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Back to Basics: Valuation Ratios That Are Important to Value Investors
Posted by: GuruFocus (IP Logged)
Date: April 16, 2012 11:01AM

GuruFocus will display valuation ratios such as P/E ratio, P/S ratio, P/FreeCashFlow, Shiller P/E and P/B on its new stock summary page. This is in addition to the intrinsic values GuruFocus will display. These are the explanations of each ratio.

P/E Ratio

The P/E ratio is the most widely used ratio in the valuation of stocks. It is calculated as:

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

It can also be calculated from the numbers for the whole company:

P/E Ratio = Market Cap / Net Income

There are at least three kinds of P/E ratios used by different investors. They are Trailing Twelve Month P/E Ratio or P/E (ttm), forward P/E, or P/E (NRI). A new P/E ratio based on inflation-adjusted normalized P/E ratio is called Shiller P/E, after Yale professor Robert Shiller.

In the calculation of P/E (ttm), the earnings per share used are the earnings per share over the past 12 months. For Forward P/E, the earnings are the expected earnings for the next twelve months. In the case of P/E (NRI), the reported earnings less the non-recurring items are used.

For the Shiller P/E, the earnings of the past 10 years are inflation-adjusted and averaged. The result is used for P/E calculation. Since it looks at the average over the last 10 years, Shiller P/E is also called PE10.

Guru Explains:

The P/E ratio can be viewed as the number of years it takes for the company to earn back the price you pay for the stock. For example, if a company earns \$2 a share per year, and the stock is traded at \$30, the P/E ratio is 15. Therefore it takes 15 years for the company to earn back the \$30 you paid for its stock, assuming the earnings stays constant over the next 15 years.

In real business, earnings never stay constant. If a company can grow its earnings, it takes fewer years for the company to earn back the price you pay for the stock. If a company’s earnings decline it takes more years. As a shareholder, you want the company to earn back the price you pay as soon as possible. Therefore, lower-P/E stocks are more attractive than higher P/E stocks. Also for stocks with the same P/E ratio, the one with faster growth business is more attractive.

To compare stocks with different growth rates, Peter Lynch invented a ratio called PEG. PEG is defined as the P/E ratio divided by the growth ratio. He thinks a company with a P/E ratio equal to its growth rate is fairly valued. Still he said he would rather buy a company growing 20% a year with a P/E of 20, instead of a company growing 10% a year with a P/E of 10.

Because the P/E ratio measures how long it takes to earn back the price you pay, the P/E ratio can be applied to the stocks across different industries. That is why it is the one of the most important and widely used indicators for the valuation of stocks.

Similar to the Price/Sales ratio and Price/Cash Flow or Price/Free Cash Flow, the P/E ratio measures the valuation based on the earning power of the company. This is where it is different from the Price/Book ratio, which measures the valuation based on the company’s balance sheet.

Be Aware:

Investors need to be aware that the P/E ratio can be misleading a lot of times, especially when the underlying business is cyclical and unpredictable. As Peter Lynch pointed out, cyclical businesses have higher profit margins at the peaks of the business cycles. Their earnings are high and P/E ratios are artificially low. It is usually a bad idea to buy a cyclical business when the P/E is low. A better ratio to identify the time to buy a cyclical businesses is the Price-to-Sales Ratio (P/S).

Price-to-Sales Ratio (P/S)

The P/S Ratio is another ratio widely used to value stocks. It was first used by Ken Fisher. It is calculated as:

P/S Ratio = Share Price / Revenue per Share

It can also be calculated from the numbers for the whole company:

P/S Ratio = Market Cap / Total Revenue

The revenue here is for the trailing 12 months.

Guru Explains:

The P/S ratio is an excellent valuation indicator if you want to compare a stock with its historical valuation or with the stocks in the same industry. The P/S ratio works especially well when you want to compare the stock’s current valuation with its historical valuation. The P/S ratio is a great valuation tool for evaluating cyclical businesses where the P/E ratio works poorly. It works the best when comparing the current valuation with the historical valuation because over time, a company’s profit margin tends to revert to the mean.

When the P/S ratio is applied to the whole stock market, it can be used to evaluate the current market valuation and projected returns. In this case, the price is the total market cap of all stocks that are traded, and sales are the GDP of the country. This is how Warren Buffett estimates the broad market valuation and project future returns.

Similar to the Price/Earnings ratio and Price/Cash Flow or Price/Free Cash Flow, the P/E ratio measures the valuation based on the earning power of the company. This is where it is different from Price/Book ratio, which measures the valuation based on the company’s balance sheet.

Be Aware:

The P/S ratio does not tell you how cheap or expensive the stock is. It cannot be used to compare companies in different industries. It works better for companies within the same industry because these companies tend to have similar capital structures and profit margins. It works the best when comparing a company with itself in the past.

Price to Book Ratio (pb)

The price-to-book ratio, or P/B ratio, can be calculated as follows:

P/B Ratio = Share Price / Book Value per Share

It can also be calculated from the numbers for the whole company:

P/B Ratio = Market Cap / Total Equity

A closely related ratio is called Price-to-Tangible-Book Ratio. The difference between Price-to-Tangible-Book Ratio and Price-to-Book Ratio is that book value other than intangibles are used in the calculation.

Guru Explains:

Unlike valuation ratios relative to the earning power such as P/E ratio, P/S ratio or Price-to-Free-Cash-Flow ratio, the Price-to-Book Ratio measures the valuation of the stock relative to the underlying asset of the company.

The Price-to-Book Ratio works the best for the businesses that earn most of their profit from their assets, e.g. banks and insurance companies.

Be Aware:

Some businesses have very light assets, such as software companies or insurance agencies. The Price-to-Book Ratio does not work well for these companies. Some companies even have negative equity, so the Price-to-Book Ratio can not be applied to them.

Related: P/E ratio, P/S ratio, Shiller P/E or Price-to-Free-Cash-Flow ratio, Book Value, Tangible Book Value

Price-to-Free-Cash-Flow ratio

Price-to-Free-Cash-Flow ratio is calculated as follows:

Price-to-Free-Cash-Flow = Share Price / Free Cash Flow per Share

Or

Price-to-Free-Cash-Flow = Market Cap / Total Free Cash Flow.

Free Cash Flow is calculated as:

Free Cash Flow per Share

= Cash Flow from Operations + (Increase) Decrease in Prop, Plant & Equipment

= Net Income + Depreciation & Amortization (DDA) – Change in Net Working Capital – Capital Expenditure.

Guru Explains:

Free Cash Flow is considered more important than earnings by value investors. The reason is because, in principle, only the net cash that can be taken from the business belongs to shareholders. This Free Cash Flow can be used to grow the business, reduce debt or return to shareholders in dividends or share buybacks.

In a DCF Calculation Free Cash Flow is used to determine the intrinsic value of companies.

Be Aware:

In real business, Free Cash Flow can be affected by the change in accounts receivable, accounts payable, management’s decision on expansion, etc. Therefore, investors should look at the Free Cash Flow over the longer term. Long-term average of Free Cash Flow is a more reliable indicator for real free cash flow.

Related: : P/E ratio, P/S ratio, Shiller P/E or Price-to-Free-Cash-Flow ratio, Book Value, Free Cash Flow, DCF Calculator

Shiller P/E Ratio

For the Shiller P/E, the earnings of the past 10 years are inflation-adjusted and averaged. The result is used for P/E calculation. Since it looks at the average over the last 10 years, the Shiller P/E is also called PE10.

The Shiller P/E was first used by professor Robert Shiller to measure the valuation of the overall market. The same calculation is applied here to individual companies.

Guru Explains:

Compared with the regular P/E ratio, which works poorly for cyclical businesses, the Shiller P/E smoothed out the fluctuations of profit margins during business cycles. Therefore it is more accurate in reflecting the valuation of the company.

If a company has consistent business performance, the Shiller P/E should give similar results to regular P/E.

Compared with the P/S ratio, the Shiller P/E makes the comparison between different industries more meaningful.

Be Aware:

The Shiller P/E assumes that over the long term, businesses and profitability revert to their means. If a company’s business model does not work in the future compared with the past, the Shiller P/E and P/S ratio will give false valuations.

Related: P/E ratio, P/S ratio

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