Valuation metrics and models can be invaluable when assessing stocks to invest in. These ratios are by no means failproof, but they can give you an idea of whether a stock is trading at premium or discount to its fair value based on profitability, growth, and its balance sheet.
In this article we breakdown different valuation metrics and highlight their strength and weaknesses. We also discuss the types of analysis that can be used to compliment valuation analysis.
- What are stock valuation metrics?
- Why use valuation metrics when making investment decisions
- 10 Common and popular valuation metrics
- Other valuation ratios and metrics
- Pros and cons of stock valuation metrics
What are stock valuation metrics?
An approximation of the fair value of a company can be determined in a number of ways. Ultimately the value of a company is always an opinion, and there is no single value that can be assigned to any investment.
Valuation metrics are ratios and models that can give investors an idea of what a company may be worth. Some are based solely on the company’s financial statements, while others compare the market price to per share statistics for the company. Typically, two or three ratios should be used to get an idea of how a company stacks up against its peers, and whether it is trading above or below its fair value.
Why use valuation metrics when making investment decisions
Valuation models and ratios may not be failproof, but they give you an idea of what will be required for a stock to give you a return. If a stock is very expensive, it will have to generate two or three years of strong earnings growth for the market price to appreciate further. If a stock is trading at a discount to fair value, there is probably a reason. It’s important to know why a stock is trading at a discount and what will be required for the price to appreciate.
Valuation ratios are invaluable for any type of stock picking or active investment strategies. In this case they can be used to compare stocks and select those with the best chance of generating a return. Having an idea of the relative value of stocks also allow you to take advantage of market volatility and corrections.
10 Common and popular valuation ratios and metrics
Broadly speaking there are two types of valuation metrics; relative value ratios and absolute value models. Relative valuation ratios allow investors to compare stocks to their sector or to the overall market. These ratios can again be split into two categories; the first compare the price or enterprise value to items from the income statement, while the second type compare a stock price to balance sheet items.
- Price to Earnings Ratio (PE ratio)
- PEG ratio
- Price to Sales
- Price to Free Cash Flow
- Equity, NAV, and Book Value per share
- Price to Book
- Dividend Discount Model
- Discounted Cash Flow
- Sum of the Parts
Price to Earnings Ratio (PE ratio)
The PE ratio, also knowns as a price multiple, simply compares the stock price to the company’s earnings per share. A stock’s PE ratio indicates the number of years of current earnings the company needs to earn to recoup the amount paid for the stock. A stock with a price of $30 and annual earnings of $2 is trading on a historical PE of 15 (30/2). If earnings for the next 12 months are forecast to be $3, then the forward PE is 10 (30/3).
PE ratios can be used to compare a stock’s market value to similar companies, or to the company’s own historical valuation. However, a PE ratio should not be used in isolation. There are reasons for a stock to trade on higher or lower PE depending on future prospects.
The PEG ratio, or Price Earnings to Growth ratio takes a company’s earnings and earnings growth into account. If two stocks are trading on a price to earnings ratio of 15, but one company is growing earnings at 10% while the other has an earnings growth rate of 20%, the second share should generate better returns. Their respective PEG ratios would be 15/10 or 1.5, and 15/20 or 0.75.
The lower the PEG ratio is, the cheaper a stock based on earnings and earnings growth. Over time a stock’s PEG ratio should tend toward 1, though rapidly growing companies often have PEG ratios as high as 5. A ratio below 1 suggests a discount, though companies with a ratio below 0.5 are usually in distress.
EV to EBITDA stands for Enterprise value to Earnings before interest, taxation, depreciation, and amortisation. This is a more sophisticated version of the PE ratio, and is calculated at the company level rather than at the “per share” level. Enterprise value is an alternative way to consider the market valuation of a company. It is calculated by adding the market value of the company to the company’s total debt, and then subtracting cash. EV gives one an indication of what it would cost to acquire the company and pay of all of its debt.
EBITDA give a better indication of the company’s operational profits by excluding interest, tax, amortization, and depreciation which often include one off items. EV/EBITDA gives investors a more precise indication of the value of the company as a multiple of the profits it can generate. This is one of the more common valuation metrics used by stock picking and active investing professionals.
Price to Sales
Dividing a company’s market value by its annual revenue is a quick and easy way to compare stocks within an industry. PE ratios are meaningless when a company is not profitable, in which case the P/S ratios can be used.
Different industries have very different profit margins, so prices to sales ratios vary considerably from one industry to the next. Retail stores typically have P/S ratios of less than one, while fast growing technology companies can have P/S ratios of between 10 and 30. Price to sales ratios are very limited when it comes to comparing companies from different industries. They also give very little indication of the actual value of a company.
Price to Free Cash Flow
In cases where complex accounting means company earnings are not a good reflection of profitability, cash flow can be used. Free cash flow is calculated by adding the investing, financing, and operating cash flow of a company. Dividing the market capitalization of a company by its free cash flow results in the price to free cash flow ratio. This will usually be a lot higher than P/E or P/S ratios but can still be used to compare companies within a sector.
Absolute valuation models use the company financials to arrive at a value that is independent of the stock market’s price for the stock. The calculated value can then be compared to the stock price to see if it is trading at a discount or premium to fair value.
Equity, NAV, and Book Value per share
Based on the balance sheet alone, the value of a company’s equity is equal to its assets minus its liabilities. This is theoretically what would be left for shareholders if the company was liquidated and its debt repaid. This type of valuation metric ignores the value of future earnings.
Dividing the equity by the number of outstanding shares give you the intrinsic value per share. The book value per share is calculated in the same way except that the intangible assets are excluded, unless they have a market value. The calculation of net asset value (NAV) differs from industry to industry but can be used to compare similar companies.
Price to Book
By dividing the stock price by the book value per share, a stock’s premium to its assets can be calculated. This is a relative valuation ratio that incorporates both the market value and book value of a share. A price to book ratio of less than 1 implies a stock is trading below its intrinsic value and may offer a margin of safety to investors.
Stocks are most likely to fall below their book value during a stock market crash, which is where value investors hope to buy them. Allocating capital to stocks with very low price to book ratios is a commonly used method of reducing portfolio risk, as downside should be limited. Factor investing strategies also make extensive use of this ratio.
Dividend Discount Model
The dividend discount model can be used to value a stock based on expected future dividends. The model assumes an annual growth rate for future dividends, as well as a terminal value. The stock’s fair value in then equal to the sum of the present value of all future dividends.
The DDM is useful for comparing dividend paying stocks. However, it has become less popular since growth investing has dominated markets. It also has limited value in today’s low interest environment.
Discounted Cash Flow
The discounted cash flow (DCF) model uses the present value of forecast future earnings to value a company. This model would be the most accurate way to value a company if future cash flows were known with certainty – which they are not. However, it does provide a best guess value when there is little else to work with.
The DCF model is often used for venture capital and private equity investments where companies have no market value. It is the most time-consuming method and requires substantial accounting and industry knowledge.
Sum of the Parts
The last valuation metric is useful for businesses that can be broken into distinct parts. It is commonly used for holding companies, investment trusts and conglomerates.
A sum of the parts (SOTP) valuation simply adds up the values of each individual holding. This is a useful approach to valuing holding companies that own both listed and unlisted investments, or companies in different industries. The most appropriate valuation metrics can be used for each investment.
Other valuation ratios and metrics:
There are a few other valuation metrics that are useful in certain instances:
- Dividend yield does not really give an indication of the value of a company but can be used to compare dividend paying stocks. It can also be used to compare a stock’s yield to other investments like real estate or bonds that pay a yield.
- Similarly, ROE and ROI can be used to compare the expected return of almost any investments to the expected return of the portfolio you already own.
- Embedded values are used to compare life insurance companies. The embedded value is calculated by adding the present value of future profits to the net value of the firm’s assets.
- Enterprise values (EVs) are sometimes used with sales or earnings before interest and tax. EV/S and EV/EBIT are simply variations on P/S and P/E ratios.
Pros and cons of stock valuation metrics
Valuation ratios and models are very useful when selecting investments. They can be used to compare a stock’s valuation to similar stocks, and to compare a stock’s price to its fair value. These ratios can also easily be incorporated along with other factors in quantitative investing models. However, there are limitations to each metric, as well as to relying on valuation analysis in general:
Valuation ratios are based on historical data, or occasionally on analysts’ forecasts. They are therefore either backward looking or based on estimates. Stock prices are determined by supply and demand, which in turn is based on expectations for the future and on sentiment.
Absolute valuation models are based on several assumptions. Both DCF and DDM models use forecasts for revenue growth, margins, and interest rates at a minimum. The model’s accuracy therefore depends on three separate forecasts, none of which are likely to be very accurate. Valuation is just one of the factors that drive stock prices over the long term. Earnings surprises, momentum, sentiment, and economic growth also need to be considered.
Behavioural finance shows us that investor decisions are frequently influenced by a number of biases. Bull markets are driven by greed and the fear of missing out, while bear markets are driven by fear. Stock prices can therefore differ substantially from their inherent value. Equities often trade at inflated values for years at a time, which make valuation analysis all but obsolete.
As we pointed out in the article on investing myths, buying stocks with a low PE ratio is not necessarily the best strategy. Over the last two decades, growth investing has outperformed investing strategies based on valuation. Growth investing often requires you to pay more than you think a company will be worth for some time.
Companies are increasingly coming under scrutiny regarding their impact on the environment, the communities in which they operate and their corporate governance. This has prompted the emergence of ESG investing which considers these factors. Traditional valuation metrics do not include ESG factors.
ETF investing and other passive investing are often able to outperform value strategies, because they have a built in momentum element. As the weighting of stocks with higher momentum increase, those stocks contribute more to the overall return of the fund. The result is that simple market cap weighted ETFs often outperform value strategies.
For many hedge funds, valuations are just one of a large number of factors that are considered. In fact, funds with short term trading strategies sometimes ignore value completely. Over the short to medium term, market sentiment is generally a more useful tool when it comes to assessing stocks. Catana Capital, for example, uses market sentiment calculated using big data and artificial intelligence as the primary tools for the Data Intelligence Fund.
Despite the shortcomings of valuation metrics, they can still play an important role for investors. Considering a handful of valuation metrics will give you an idea of the type of investment situation you are buying into. This will help you understand what will be required for the stock to generate a return.
Valuation ratios can also help you choose between a number of stocks. Valuation analysis should not be considered a substitute for other forms of analysis. And, while valuation can be used to reduce portfolio risk, it should not be considered a substitute for portfolio hedging or diversification through asset allocation.