Would you buy it if I offered to sell my company for Rs 50 Lakhs? Is it worth it? Even though it seems cheap at Rs 50 lakhs, you are paying to lose money if I have a loss-making business at present.
That's why valuation ratios are essential in determining a company's worth. A valuation ratio reflects the relationship between the market value of a company or its equity and some fundamental financial metrics. The objective of the valuation ratio is to reflect the price you are paying for some stream of earnings, revenue, or cash flow. In this article, we will discuss the valuation ratio and various types of valuation ratios.
What is the Valuation Ratio?
There are end numbers of valuation ratios out there that helps in analyzing the company. The valuation ratio helps in determining a company's worth. These ratios put that observation into the context of a company's share price, where they serve as valuable tools for estimating the investment potential. These ratios are most valuable when thinking about the future. Therefore, the ratios and financial parameters we choose for valuation should be based on what the consensus expects regarding earnings, cash flow, etc. While your opinion of earning potential may vary, it's good to know about the market expected to understand what is built into the price.
Purpose of Valuation Ratio
Valuation ratios give investors a clear picture of what a company may be worth. Few Valuation ratios are based solely on the company's financial statements, while others compare the market price to per share data. Typically, 2 or 3 valuation ratios should be used to understand how a company stacks up against its competitors and whether it is trading above or below its fair value.
Valuation ratios may not be 100% certain, but they give you an idea of what will be required for a stock to provide you with a return. If a stock is expensive, the company must provide 2 or 3 years of steady profit growth to allow the price to appreciate even more. There's probably some reason why a company is being sold at a loss to its fair value. It is essential to know why a stock trades at a discounted price and what is needed for the price to increase.
Valuation ratios are invaluable for stock picking or active investment strategy. These ratios can compare stocks and select those with the best chance of generating a return. The main reason behind that is having an idea of the relative value of stocks also allows you to take benefits of market volatility and corrections.
Types of Valuation Ratio-
Below mentioned are the types of Valuation Ratios-
Price-to-Book value ratio is also known as PB Ratio. It is calculated by considering the current price per share and dividing it by the book value per share. The book value is a difference between assets and liabilities.
For Instance, a company with a share price of Rs 400 and a book value of 550 per share would have a P/B ratio of 0.72. A ratio higher than one generally indicates an investor is prepared to spend more equity per share. In contrast, the ratio below 1 indicates that the investor is willing to pay less.
Price-to-earnings ratio is also known as PE Ratio.PE Ratio looks at the relationship between a company's stock price and earnings. The ratio provides investors with an understanding of how the market is established. It is calculated by dividing a company's present price of shares by the profits per share.
In this case, for example, If a company is trading for Rs 350 share, and its profits over the last twelve months have been Rs 15 per share, the ratio of P/E for the stock will be 23.33 (350/15) if the P/E increases and the sentiment of investors in the present is positive. On the contrary, a drop in P/E is an indication that the company is out of favor with investors.
The price-to-sales ratio reflects how much the market is willing to pay for every dollar of sales made by the company. To determine it, you must take the company's market capitalization and then divide it by the total sales in the past twelve months. A market capitalization is the number of shares issued divided by the value of each share.
The P/S ratio may be used instead of the P/E ratio in cases where the business is in a net loss. One of the advantages of using the Price-to-Sales ratio is that sales are much harder to manipulate than earnings. In addition, since a company's sales are generally more stable than its earnings level, any significant changes in the Price-to-sales ratio are often more likely to indicate a departure from its intrinsic value (either up or down).
The price-to-cash-flow ratio assesses the price of the company's stock relative to how much cash flow the company generates. It is determined by dividing the company's market cap by its operating cash flow in the past 12 months. It can also be determined by dividing the per-share stock price by the operating cash flow. The P/CF ratio is an alternative method to the P/E ratio.
PCF is an effective tool for comparative analysis; it is only helpful in some cases. For example, the PE Ratio represents the amount that investors are currently willing to pay for every rupee of net income the company generates. In contrast, PCF represents the amount that investors are willing to pay for every rupee of cash generated by the company.
So since the Price Cash-flow uses cash from operations to assess the value of a company, it is difficult for the company to manipulate the cash with non-cash expenses like depreciation and non-cash accruals like accounts payable and receivables. However, earnings and book values can fall prey to creative accounting. Hence the PCF is a far more important ratio.
The price/earnings-to-growth ratio is the relationship between the price-to-earnings ratio and a company's projected earnings growth. PEG is determined by dividing the Price-to-earnings ratio by the earnings-per-share growth. For Instance, if a company's Price-to-earning ratio is 16.5 and its earnings-per-share growth over the next three years is expected to be 10.8%, its PEG ratio would be 1.5. A Price/earning-to-growth of 1 or less is typically taken to indicate an undervalued company.
Conversely, a PEG of more than one is generally taken to indicate that the company is overvalued. To get an accurate picture of value, the PEG ratio of the company should be compared with the PEG of the market and the industry in which the company competes.
Conclusively, we can say that Valuation ratios are some of the commonly quoted and easily used ratios for analyzing the interest of an investment in a company. Primarily, these measures integrate a company's publicly traded stock price to give investors an overview of how inexpensive or expensive the company is in the market.