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 third and final part of the series. The first two articles can be found…
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 third and final part of the series. The first two articles can be found here and here.
Share price to free cash flow per share (or market capitalisation to free cash flow)
The price to free cash flow per share compares the company’s market price to its free cash flow.
One thing we should take note is that free cash flow takes into account a company’s operating cash flow, less capital expenditures. It differs from the overall cash flow of the company, which also takes into account additional financing cash flows. Free cash flow, is hence, a better gauge of the cash generated from business operations.
To calculate free cash flow per share, we start by deducting capital expenditures from operating cash flow. This can be found on the cash flow statements of companies. We then divide this by the total number of outstanding shares.
The price to free cash flow ratio can then be calculated by dividing the price of the share and its free cash flow per share. As with the price to earnings ratio, the lower the multiple, the more value we are getting as shareholders based on its cash flow generation. It means that the company has strong financial muscle to pay out dividends and manage its operations.
However, as with all the ratios we have dealt with so far, it is important not to look at this ratio in isolation and to take note of all other aspects of the business.
Price-earnings to growth ratio
The price-earnings to growth ratio (PEG) is one of the most useful ratios to compare fast-growing companies. The legendary money manager, Peter Lynch, believes that the PEG ratio helps to solve the shortcomings of simply using the price to earnings ratio (PE), which was discussed in the first article.
To calculate the PEG ratio, we simply take the price-earnings multiple of a company and divide it by the projected future growth. For instance, a company with a PE of 20 and a forecasted 5-year growth of 20% per year, has a PEG multiple of 1. The lower the PEG multiple, the more reasonable the company is priced based on its growth and current earnings.
Peter Lynch felt that stocks that traded at PEG ratios of under one usually proved to be long-term bargains. However, one important thing to take note of is this ratio requires investors to estimate the growth prospect of a company over a period of time. This may not be accurate, and different investors may come up with different estimates, resulting in widely varying PEG ratios.
The Foolish bottom line
Valuation ratios are the simplest and most used valuation metrics. 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 its overall business.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.