Three ratios for valuing shares

Three ratios for valuing shares

Analysts and traders alike commonly use ratios to analyse stocks and ascertain the potential value of their shares. While no method is fool-proof, each ratio has a specific function which makes them almost co-dependent on one-another, should one wish to gain a more complete insight into a stock.

What must be remembered is that when comparing the ratios of different stocks, one should only compare stocks and shares of the same sector, as some sectors have more rapid growth than others – for instance banks versus pharmaceutical.

Price-Earnings Ratio

Firstly, the P/E ratio – or earnings multiple – is a method widely employed by analysts and financial commentators. Not only is this ratio among the most commonly used, but it has a direct utility in that it measures the proportion of earnings return an investor will see on the price paid. This is done by comparing a firm’s share price to its earnings per share (EPS) or market capitalisation to its net profit, with the ratio being determined by how many pounds of investment into a firm would be required to yield a pound of its earnings. Therefore:

Share Price/EPS = P/E Ratio

To calculate the EPS, one must add together the earnings from the last four quarters to get a full years earnings, then divide this by the number of shares. For instance; £16 billion/4 billion shares = an EPS of £4.

This is called a trailing or historical EPS, which can be used for a trailing P/E ratio. The same can be done for the coming four quarters based on analyst estimates, which would generate a forward or forecast P/E ratio.

Then, is one knows the share price – for example £80 per share – and the EPS – £4 -, they calculate the P/E ratio:

£80/£4 = 20

With a P/E of 20, an investor would have to spend £20 to see a £1 return.

P/E ratios are useful as they quickly inform an individual what proportion of their investment they will yield in annual earnings.

However, they are limited by two factors. Firstly, they conflate data which would tell us whether a business is doing well or just in a sector that  grows in a particular way. For instance, a very low P/E could either be a cheaply valued share, or a firm facing a number of challenges causing negative expectations of future earnings.

A share with a high P/E could be one that is seen as very expensive or in a high growth phase where earnings are expected to grow considerably, such as bio-tech.

This may raise questions about how to interpret P/E Ratio but a way of counter-acting this would be to compare recent P/E ratios with past financial results for the same firm and other firms in the same sector as well as comparison of the sector P/E to give any one firm’s PE Ratio context.

A more serious limitation is the fact that P/E ratios do not account for debts or other outgoing costs in their analysis. For instance, some companies such as Netflix have very high P/E ratios because of low profits, however this is because of their large-scale investment on movie rights and new content, and does not mean they are stock that is not worth buying.

Price-to-Sales Ratio

The P/S ratio is not as widely used as the P/E ratio, because it offers less direct access to the earnings and potential dividends one can expect from their investment. However, while it doesn’t inform one of the short-term earnings they can expect from an investment in a stock, its use of Sales Per Share – SPS – instead of EPS, allows one to more accurately assess the value of a share based on top line revenue. This is useful as the P/S ratio relies on raw sales data, not profits, thus is a more accurate way of measuring the ability of a company to generate sales; growth companies such as Purplebricks Plc are not penalised for their large-scale investment in the short-term, which could make them more profitable in the long-run.

Calculating a P/S ratio is similar to calculating a P/E ratio, one need only substitute EPS for SPS. Therefore:

Share price/SPS = P/S Ratio

Thus, if trailing twelve month (ttm) sales equal £500 million and there are 100 million shares, the SPS equals £5.

If the share price is £10, then:

£10/£5 = 2

Another good use for this ratio is that it can proportionally and more tangibly illustrate year-on-year sales progress for a firm. Additionally, if a firm has a higher P/S than its competitors, it could mean that the firm commands a premium market valuation because the market forecast it will grow at a faster rate than its competitors.

Overall, P/S ratios are more suited to investors in earlier stage companies, with an eye on long-term sales rather than receiving dividends in the short term.

Enterprise Multiple

The Enterprise Multiple, or EV/EBITDA ratio, is a measure that accounts for all assets, debts, cash and equity associated with a business, to ascertain its overall value, usually from the perspective of potential buyer, of the entire company.

From this, it can be determined whether a firm – as a whole – is overvalued or undervalued; with a high EM suggesting the former and a low EM the latter.

EV/EBITDA = EM

The EV or enterprise value is calculated by working out:

(market capitalization) + (value of debt) + (minority interest) + (preferred shares) – (cash and cash equivalents).

The EBITDA is a firm’s earnings before interest, tax, debt and amortization.

Therefore, if the EV is £400 billion and the EBITDA is £40 billion:

£400 billion/£40 billion = EM of 10X

If the EBITDA is high in proportion to EV, then the firm is undervalued, and thus the EM will be low and presents the possibility of a good value acquisition. The Enterprise Multiple is useful as it examines a firm as a whole rather than looking at specific performance figures such as sales or profits, and thus takes account of variables such as debt, which other multiples – such as P/E ratios – do not.

Similarly, it is a better metric for mergers and assessing takeover candidates than market capitalization, as EV not only considers debt, but an EM is useful for transnational comparisons as it ignores the distorting effects of different country’s taxation policies. The enterprise value in effect gives you a true representation of what you will end up with if you buy a company, taking into consideration the debts you will take on and any cash pile.