As an investor, knowing whether a company's stock is cheap, expensive, or fairly valued is one of the most critical areas of focus and is, therefore, a critical part of smart investing. This is the function of valuation ratios. Valuation ratios are used by almost all investors, regardless of experience level, to compare businesses, assess market expectations, and most importantly, make informed judgments.
This tutorial will examine the definition of value ratios, analyze their many types, quantify and conduct a valuation ratio study, and provide useful applications.
What Are Valuation Ratios?
An indicator of a company's market value in relation to its financials (performance, assets, or earnings) is a valuation ratio. Investors can use these ratios to assess if a stock's pricing is reasonable.
Is this stock worth buying now?
Valuation ratios look at the market price of the stock in relation to the company's earnings, sales, cash flow, or book value to measure the ratios. These ratios are great to help with stock selection, especially when considering stocks within the same industry or to help determine when a stock is overpriced or underpriced.
Valuation Ratios Definition
Valuation ratios are created to measure how much a company's earnings or assets are worth to investors.
Example:
Investors who pay 20 rupees for a company that earns 1 rupee (1:20) or 8 rupees for the same company (1:8) are considered to have good value and are willing to invest significantly.
From a high-level perspective, paying a high price for a company's earnings doesn't mean the stock is 'bad.' Likewise, paying a low price for a company's earnings doesn't mean the stock is 'good.' This is why valuation ratio analysis is important.
Why Valuation Ratios Count in The Investor's Draw
The importance of valuation ratios can be understood from the following points:
- First, they keep the investor from overpaying for the same share during the market frenzy.
- Second, they can pinpoint potential opportunities that have the potential to be ignored because of the market.
- Third, they provide an objective comparison of rival companies in the market.
- Lastly, they provide a sense of cushion in case of overzealous expectations.
Valuation ratios help keep the analytical side of the investing process active instead of becoming emotional.
Valuation Ratio Types
Using a set of valuation ratioscan provide a more widespread view on various financial aspects of the company being evaluated; therefore, using multiple ratios is common among more sophisticated investors.
In this section, we review the more widespread and essential valuation ratios available.
1. Price to Earnings Ratio (P/E Ratio)
The P/E Ratio is the most common and widely utilised stock market valuation ratio.
Formula
P/E Ratio = Market Price per Share ÷ Earnings per Share (EPS)
Interpretation
- High P/E means the Market expects high future growth.
- Low P/E could mean the Stock is undervalued or is facing some challenges.
Example
Suppose a stock is trading at ₹200 and the EPS is ₹20:
P/E = 200 ÷ 20 = 10
Analysis
P/E ratio is significant for:
- Peer Comparison within the same Industry.
- Assessing the Growth Expectations.
The standalone P/E ratio has a lot of limitations. High-growth companies have high P/E levels.
2. Price to Book Value Ratio (P/B Ratio)
P/B ratio is used to compare the company’s market value to its net assets.
Formula
P/B Ratio = Market Price per Share ÷ Book Value per Share
Interpretation
P/B < 1 means the Stock is trading below the value of the assets.
P/B > 1 means the market is valuing the company more than its net assets.
Best Used For
- Banks and other financial institutions.
- Industries with a lot of core assets (Asset-heavy Industries).
Analysis
A low P/B ratio may signal undervaluation but could also mean poor quality of assets. Always check the return ratios as well.
3. Price to Sales Ratio (P/S Ratio)
P/S ratios assess a company’s value using revenue instead of profit.
Formula
P/S Ratio = Market Capitalisation ÷ Total Revenue
Why It Matters
- Useful in cases where profit periods are inconsistent or negative.
- Typically used in assessing startups or rapidly growing firms.
Interpretation
P/S ratios are best when on the lower end, but margins need to be looked at closely.
4. Price to Earnings Growth Ratio (PEG Ratio)
The PEG ratio adds a dimension of growth to the P/E ratio.
Formula
PEG Ratio = P/E Ratio ÷ Earnings Growth Rate
Interpretation
PEG < 1 → Potentially undervalued
PEG = 1 → Valued fairly
PEG > 1 → Valued too high for the growth anticipated
Analysis
The PEG ratio is quite good for growth stock comparisons as it offers a good balance between the value and the expected growth in earnings.
5. Enterprise Value to EBITDA (EV/EBITDA)
This ratio looks at the company’s valuation with debt included.
Formula
EV/EBITDA = Enterprise Value ÷ EBITDA
Where:
Enterprise Value = Market Cap + Debt − Cash
EBITDA = Earnings Before Interest, Tax, Depreciation, and Amortisation
Why Investors Use It
- Neutralises capital structure differences.
- Preferred by institutional investors.
Best Used For
- Capital-intensive industries.
- Cross-company comparisons.
6. Dividend Yield
This ratio is also about valuation, but it is also about income.
Formula
Dividend Yield = Annual Dividend ÷ Market Price
Interpretation
- High yield can be attractive, however, it can be risky.
- Low yield means the company is focused on growth.
Analysis
Dividend yield works best when combined with payout ratio and earnings stability.
Valuation Ratio Analysis: How to Use Them Correctly
It is better to focus on valuation ratio analysis than on memorising the formulation. This is how smart investors approach valuation ratios.
1. Compare Within the Same Industry
- Do not underestimate the importance of sticking to the same sector when comparing valuation ratios.
- When incorporating a technology company and a financial institution, a different set of valuation benchmarks will be needed.
2. Combine Multiple Valuation Ratios
- Over-reliance on one indicator is not ideal.
- A more suitable way would be using P/E and PEG to analyse growth, P/B and ROE to analyse financial stocks. Analysing cash flow metrics combined with EV/EBITDA to assess capital-heavy businesses
3. Consideration of both growth and the quality of the business
- A high valuation ratio is justified if there is revenue growth. Profit margin growth exists.
- There is predictive dominance.
- Cheap stocks with no fundamentals typically stay cheap.
4. Assessing previous valuation levels
Current valuation ratios should be compared to the company's past valuation ratios. This provides additional context for valuation ratios.
Common Mistakes in Valuation Ratio Analysis
The following are the reasons most investors misuse valuation ratios:
- Low valuation is a good investment assumption
- Futuristic growth and earnings potential are ignored
- Industries are compared with a lack of context
- Earnings data is used that is no longer valid
- Debt is ignored when valuing companies.
Valuation Ratios vs Market Sentiment
When looking at the ratios, it’s seen that the value is based on fairly priced fundamentals, while the price is based on market emotion.
During bull markets:
Rationale plays fullness while valuing increases.
During bear markets:
Rationale plays fullness while valuing decreases.
Truly rational investors maintain a valuation ratio regardless of how volatile the market is.
Who Can Benefit From Valuation Ratios?
Some examples are:
- Long-term investors.
- Value investors.
- Growth investors.
- Retail investors looking to build a portfolio
- Fundamental analysts
Even short-term or day traders can use the ratios to keep from buying overpriced stocks.
Concluding Remarks
Investment judgments can be greatly enhanced by comprehending the concept of valuation ratios, knowing their many forms, learning their formulas, and using appropriate valuation ratio analysis.
Although valuation ratios don't forecast short-term price changes, they shield investors against long-term errors. Valuation ratios are an effective investing tool when combined with financial ratios, growth research, and business knowledge.
DISCLAIMER: This blog is NOT any buy or sell recommendation. No investment or trading advice is given. The content is purely for educational and information purposes only. Always consult your eligible financial advisor for investment-related decisions.
