Valuation Ratios

It is generally assumed that the market value of a share reflects both the past performance and the expected performance of a company. It indicates how the company is perceived by the market, even though the market often misprices stocks. The market price of a share reflects a company’s profitability, growth prospects, risk characteristics, corporate image and liquidity position. Hence valuation ratios are considered to be a comprehensive measure of a company’s performance. The following are some of the most commonly used valuation ratios.

Price to Earnings Ratio

 

The price to earnings ratio (PE ratio) is one of the most popular financial terms used in stock market discussions. It is also referred to as a company’s ‘multiple’ and is readily available in the financial section of newspapers. A PE ratio of 11x indicates that the market is willing to pay 11 times the earnings of the company. The ratio is calculated as:

 

Price to Earnings ratio = Market Price per share / Earnings per share

 

The market price used in the above calculation may be the price prevailing on a particular day or the average price over a period of time. Earning per share (EPS) is simply profit after taxes and after paying dividends divided by the number of outstanding shares. Generally, a high PE is an indication that the market believes that the company has very promising growth prospects. Companies in more mature industries often trade at lower multiples for example, utilities and banks.

 

One thing that must be kept in the mind is that the EPS used in the above formula can be trailing earnings or forecasted earnings. Trailing earnings refer to the company’s reported earnings, per share, over the last twelve months of operation. Forecasted earnings are based on analyst forecasts of what they expect the firm to earn in the coming twelve-month period, analysts are frequently wrong.

 

A PE ratio is generally compared with the PE ratios of other companies in the same industry as broad factors affecting the entire industry are similar. The PE ratio can also be used to determine whether a company’s stock is undervalued or overvalued by comparing it with the industry’s average PE ratio, and while this might be an indicator of an undervalued company it can also be an indicator of a company in financial trouble since investors refuse to buy the stock pushing its market price and its PE down. A company with a PE ratio of 11x will be considered as undervalued if the average industry PE is 15x. However, it is important to keep in mind the reasons that a company’s PE ratio is low, items such as ongoing lawsuits and large loans are sometimes perceived as crucial threats that a company is open to. Price to Earnings is not always enough to determine whether or not a company is undervalued, and can sometimes be a trap for value investors who see a low multiple as a deal every time. If an investor purchases a stock at a very low multiple compared to its industry peers, but the stock is in major financial trouble it is known as a value trap, since the investor gets lured in by the cheap price but neglects the other more serious financial problems of the company.

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