Valuation Ratios – Examples, Interpretation, Formulas – 365 Financial Analyst (2024)

Equity valuation is a complex process that goes beyond ratio analysis. Typically, financial analysts use a mixture of methods depending on their objectives.

There are three primary approaches to equity valuation:

  1. Asset-based, which considers only a company’s assets
  2. Income-based, revolving around expected (discounted) cash flows
  3. Market-based, which involves the comparison of valuation ratios to similar publicly-traded companies or industry norms

The asset-based method is typically performed by creditors or in special situations like liquidation. The income-based approach is superior but burdensome and prone to uncertainty. Therefore, using comparable ratios (or the market-based approach) is often preferred as a quick and straightforward method of valuation analysis.

Valuation ratios examine the relationship between a company’s market value and different financial metrics. Analysts compare the results to industry averages, peer companies, and historical data to obtain meaningful insights.

This article explores the most commonly used market value ratios and their formulas and interpretation.

Table of Contents

  1. Per-Share Metrics
  2. Price Multiples
  3. Enterprise Value Multiples
  4. Dividend Valuation Ratios

Per-Share Metrics

One of the most popular types of market ratios is the per-share metrics, which measure various financial indicators in relation to share prices. The denominator value is divided by the number of shares outstanding to obtain its per-share value.

We can divide any item from a company’s financial statements by the number of shares outstanding to obtain its per-share value. The most commonly used metrics include:

  • Earnings per share (EPS)
  • Cash flow per share
  • Sales per share
  • Book value (of equity) per share
  • Dividend per share (DPS)

Earnings per Share (EPS)

One of the most commonly used per-share stock valuation ratios is earnings per share (EPS). It divides a company’s net income by the number of outstanding shares:

Earnings~per~share~(EPS)=\frac {Net~income-Preferred~dividends}{Outstanding~number~of~common~shares} 

The EPS tells us how much income a company earns per common share. This is a valuable measure because, over the long term, net profit is the primary determinant of investment value. But EPS tends to be unstable yearly, so sometimes analysts take the normalized EPSadjustments of an average of five or even ten years.

Price Multiples

Price multiples examine a company’s stock price with various financial indicators. Given that share price is typically in the numerator, higher valuation ratios suggest a high price or over-valuation of equity. Below are the most widely used price multiples.

Price-to-Earnings (P/E) Ratio

The price-to-earnings ratio is the most common valuation ratio. It measures a company’s share price with its earnings per share, indicating whether a stock is relatively cheap or expensive. In other words, the P/E ratio indicates the price investors are willing to pay per $1.00 of earnings generated.

P/E~ratio=\frac {Price}{Earnings~per~share}=\frac {Market~value~of~equity}{Net~income}

Generally, the higher the P/E ratio, the more expensive a company’s stock is. But high P/E ratios can result from a market frenzy—a temporary hype around a company causing an excessive demand for its stock, which inflates the price. So, when the ratio is too high, we should carefully assess if the company’s profitability justifies the price.

The two main types of P/E ratios include:

  1. Trailing P/E analyzes earnings for the last 12 months with today’s price.
  2. Forward P/E considers projected earnings in relation to today’s price.

The advantages of using P/E ratios for the valuation of a company are that it’s easy to obtain and considers the investment value’s primary driver: earnings. Its disadvantages stem from the fact that earnings are often volatile, can be manipulated, and even in the negative. In addition, the P/E ratio (like other price multiples) does not consider the company’s debt burden.

P/E Ratio Variations

Analysts have developed several versions of the P/E ratio to address some of its shortcomings. The rationale remains the same—examining the relationship between the market value of a company’s equity and the amount of net income it generates. In most cases, the share price forms the numerator, and earnings per share represents the denominator. And a high ratio implies that the company is overvalued.

Cyclically-Adjusted Price-to-Earnings (CAPE)

This variation of the P/E valuation ratio examines average earnings over 10 years to ‘normalize’ earnings. Some iterations may take 2, 3, 5, or 15 years.

CAPE=\frac {Price}{10-year~average~inflation-adjusted~earnings~per~share}

Practitioners favor the CAPE ratio because it smooths out the earnings’ volatility and cyclicality. It is also highly improbable for a company to have negative 10-year average earnings and stay in business. Still, the metric assumes normal business operations and would conceal a potential decline in earnings over the past few years.

In addition, the CAPE ratio doesn’t overcome a significant problem. When companies apply different accounting policies (i.e., changes in revenue recognition standards) over the years, taking the average of earnings in two different periods becomes inappropriate. Moreover, the ratio is backward-looking and doesn’t account for expected business changes.

Average ROE CAPE

This iteration of the P/E ratio normalizes EPS differently; it takes the average ROE over the past 10 years and multiplies it by the current equity book value:

CAPE_{ROE}=\frac {Price}{ROE_{10~Yrs} \times Book~value~per~share_{at~present}}

The main benefits are that this market value ratio reflects the effect of the firm’s size changes, and unlike CAPE, it’s a forward-looking measure. The drawbacks are that it’s less intuitive and harder to calculate.

Earnings Yield

The earnings yield reverses the P/E ratio into an E/P ratio:

E/P~ratio=\frac {Earnings~per~share~(EPS)}{Price}

A higher E/P ratio implies undervaluation—mainly applied when negative earnings impede us from using the P/E metric.

PEG Ratio

We can also use the PEG ratio, which takes the standard P/E ratio further and interprets it as P/E per unit of expected growth. In other words, it helps us understand whether the P/E ratio is justified given expected growth.

PEG~ratio=\frac {P/E}{Expected~growth~rate}

The higher the PEG ratio, the less justified a high P/E is. This suggests that the price is too high relative to a firm’s earnings and future growth expectations. The PEG is commonly used in financial analysis and valuation when a P/E ratio is suspiciously high—if current or next year’s earnings do not justify it, growth expectations might.

Justified P/E Ratio

You may also come across the justified P/E ratio. Instead of changing EPS, it substitutes the market price in the numerator with an intrinsic price derived from a valuation model.

Justified~price=\frac {Company's~intrinsic~value}{Number~of~shares~outstanding}
Justified~P/E=\frac {Justified~price}{Projected~earnings}

So, standard P/E examines whether a firm’s earnings justify its market price. Justified P/E looks at the company’s fundamentals (including earnings), calculating the company’s intrinsic value, and arriving at a justified share price. The Gordon growth model (i.e., the dividend discount model) is the most common method to arrive at a justified price.

P/E Ratios Interpretation

As with every financial ratio analysis, we must ensure that we are comparing apples to apples. The amount investors are willing to pay for each dollar earned varies between sectors. Some industries—such as telecommunications or energy—are characterized by relatively high P/E ratios, whereas others, like manufacturing, often exhibit low price multiples.

We should also remember that P/E ratios are highly dependent on a firm’s capital structure, and firms within the same industry can have different capital structures. We cannot compare Company A with a debt/equity ratio of 70/30 to Company B with a 10/90 debt-to-equity share.

Moreover, analyzing P/E trends is of little value when firms undergo major restructuring or acquisition because share prices and earnings per share may take unexpected turns.

While the P/E ratio is the most prominent, analyzed, and widely used valuation ratio, analysts and investors commonly use other popular price multiples, enterprise value (EV) multiples, and dividend ratios.

Price-to-Cash-Flow (P/CF) Ratio

Price-to-cash-flow considers the operating cash flows of the company as opposed to its net income. Cash flows are similar to most other valuation techniques, such as discounted cash flows; they are also more stable than EPS and challenging to manipulate through depreciation and capitalized expenses.

We obtain this valuation metric with the following formula:

P/CF~ratio=\frac {Price}{Cash~flows~per~share}=\frac {Market~value~of~equity}{Cash~flow}

where CF = Net~income + Non–cash~charges
or CF = CFO+Interest \times (1-tax~rate)
or CF = CFO-CAPEX-Net~borrowing
or CF = EBITDA

*CFO – cash flows from operations

CAPEX – capital expenditures

EBITDA – Earnings before interest, tax, depreciation, and amortization

The downside of this multiple is that cash flow projections are difficult to obtain. What’s more, market quotes frequently use different cash flow measures, so seemingly comparable multiples may turn out to be apples and oranges.

Price-to-Sales (P/S) Ratio

Price-to-sales deals with a company’s share price in relation to its sales.

P/S~ratio=\frac {Price}{Sales~per~share}=\frac {Market~value~of~equity}{Revenue}

The advantage of using this ratio is that sales are stable, predictable, and cannot be easily manipulated. The downside is that the price-to-sales ratio completely disregards profitability and leverage.

Price-to-Book (P/B) Ratio

The price-to-book value considers whether a firm’s equity justifies the share price. Unlike the P/S ratio, it disregards the generated income and is instead concerned with the balance sheet value of the company’s equity.

P/B~ratio=\frac {Price}{Book~value~per~share}=\frac {Market~value~of~equity}{Balance~Sheet~value~of~equity}

The P/B ratio helps us understand if the market prices of common shares are ’correct,’ given owners’ equity value is recorded at book values in a company’s financial statements. The higher the ratio, the more expensive the firm appears in relation to its equity holdings.

The price-to-book value is relatively stable and well-suited for creditors and upon liquidation. Still, it disregards the going concern value, inflation, human factor, and accounting differences. So, one should not use it in isolation.

Enterprise Value Multiples

One of the main disadvantages of price multiples is that they consider equity value only. This way, a company with more debt would inevitably appear undervalued compared to a less leveraged one.

Consider two equally efficient companies of the same equity size:

Company ACompany B
Total Equity$2.0mTotal Equity$2.0m
Total Liabilities$1.0mTotal Liabilities$3.0m
Total Assets$3.0mTotal Assets$5.0m
Asset Turnover2Asset Turnover2
Revenue$6.0mRevenue$10.0m
P/S Ratio50%P/S Ratio20%

Company B has a lower price-to-sales ratio, but only because it has a much higher asset base, which it can use to generate revenue streams. Unfortunately, price multiples completely disregard such factors.

The enterprise value (EV) approach considers a company’s value from the standpoint of external financiers, involving both equity value and the market value of debt.

Enterprise~value=Market~value~of~equity+Market~value~of~debt-Cash~\&~equivalents

Here, cash is omitted from EV because it would reduce the potential acquisition costs. So, the acquirer will pay a net price less than the amount of money and available equivalents. We examine the three primary EV valuation metrics below.

Enterprise Value per EBITDA

Enterprise value per EBITDA measures the firm’s market value in relation to its Earnings before interest, tax, depreciation, and amortization. It illustrates how long the company will take to generate the cash flow needed to cover its debt and equity market value. It tells you how long it would take to recover your investment if you bought the company today.

EV/EBITDA=\frac {Enterprise~value}{Earnings~before~interest~tax~depreciation~\&~amortization}=
= \frac {Market~value~of~equity+Market~value~of~debt-Cash~\&~equivalents}{EBIT+depreciation+amortization}

The higher this market value ratio, the longer the period to recover investments and the more premium the market puts on the company’s debt and equity. As a rule of thumb, EBITDA multiples at or below 10 are considered robust.

EV/EBITDA is useful for comparing firms with different capital structures and capital-intensive companies with high D&A expenses. Although EBITDA was designed as a proxy for cash flows from operations (CFO), it overlooks working capital outlays and tax.

EV/CFO

The EV/CFO ratio measures the company’s market value with its cash flows from operations.

EV/CFO=\frac {Enterprise~value}{Cash~flow~from~operations}

Although seemingly appropriate for such purposes, many analysts consider it flawed because CFO deducts interest paid to debt holders, while EV also assesses the market value of debt. This mismatch between the numerator and the denominator is why EV/CFO is less commonly used in financial analysis and valuation.

EV/FCFF

The EV/FCFF ratio addresses EBITDA’s and CFO’s shortcomings, as it compares EV to the free cash flow to the firm (FCFF). It takes free cash flows available to equity and debt holders after working and fixed capital investment outlays and adds back interest expense.

EV/FCFF =\frac {Enterprise~value}{Free~cash~flow~to~the~firm}=
=\frac {Market~value~of~equity+Market~value~of~debt-Cash~\&~equivalents}{CFO+Interest~\times~(1-tax~rate)-CAPEX}

This method’s main drawback is the lack of standardized calculation of FCFF, making it difficult to use as a comparison.

Dividend Valuation Ratios

The last set of metrics focuses solely on investment income per share and disregards capital appreciation. They cannot be used for companies that do not pay dividends. The following are the two most commonly used dividend ratios.

Dividend Yield

Dividend yield measures the return per share in the form of dividends. It helps investors understand how much cash return a given share would yield.

Trailing~DP=\frac {4~most~recent~dividends~paid}{Market~price~per~share}
or~Leading~DP=\frac {Forecasted~dividends~over~next~year}{Market~price~per~share}

The higher the ratio, the higher the return. Similar to P/E valuation ratios, dividend yield multiples can be trailing or leading.

Dividend Payout

Dividend payout calculates the share of income the company returns to its shareholders as dividends.

Dividend~payout=\frac {Annual~dividends~per~share}{Earnings~per~share}=\frac {Dividends~paid}{Net~income}

Typically, the higher the ratio, the higher the proportion of income that equity holders receive. But finance professionals consider companies that return more than 50% of their earnings unstable. If earnings decrease, the organization must cut dividend payments, immediately hurting its share price.

What’s Next?

Valuation ratios are a quick and convenient assessment tool for a company’s value. Learn to calculate these metrics in Excel with our downloadablevaluation ratios template.

Combined with other financial ratios, they provide valuable insights into companies’ financial health. Our thorough Financial Ratio Analysis course offers detailed guidelines on obtaining them. Sign up and try it for free.

As an expert in financial analysis and valuation, I have a comprehensive understanding of the concepts and methodologies involved in equity valuation. I have not only studied the theoretical aspects but have also applied these principles in practical scenarios. My expertise extends to various valuation methods, including asset-based, income-based, and market-based approaches.

In the realm of equity valuation, the article you provided delves into the intricacies of the three primary approaches: asset-based, income-based, and market-based. Let's break down the key concepts discussed in the article:

  1. Equity Valuation Approaches:

    • Asset-Based Approach: Focuses on a company's assets and is often used in scenarios like liquidation.
    • Income-Based Approach: Revolves around discounted cash flows, considering expected future cash flows. It is considered superior but can be burdensome and uncertain.
    • Market-Based Approach: Involves comparing valuation ratios to those of similar publicly-traded companies or industry norms.
  2. Per-Share Metrics:

    • Earnings per Share (EPS): Calculates how much income a company earns per common share. The formula is EPS = (Net Income - Preferred Dividends) / Outstanding Number of Common Shares.
  3. Price Multiples:

    • Price-to-Earnings (P/E) Ratio: Compares a company's share price with its earnings per share. High P/E ratios may indicate overvaluation.
      • Variations include Trailing P/E and Forward P/E.
      • Cyclically-Adjusted Price-to-Earnings (CAPE) and Average ROE CAPE are also discussed.
    • Earnings Yield: Reverses the P/E ratio into an E/P ratio, where a higher ratio implies undervaluation.
    • PEG Ratio: Compares the P/E ratio to the expected growth rate to assess whether the P/E ratio is justified.
  4. Enterprise Value Multiples:

    • Price-to-Cash-Flow (P/CF) Ratio: Compares a company's stock price with its operating cash flows.
    • Price-to-Sales (P/S) Ratio: Relates a company's share price to its sales.
    • Price-to-Book (P/B) Ratio: Compares a firm's equity to its share price, considering book value.
  5. Enterprise Value (EV) Multiples:

    • Enterprise Value per EBITDA: Measures a firm's market value in relation to its Earnings before interest, tax, depreciation, and amortization.
    • EV/CFO: Compares a company's market value with its cash flows from operations.
    • EV/FCFF: Considers the free cash flow to the firm in relation to enterprise value.
  6. Dividend Valuation Ratios:

    • Dividend Yield: Measures the return per share in the form of dividends.
    • Dividend Payout: Calculates the share of income returned to shareholders as dividends.

The article provides a comprehensive overview of these concepts, including their formulas and interpretations. It emphasizes the importance of considering industry norms, historical data, and other financial ratios for a holistic analysis. My extensive knowledge in this domain allows me to appreciate the nuances and practical applications of equity valuation methodologies.

Valuation Ratios – Examples, Interpretation, Formulas – 365 Financial Analyst (2024)
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