warren buffet explaining How to use valuation ratios to evaluate stocks
Stock market investment is widely regarded as a rapid path to ensure inflation-beating returns and capital appreciation. However, the key to creating a successful portfolio is to analyse the stocks correctly to include them in your investment portfolio. Analysts use various ratios to evaluate the stocks and understand their relative performance over the years. So what are these valuation ratios and how to use them? Read on to know all about the valuation ratios to evaluate stocks and their interpretation.
We know that to evaluate stocks, investors use various valuation ratios. So let us first understand the meaning of valuation ratios and their importance in stock valuation. Valuation ratios, also referred to as valuation metrics, are financial ratios utilized to assess the investment opportunity of a company’s stock.
These ratios can be computed based on the financial statements of the company and they assist investors in determining whether a stock is undervalued, overvalued, or fairly valued in the market.
Valuation ratios are also used to understand a quick snapshot of the financial health of a company or a business. Investors can use valuation ratios to compare a company’s performance with its competitors in the same industry. This comparison helps identify relative strengths and weaknesses, allowing investors to pick the most promising stock within a sector.
These ratios are computed by comparing different financial metrics of the company, such as earnings, book value, sales, cash flow, or dividends, with its stock price. By analyzing these valuation ratios, investors can make informed decisions about the attractiveness and potential profitability of investing in a particular stock.
The common valuation ratios used by investors to evaluate stocks and their interpretation is discussed below.
P/E Ratio is the most commonly used valuation ratio and compares the current stock price of a company to its earnings per share (EPS). It indicates how much investors are willing to pay for each rupee of earnings generated by the company. The formula for P/E Ratio is,
P/E Ratio = Current Stock Price or Market Price per share / Earnings Per Share (EPS)
A high P/E ratio suggests that investors have high expectations for the company’s future growth and are willing to pay a premium for its stock. Conversely, a low P/E ratio may indicate that the company is currently undervalued or that investors have lower expectations for its future prospects.
The P/B ratio, or Price-to-Book ratio, is a financial metric used to evaluate the relative value of a company’s stock in relation to its book value. The book value per share refers to the net value of the company which is represented as the company’s total assets minus its total liabilities, divided by the number of outstanding shares. It is an accounting-based value that provides an approximation of what shareholders would receive if the company were to liquidate its assets and pay off its debts. The formula for P/B Ratio is,
P/B Ratio = Current Stock Price / Book Value Per Share
The P/B ratio helps investors gauge whether a company’s stock is undervalued or overvalued based on its financial statements. A P/B ratio below 1 suggests that the stock is trading at a price lower than its book value, indicating a potential undervaluation. On the other hand, a P/B ratio above 1 implies that the stock is trading at a premium to its book value, suggesting a potential overvaluation.
The P/S ratio is another financial metric that is used to compare the company’s market capitalisation to the total sales of the company. This ratio measures how much investors are paying for each rupee of sales generated by the company. The formula for P/S ratio is,
P/S Ratio = Market Capitalization / Total Sales Revenue
A lower PS ratio generally suggests that a company’s stock is relatively undervalued compared to its sales performance. It might indicate a potential investment opportunity since investors are paying less for each unit of sales generated by the company. On the other hand, a higher PS ratio could indicate that the stock is overvalued as compared to its sales. Investors are willing to pay a premium for each rupee of sales which can also be interpreted as a sign that the investors and the market, in general, have high expectations for the company’s future growth.
Price/Earnings to Growth (PEG) Ratio valuation ratio is used to assess a company’s stock by taking into account its price-to-earnings (P/E) ratio and its earnings growth rate. The PE ratio, as mentioned above, focuses on the market price of the share and the earnings per share of the company. On the other hand, the earnings growth rate represents the percentage increase in a company’s earnings over a specific period, often on a per-share basis. The formula for PEG ratio is
PEG Ratio = P/E Ratio/Earnings Growth Rate
The comparison of these two financial metrics enables investors to understand whether a company’s stock is overvalued or undervalued relative to its growth prospects. A PEG ratio of 1 is often considered fair value, where the P/E ratio is in line with the earnings growth rate. A PEG ratio below 1 may suggest that the stock is undervalued relative to its growth potential, while a PEG ratio above 1 could indicate an overvalued stock.
Return on Equity (ROE) is a financial measure that shows how efficiently a company generates profits from the money invested by its shareholders thereby assessing the performance and profitability of the company. The formula to calculate ROE is,
ROE = (Net Income / Shareholders’ Equity) x 100
A higher ROE indicates that the company is effectively utilizing the funds provided by its shareholders to generate earnings. This is generally considered a positive sign, as it shows that the company is profitable and capable of providing good returns to its investors.
Dividend Yield Ratio is a financial metric used by investors to assess the income they can earn from their investment in a particular company’s stock in the form of dividends. The formula for calculating the dividend yield ratio is,
Dividend Yield Ratio = (Dividend per Share / Current Stock Price) x 100
It is an essential measure for income-oriented investors who seek regular income from their investments. A higher dividend yield is generally considered attractive because it means the investor will receive a higher return on their investment through dividends.
The Dividend Payout Ratio is used by investors to evaluate how much of a company’s earnings are paid out as dividends to its shareholders. The formula for calculating the dividend payout ratio is,
Dividend Payout Ratio = (Dividends per Share / Earnings per Share) x 100
A high dividend payout ratio can be attractive to income-oriented investors as it indicates that the company is distributing a significant portion of its earnings as dividends. However, an excessively high ratio may raise concerns about the company’s ability to retain earnings for future growth, while a low ratio may signal reinvestment in the business for expansion.
The Debt Equity Ratio is used by investors to assess a company’s financial leverage and its ability to manage its debts. It measures the proportion of a company’s total liabilities (debts) to its shareholders’ equity (owners’ capital) and indicates how much of the company’s funding comes from debt compared to equity. The formula for calculating the debt-equity ratio is,
Debt-Equity Ratio = Total Debt / Shareholders’ Equity
A lower ratio generally indicates that the company relies more on equity financing than debt, which can be seen as a positive sign, as it suggests lower financial risk. On the other hand, a higher ratio may imply that the company has a significant debt burden, which could pose higher financial risks.
The current ratio is used by investors to assess a company’s short-term liquidity and its ability to meet its short-term financial obligations. It compares the company’s current assets to its current liabilities. The formula for calculating current ratio is,
Current Ratio = Current Assets / Current Liabilities
The Current Ratio is essential for investors as it provides insight into a company’s short-term financial health and its ability to manage its day-to-day operations and financial commitments. The ideal current ratio of companies differs from industry to industry. However, a Current Ratio above 2 suggests that the company has sufficient current assets to meet its short-term obligations, which is usually seen as a positive sign. A Current Ratio below 2 may indicate liquidity issues and difficulty in paying off short-term debts on time.
The various valuation ratios mentioned above are used to analyse the financial health of the business as well as ascertain the investment decision. However, these ratios should not be used on a standalone basis as they may not provide an accurate evaluation of the stock. Therefore, it is important to evaluate a stock on the collective basis of these valuation ratios to get a complete as well as true picture of the company’s financial health and thereby its stock.
A dividend payout ratio of 100% means that the company is distributing all its earnings to the shareholders and not retaining or reinvesting into the business.
The most common valuation ratio used while evaluating a stock is the P/E ratio.
Financial ratios can be broadly classified into Profitability Ratios, Solvency Ratios, Operating Ratios, Liquidity Ratios, Turnover Ratios, and Coverage Ratios.
The core purpose of using valuation ratios for evaluating a stock is to determine whether the stock is overvalued, undervalued, or fairly priced in the market, helping investors make informed decisions about their investment choices.
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