MENU

4 Useful Valuation Ratios For Stock Market Investors

Valuation ratios are an easy and consistent way to gauge how expensive or cheap a company is compared to its peers or its past. The ratios – especially the ones that depend on historical numbers – are also one of the more reliable valuation methods that do not require much assumptions or estimations.

As such, this is the starting point of most investors’ decision making. In this series of articles, I would like to introduce six valuation ratios that all investors must know. This is the second part of the series. In the first part here, I took a look at market capitalisation to net income and market capitalisation to revenue. [Editor’s note: The third part of this series has been published. It can be found here.]

Market capitalisation to book value (or price per share to book value per share)

This ratio compares the market value of the stock to its book value. It is calculated simply by dividing the market capitalisation of a company by its book value. Another way to calculate this is by dividing the share price with the book value per share.

The book value of the company is calculated by deducting total liabilities of the company from the total assets of the company. The book value is, in essence, the shareholder’s equity of a company.

A ratio lower than one indicates that the company’s stock is trading at a discount to its book value. This means that if the company were to liquidate all its assets and pay off all its liabilities, it will return more to shareholders than the current price that the shareholders paid for the stock. Value investors, therefore, look to invest in companies with a reasonable price to book value ratio. Having said that, there may be reasons why stocks trade at a discount to their book value. One reason is that companies may have a lot of intangible assets on their balance sheet, which in reality is hard to cash in on.

Also, take note that some companies may trade at discounts to their book value because the company may have been unable to earn a sustainable return on their equity. This may make them poor investments despite their low price to book value ratio.

Market capitalisation to tangible book value (or price per share to tangible book value per share)

The next ratio, which was popularised by the late investing legend Benjamin Graham, is the market capitalisation to tangible book value ratio. Tangible book value refers to the book value of the company that can be meaningfully sold in the open market. It excludes intangible assets like goodwill, intellectual property and patents.

This ratio gives investors a more accurate gauge of how much a company is worth if it were to liquidate all its assets because in reality most of it intangible assets cannot be liquidated easily even though they are marked a certain value in the balance sheet.

A ratio lower than one indicates that the company is trading at a discount to its tangible book value and investors can make a profit if the company decides to liquidate all its sellable assets and return the takings to shareholders.

The Foolish bottom line

Valuation ratios are the simplest and most frequently used tools to value a company. That said, as useful as it is, we should not use these metrics in isolation. It is vital that we understand other aspects of the company and the quality of its overall business as well.

Meanwhile, for more (free!) investing insights, sign up here for your FREE subscription to The Motley Fool's investing newsletter, Take Stock SingaporeIt will teach you how you can grow your wealth in the years ahead.

Like us on Facebook to keep up-to-date with our latest news and articles. The Motley Fool's purpose is to help the world invest, better.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.