Valuation ratios are an easy way for investors to compare companies across all industry types. They can give us a consistent way to gauge how expensive or cheap a company is. With that, I will like to highlight six valuation ratios that all investors should know in a short series of articles. This article is the first in the series, and it will touch on two valuation ratios. [Editor’s note: The second and third article in this series have been published. They can be found here and here.] But before I begin, I want to clarify that for…
Valuation ratios are an easy way for investors to compare companies across all industry types. They can give us a consistent way to gauge how expensive or cheap a company is.
With that, I will like to highlight six valuation ratios that all investors should know in a short series of articles. This article is the first in the series, and it will touch on two valuation ratios. [Editor’s note: The second and third article in this series have been published. They can be found here and here.]
But before I begin, I want to clarify that for each ratio, we can calculate the valuation ratios based on either historical numbers, or future projections.
For historical numbers, we typically use the financial numbers of a company over the last 12 months (in finance speak, this time frame is known as the trailing-12-month period, or TTM period). Meanwhile, forward-looking ratios make use of analysts’ expectations for the future year. Valuation ratios based on historical numbers are typically one of the more reliable valuation methods that do not require much assumptions or estimations. Without further ado, let’s begin!
The market capitalisation to net income (or price per share to earnings per share) ratio
This ratio – which is popularly known as the PE ratio (price-to-earnings ratio) – allows investors to gauge the price of a company relative to its TTM earnings or future earnings. The first step in calculating this ratio is to get the market capitalisation of a company.
Market capitalisation (market cap) refers to the total market value of all the outstanding shares of a company. It can be calculated by multiplying the total number of outstanding shares with the price per share. As an example, a company with a share price of $10 and one million outstanding shares has a market cap of $10 million.
To calculate the market cap to earnings ratio, we then divide the company’s market cap with its TTM earnings. For example, if the same company above has net income of $1 million in the last 12 months, its market cap to earnings ratio would be 10.
Generally speaking, the higher the ratio, the more expensive the company is relative to its earnings. Companies that have higher growth potential tend to be priced at a premium to their peers and to the market, and thus trade at higher ratios.
As investors, we can make use of this ratio by comparing companies with similar businesses to determine which company provides more value to investors. The PE ratio of a company can also be compared against its own history to see if it’s high or low.
Another way of calculating this ratio is by dividing a company’s share price with its earnings per share. The earnings per share, as well as TTM net income figure, can both be found in the quarterly and annual reports of a company.
The market capitalisation to revenue (or price per share to revenue per share) ratio
Another commonly used and useful metric is the market cap to revenue ratio – or more commonly known as the price-to-sales (PS) ratio. This is a useful method for valuing companies that may have lumpy earnings or are not yet profitable. This ratio is also the least susceptible to any discrepancies in accounting methods, or one-off items that can affect a company’s net income.
The easiest way to calculate this ratio is by dividing a company’s market cap with its revenue over the last 12 months. For example, a company with a market cap of $20 million and TTM revenue of $5 million has a PS ratio of 4.
Once again, it is useful to compare a company’s PS ratio with that of its peers, or its historical average, to get an idea of how cheap or expensive the company is. And generally speaking, a high PS ratio would correspond to an expensive stock. It’s also the same in reverse; a low PS ratio would correspond to a cheap stock.
The Foolish bottom line
Valuation ratios are simple, useful, and commonly applied. But, we should not use these metrics in isolation. It is vital that we understand other aspects of a company and its overall business.
Stay tuned for more valuation ratios in the coming days!
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.