Valuation Ratios And Their Significance For Your Stock Investment
One financial process that an investor needs to be educated on is valuation. Learning about valuation ratios and how to calculate them is part and parcel of any stock investing strategy. A cheap stock may appear to be a good buy but is not necessarily a good investment.
Investors who are unfamiliar with ratios will purchase the stock because the price is cheap but a well-informed investor will dig deeper. Knowledgeable investors will not simply jump and purchase an individual stock without conducting a fundamental analysis.
Stock prices are always relative. From an investment angle, an individual stock is cheap only if the value you’re getting in return exceeds the price. That is why valuation ratios are important because you get to find out if a stock is cheap or expensive.
The 5 most important valuation ratios you need to know
Price per earnings (P/E) ratio
The P/E ratio is the most basic and the most viable valuation method used by stockbrokers and traders. Every investor needs to know the P/E ratio.
When converted into a formula, the P/E ratio should read:
P/E ratio = price of the stock per share/earnings per share
Obtaining earnings per share information is no longer a tall order. Almost all stock market platforms and every financial website contain this financial data. The P/E ratio is a proven tool when you need to valuate a company versus industry players or from a historical perspective.
In essence, the P/E ratio looks at the connection and relationship between a company’s stock price and its earnings. As an investor, you get a hint of what the market is prepared to pay for the company’s earnings. The ratio is computed by dividing the company’s current share price by its earnings per share.
For illustration purposes, let us assume Company A is currently trading at S$20.00 a share and its earnings over the last 12 months are S$1.25 per share, then the P/E ratio for the stock would be:
P/E Ratio = S$20.00/S$1.25 = 16.0
An increasing P/E ratio means the current investor sentiment is favourable and the company is worth more. Falling P/E ratios indicate investors’ interest in the company’s stock is waning.
Price to earnings growth (PEG) ratio
This valuation ratio is somewhat related to the P/E ratio but in a more dynamic way. The PEG ratio goes a step further. It incorporates the anticipated earnings growth of the company with its P/E ratio. The ratio is computed by dividing the P/E ratio by the earnings-per-share growth.
For example, if Company A’s P/E ratio is 16.0 and its earnings-per-share growth over the next three years is expected to be 10.5%, then its PEG ratio would be:
PEG Ratio = 16.0/10.8 = 1.48
The resulting figure is significant for investors. A PEG ratio of 1 or less is characteristic of a company that is undervalued. If the ratio is above 1, the company is overvalued. To get a richer depiction of its value, compare the PEG ratio of the company with the PEG of the broader industry or the particular sector where the company belongs.
This is the valuation method used when you want to know whether a stock that is growing quickly can still maintain a good value or not. However, be mindful about the growth rate, it might be based on an estimate.
Price to cash flow (P/CF) ratio
Among the valuation ratios that is deemed to be secure from any manipulation is the P/CF ratio. This method measures the company’s ability to provide cash flow on a per share basis.
The ratio is computed by dividing the company’s market capitalization by its recent operating cash flow, in the last 12 months. It can also be calculated by dividing the stock price per share by the operating cash flow per share. Some investors favor this over the other methods simply because relying on cash flows as the benchmark is often more reliable.
Price-to-book value (P/B) ratio
Valuing a company based on its book value works well for the conservative or traditional investor. The P/B ratio is calculated by picking the current price per share then dividing it by the book value (or shareholder’s equity) per share.
Simply put, difference between the assets and liabilities on the balance sheets is the book value of the company. Price-to-book value (P/B) is a measurement or estimation of the company’s value if it were to be sold or liquidated in the market.
As an example, if the share price of Company A is S$50 and its book value is S$55 per share, then the resulting P/B ratio would be 0.9. A ratio greater than 1 generally infers that the market is willing to pay more than the equity per share. Inversely, the market is willing to pay less of the P/B ratio is below 1.
Not all companies pay dividends although learning about a dividend yield can aid an investor in valuing a company. The dividend yield of a stock can be computed by dividing the annual dividend amount per share by the stock price per share. Dividend paying stocks are usually more established and more likely to be a value stock, in contrast to growth stocks which often yield almost zero or nothing.
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Use the valuation ratios to simplify your evaluation
Computing for valuation ratio is useful and expedient when comparing stock prices or analysing their price movements. The key is identifying which ratio is applicable and when to use it. Understanding these valuation ratios will empower you to make sound investment decisions.
These ratios are basically taken from the financial statements and therefore are good indicators of a company’s potential as an investment. Once you’ve learned the significance and meanings of these ratios, scouting for investments won’t be as difficult. In fact, you’d be adequately equipped to tell between a good investment and a risky one. Valuation ratios help simply the evaluation process.
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