinks that future profitability will be greater than the required rate of return - assuming that book value reflects the fair values of the asset.
Valuation ratios can tell us so much about stocks, especially when you start comparing across companies, industries, and ratios. There isn’t necessarily one that can unlock the key. Take all of the puzzle pieces together though, and you can uncover some interesting business drivers.
For example, Lowe’s and Facebook trade at similar P/E multiples of 16x 2020 consensus earnings estimates. However, on a price-to-sales-basis, Lowe’s is quite a bit cheaper at 1.4x vs. Facebook’s 2.1x. What can we glean from this? What is the market saying? Essentially, the market is saying Facebook’s revenue is worth more than Lowe’s—that it has a higher operating margin. When we check the facts, we can see FB’s operating margin is around 40% while Lowe’s is closer to ~10%. If this weren’t the case, we could quickly see a misstep in the market’s judgment.
You can see how the math works in the following table. While Low Margin Company and High Margin Company have the same market cap and P/E ratio, the High Margin Company has a significantly higher operating margin (20% vs. Low Margin Company’s 10%).
So while there isn’t necessarily one “right” valuation ratio, taken together, with a little help from forensic valuation ratio analysis, we can learn a fair amount.
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