If stock markets had an alternative name, it would be ‘Volatility’. The price of every stock changes every second. In such an environment, it becomes very difficult to find out the right price for a share. And this is probably one of the most important aspects of investing in stocks – buying at the right price. Any higher and you compromise on your gains.
This is where stock valuations come handy. The most common ratio used these days is the P/E ratio. Yet, it may make sense to consider other ratios too, which are mentioned below:
The Price to Book Value ratio is probably the second most common ratio used after P/E. Book Value represents the money you, the investor, would get if the company were to be liquidated. It is also called the company’s networth. So, essentially, the P/BV ratio represents how much money you would pay for a stock for each rupee of the company’s assets. The P/BV ratio is most apt for companies in the banking and similar industries with high tangible assets. For example, the IT companies have intangible assets like employee resources, patents, etc. which are not easy to quantify. In such cases, the P/BV ratio may not be handy.
You may know that stock prices are linked to company’s growth. Yet, often the share prices jump at a faster rate than company’s profit growth. This often leads to gross mispricing. The stocks then correct and the prices plunge soon after. This is why analysts use the P/EG or Price to Earnings to Growth ratio, which compares the share prices to the company’s profit growth. To calculate this, you simply divide the PE ratio with the expected growth in the company’s earnings. You then get a value that is either less, equal to or greater than 1. A value less than 1 indicates the stock is undervalued or cheap.
Sometimes, analysts prefer to gauge a company’s profitability in terms of the cash it is generating and not the total profits. This could be because of various reasons – inconsistent accounting practises, lots of non-cash transactions, etc. In any case, cash flows are always ‘current’. Company revenues often take into account money that is yet to come in. So cash flows are considered a better representative of profitability. Analysts then compare the share price with these cash flows instead of net profits. This shows how much money you are shelling out for every rupee the company earns as cash. The downside to this is that cash flows are more volatile and harder to predict than revenues and profits.
How do you evaluate companies that are distressed and earning low profits? In such cases, you use the Price to Sales ratio. As the name suggests, the ratio compares the stock price to the company’s sales. So if a company has a P/S ratio of 20, it means you are paying Rs 20 for every rupee the company earns from selling goods or services. This ratio is considered to be one of the most bankable ratios in stock valuation. It is for the simple reason that the P/S ratio can be used for almost all kinds of companies across industries and sectors.
Earnings yield ratio shows how much earnings you received for the money you spend on your investment. In other words, earnings yield is the inverse of P/E ratio. The convenience of earnings yield is that since it measures the return you received for the money you spend on your investment, it’s makes it easier for you to compare the company’s return against alternative investment options such as bonds or fixed deposits. So, practically it’s more useful than a P/E.
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