Investors put their money in stocks according to endless types of strategies. However, before investing in a company, they should always check several main ratios that determine the valuation of a certain business. Defining the value of a stock may be pretty complex and it depends on how much deep you want to dig.
There is never enough information an investor can accumulate during research. There are many financial ratios, but this article will show you the five most important valuation measures you should know about and look at while thinking about investing your money in specific stocks.
Price-to-Earnings (P/E) ratio
How the P/E ratio is calculated = stock price/earnings per share
P/E is one of the most popular and used stock metrics in the world. It shows how much more investors are willing to pay for a stock above its yearly earnings per share. For example, tech stocks use to have a very high P/E, mainly during bull markets. Amazon currently has a P/E of 81.61 despite its 50% drawdown in 2022.
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If a stock’s P/E ratio is 15, it means investors are willing to pay 15 times its annual earnings per share to own it. While opinions vary on what is expensive or cheap, it’s important to remember that the higher the number, the more overvalued the company becomes. Nevertheless, the stock may still continue to rise if its growth rate is strong.
So a company with a high P/E and slowing growth rate is utterly a bad sign as investors may dump it and look for a better investment. P/E of 5 to 20 is considered cheap, while P/E over 60 is seen as too high. The P/E ratio of the S&P 500 index actually reached 120 before the financial crisis started in 2008. The P/E ratio may be good for measuring whether a company is undervalued or overvalued, but there is an even better ratio for that – P/B.
Price-to-Book (P/B) ratio
How the P/B ratio is calculated = stock price/book value per share
This ratio shows the company’s value relative to its net asset value (book value). It effectively reveals what the company owns versus what it owes, or assets versus liabilities. So, a low P/B ratio may mean the stock is undervalued, while a high P/B may point to a possible overvaluation. For instance, Apple’s P/B at the moment is 44.6, which is considered significantly overvalued.
The P/B ratio shows how much people on the market value a company’s equity compared to how much it is worth on paper. The market value of a stock is a forward-looking metric that reveals how much money a company will make in the future. The book value of equity is an accounting measure based on the “historic cost principle.”
It points out how much equity was issued in the past, how much money was made or lost, and how dividends and share buybacks changed that amount. All that bundled together is what forms a P/B ratio, which is a great fundamental metric tool. If a company has a P/B ratio of 1, it is fairly valued. If it is below 1, it is considered undervalued.
Companies with more than the value of 5 P/B may be overvalued, but there is no peak to that as you can see. Apple stock’s P/B is 44.6. That’s extremely overvalued. It’s important to remember that tech stocks tend to be overvalued in the long-term as they are valued differently to, let’s say, mining companies.
Price-to-Sales (P/S) ratio
How the P/S ratio is calculated = stock price/sales per share
Some companies may have high quarterly sales (revenue) but low earnings (profits). This could be because they spent a big chunk of their sales. Some investors are willing to forget about profitability now if it means the company could turn profitable in the future. They know that some firms may need to spend their cash and quarterly sales profits to build a bigger and better company for the future.
Sales are the most important thing here. That is why Spotify, Airbnb, Uber, and other similar businesses achieved such a high valuation while not bringing a positive cash flow. The price-to-sales ratio shows how much more investors are willing to pay for a company’s stock than its revenue. When compared to earnings, sales are less likely to be manipulated by management.
Sales are sales, the end of the story. Even though different costs can affect earnings, it’s easy to figure out how much a business makes in sales. That is why P/S is one of the most important ratios to look at while considering an investment in a company.
Price to Free Cash Flow (P/FCF) ratio
How the P/FCF ratio is calculated = market capitalization/free cash flow
A common method of valuing a company’s stock is through the price-to-free-cash-flow (P/FCF) ratio, which takes into account the current market price of a share and the company’s free cash flow from operations. FCF is calculated by subtracting capital expenditures (CAPEX) from a company’s total operating cash flow; this statistic is comparable to the valuation metric of price to cash flow but is seen to be more accurate because it uses free cash flow.
Free cash flow is vital because it is a leading indicator of a company’s ability to generate extra revenues, which is a major factor in determining the stock’s price. Given that the price to free cash flow ratio is a valuation tool, a low value suggests that the stock is inexpensive with respect to the company’s free cash flow.
For the opposite side of the spectrum, a high price to free cash flow ratio may suggest that the stock is overvalued. That is why value investors look for companies with low or declining P/FCF levels, which often reflect high or increasing free cash flow totals and relatively low share prices relative to other companies in the same industry.
So the lower price to free cash flow, the more attractive the stock becomes. For example, Meta’s P/FCF ratio is 11.34 after the stock dropped by around 70% in 2022. This is a better number than the one of Netflix, as Netflix’s P/FCF ratio is 190.49 as of December 9th.
Debt-to-Equity (D/E) ratio
How the D/E ratio is calculated = total liabilities / total shareholder’s equity
And lastly, the debt to equity ratio is something investors should watch out for, especially in 2022 when debt is expensive. This is similar to the P/B ratio as it shows what a certain company owes versus what it owns. As with other valuation metrics, the lower the value of this ratio, the better it is. Generally speaking, investors prefer D/E ratio to be below 1, while D/E over 1 poses a higher risk.
The D/E ratio is basically a way to interpret a company’s financial leverage. Too much leverage might be devastating, while using a little leverage may be smart and beneficial. It’s an important evaluation tool as it shows to what degree is a company financing its business through its own resources or debt.
The data essential to calculate the D/E ratio is available on a company’s balance sheet. Companies that use debt to their advantage in a smart way may quicken their growth and stock price increase. This ratio doesn’t provide investors with a complete picture as any single ratio.
Thus, investors need to combine the usage of several ratios with other research and analytical methods. It’s not that simple. A certain stock is not cheap just because P/B is 0.5, or a D/E ratio of 0.2 means buy the stock. It’s all like puzzle pieces that need to be put together. Once you start putting the pieces together, the whole picture might become clearer.