The ratios presented so far are aimed at appraising a companys performance to get a better understanding of its intrinsic value. If a business were an orchestra, productivity, financial structure, and profitability would be sections, like brass, woodwinds, and strings. The total sound produced depends not just on individual sounds made by individual instruments but also how they work together to produce music.
Now heres the critical question: As a music buff, how much would you pay to listen to it? Thats the question that valuation ratios try to answer: How much would you pay for tickets to this concert? Here, finally, the stock price enters the stage.
And now, the most popular ratio of all, the one seen in the newspaper, heard about on talk shows, found in all those beginning books on investing, makes its appearance here: the price – to – earnings ratio.
Alongside P/E, other valuation ratios, including price – to – sales, price – to – book, and a couple of boutique P/E variations, enter the mix.
Price – to – earningsMost investors are probably familiar with P/E, so the calculation doesnt need to be illustrated here. Rather, it makes sense to share a couple of useful derivatives: earnings – to – price and price – earnings – to – growth, both of which bring greater understanding to the base P/E measure. Chapter 4 also explores P/E in greater detail.
Earnings – to – price
Take our construction products manufacturer example: 17.6 was a recent P/E based on a share price of $33 and TTM earnings of 1.87. Earnings yield would thus be 1/17.6, or 5.7 percent. Whats the significance? This investment could be compared to a long – term Treasury security as a prospective investment. Which investment is better? An investment in that business returns more and, while being riskier, affords the opportunity for gain through growth. The difference in earnings yield illustrates the basic risk/return tradeoff between investing in corporate equities versus safe fixed – income Treasuries.
Price – earninqs – to – qrowth
Investors pay more for companies with greater growth prospects. Greater growth prospects mean greater earnings and greater earnings yields sooner. From this comparison, you get a ratio known as price – earnings – to – growth, or PEG:
Price – earnings – to – growth = P/E earnings growth rate
If Cisco has an earnings growth rate of 25 percent, while our sample manufacturer is 10 percent and Bank of Americas is 5 percent, then PEG is 27.4 25 or 1.1 for Cisco, 17.4 10 or 1.74 for our company, and 10 5 or 2 for Bank of America. If youre confident in the sustainability of the growth rates, youd pick Cisco as the best investment because its P/E is modest compared to its growth rate.
Price – to – sates
2.0 isnt out of hand, but the business had better grow consistently into its valuation. P/S can be a way to filter out unworthy candidates.
Price – to – book
Heres the formula:
Some book value measures include intangible assets, and others exclude them.
Value investors use price – to – book a bit like price – to – sales: as a test for obvious lack of value. P/B of 1.0 is very good – unless the asset base is a bunch of rusty unused railroad tracks. P/B of less than 1.0 signifies a buying opportunity if book assets are quality assets. A price way out of line with book had better be justified by conservative asset valuation or by the nature of the industry. In the software industry, for example, if R&D is properly expensed and intellectual capital intangibles are aggressively amortized, book value and P/B will be low. Again, like elsewhere, trends and apples – to – apples comparisons are important.
Market cap
When calculating price – to – sales ratios or other valuation measures, its sometimes easier to look at aggregate rather than per – share amounts. Sales are reported as an aggregate figure, not as a per – share figure. So to compare apples to apples, you can look at aggregate share valuation instead of the per – share price.
This aggregate figure is known as market capitalization, or market cap for short. Market cap is simply the number of shares times the stock price. Divide total market cap by total sales, and you have the price – to – sales ratio.
