• Valuation Ratios

    There are some other important ratios used to conduct the valuation of a company. These valuation ratios are mainly used to compare a company’s current valuation or market price with other companies operating into the same sector or industry or with the industry average. The main objective of this comparison is to find out whether the share of the company is overvalued or undervalued compared to its peer companies.

    Here we use the market price of the company and other income statement or balance sheet related fields to check the valuation of the company.

    The mainly used four valuation ratios are

    • Price/Earnings (P/E) Ratio
    • Price/Book Value (P/BV) Ratio
    • Price/Cash Flow (P/CF) Ratio
    • Price/Sales (P/S) Ratio

    The Price/Earnings (P/E) Ratio is the most widely used valuation indicators in the share market to check the valuation of a company. The P/E ratio is calculated from the market price of the share divided by the earnings per share.

    Price/Earnings (P/E) Ratio = Share Price/ Earnings per Share (EPS)

    As the Price/Earnings (P/E) Ratio depends on the market price of the share and the market price mostly depends on the market and economic condition, the Price/Earnings (P/E) Ratio is also depends on the market and economic conditions significantly. The market price normally stays high during the bull market and high economic growth, that time P/E ratio returns higher value. Same way, the market price normally stays low during the bear market and low economic growth, that time P/E ratio returns lower value. In spite of these drawbacks, the P/E ratio is widely used by the share market investors to check the valuation a company.

    P/E ratio is also used to compare a company’s valuation with other companies from the same industry or with the industry average. If a company’s P/E ratio is higher than the P/E ratio of other peer group companies or industry average, the company’s share price is overvalued. Same way, if a company’s P/E ratio is lower than the P/E ratio of other peer group companies or industry average, the company’s share price is undervalued.

    The main drawback of P/E ratio is that earnings can be negative which makes this ratio irrelevant to check the valuation. Another problem with P/E ratio is that the earnings can easily be manipulated by the company which can affect P/E ratio significantly.

    To overcome these problems with P/E Ratio, Price/Book Value (P/BV) Ratio is used as another valuation ratio which uses the Book value of a company instead of earnings. Book value is the current value of all the assets carried on the balance sheet and is calculated as the cost of the assets minus the accumulated depreciation.

    Book Value of Asset= Cost of all the assets – Accumulated Depreciation

    The Price/Book Value (P/BV) Ratio is calculated as the market price of share divided by the total book value per outstanding share. The total book value is same as the shareholders’ equity which is calculated as

    Shareholders’ Equity = Assets – Liabilities

    Considering this, the Price/Book Value (P/BV) Ratio is calculated as the market price of share divided by the total shareholders’ equity per outstanding share.

    Price/Book Value (P/BV) = Share Price/ Book Value per outstanding Share

    Price/Book Value (P/BV) = Share Price/ Shareholders’ Equity per Share

    The Book value can never be negative which makes it useful for all the companies, even for the companies with negative earnings.

    The book value or the shareholders’ equity is calculated from the balance sheet where the earnings are calculated from the income statement. As the balance sheets cannot be manipulated easily, P/BV ratio provides better picture about the valuation of the company. It is mainly used for companies which hold huge assets on balance sheet and having negative earnings due to higher investment and expansion.

    Another Valuation ratio is Price/Cash Flow (P/CF) Ratio, which is used to check the valuation of a company from the cash flow point of view. The market price of the share was divided by the amount of cash flow the company generates per outstanding common shares.

    Price/Cash Flow (P/CF) Ratio = Market Share Price /

    Operating Cash Flow per outstanding share

    The main advantage of using the P/CF ratio is that, it cannot be manipulated easily like earnings. So the P/CF ratio provides much more reliable information about the company valuation. Also Cash flow is not affected by any kind of non-cash expenses like depreciation and amortization unlike earnings, which also makes P/CF ratio more suitable for the investors to use than P/E ratio.

    The fourth and last valuation ratio used to check the valuation of a company is Price/Sales (P/S) Ratio which considers the total sales revenue per outstanding shares to calculate the P/S ratio. Manipulation of sales data is very tough which makes this ratio very useful as a valuation ratio.

    Price/Sales (P/S) Ratio = Market Share Price /

    Sales Revenue per outstanding shares

    All these valuations ratios are used to check the valuation of a company or compare the current valuation of the company with other peer groups.

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