Valuation Ratios and Its Types

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What are valuation ratios?

Valuation ratios are financial metrics that helps to evaluate whether a company is overvalued or undervalued when compared to a certain measure, such as price and enterprise value. In other words, valuation ratios help to determine the cost of an investment with respect to the value or benefits of owing that investment.

 

Types of valuation ratios

a) Earnings Per Share: It measures earnings of the company per outstanding share.  It indicates how much money a company earns for each share of its stock.

A high EPS indicates greater value as investors will pay more if they think company has higher profits relative to its share price. Higher EPS is more desirable than low EPS as it means that the company is more profitable and has more profits to distribute to its shareholders.

 

b) Price/Earnings Ratio: It measures the current share price of a company relative to its Earnings Per Share (EPS). This ratio is used by investors to determine relative value of company’s shares in an apple-to-apple comparison.

A high P/E ratio indicates that company’s stock is over-valued and low P/E ratio indicates that the company’s stock is under-valued. Conversely, high P/E ratio indicates that the investors are optimistic and are expecting high growth in futures and low P/E ratio indicates that investors are pessimistic about company’s future growth.

 

c) Price/Book Value Ratio: It measures the current share price of a company relative to its book value per share. Book value is defined as the net asset value of the company and is calculated by adding up total assets and subtracting liabilities. In other words, if a company is liquidating all of its assets and paid off all its liabilities, the value remaining would be company’s book value.

Lower P/B ratio indicates that stock is undervalued, and high P/B ratio indicates that the stock is overvalued. Theoretically, P/B ratios under 1 are typically considered solid investment.

 

d) Price/Sales Ratio: It measures the current share price of a company relative to its revenue. It shows how much investors are willing to pay per rupee of sale.

Lower P/S ratio indicates that stock is undervalued, and high P/S ratio indicates that the stock is overvalued. One downside of P/S ratio is that it does not consider whether a company is earning profit or not.

 

Interpretation of Valuation ratios

High valuation ratios means that the company is over-valued but what value should be considered high and what low? Axis Bank has a P/E ratio of 31.13 and Kansai Nerolac has a P/E of 56.89. Does this mean that Kansai Nerolac is overvalued and Axis Bank is undervalued? No. Average P/E of banking sector is 28.25 and average P/E of paint industry is 86.12. It means that Kansai Nerolac’s P/E is lower than industry average and Axis Bank’s P/E is higher than industry average. It is always better to compare valuation ratios with industry benchmark or compare it with company’s competitors. It is necessary to find the right pair of competitors. A right competitor is the one who is of the same size, operates within the same industry and same geographical location.


Example


EPS = (5,00,000 – 50,000) / 1,00,000

        = Rs4.5

 

P/E ratio = 10 / 4.5

                 = 2.22

 

P/B Ratio = 10 / [ (6,00,000 + 50,000 – 1,25,000 – 25,000) / 1,00,000 ]

                  = 10 / (5,00,000 / 1,00,000)

                  = 10 / 5

                  = 2

 

P/S Ratio = 10 / (15,00,000 / 1,00,000)

                 = 10 / 15

                 = 0.66

 

Final Words:

Valuation ratios helps to determine whether a company is undervalued or overvalued. Remember, valuation ratios are not the only ratios you should track. Along with valuation ratios, look for profitability ratios, liquidity ratios, turnover ratios and solvency ratios as well as do your exhaustive research before investing.

 

Happy Investing!

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