5 Price Ratios For Analyzing Stocks by Mitchell Mauer
This article appeared first on The Stock Market Blueprint Blog.
What Are Price Ratios?
Price ratios are quick and easy metrics to use when analyzing investment opportunities. They tell investors how high or how low a stock is valued relative to a business’s financial results.
What does value investing really mean? Q1 2021 hedge fund letters, conferences and more Some investors might argue value investing means buying stocks trading at a discount to net asset value or book value. This is the sort of value investing Benjamin Graham pioneered in the early 1920s and 1930s. Other investors might argue value Read More
Low price ratios are an important characteristic of a value stock. They provide an opportunity for investors to buy the stock at a relatively cheap price.
The most widely used price ratios are:
- Price-to-Book (P/B)
- Price-to-Earnings (P/E)
- Price-to-Sales (P/S)
- Price-to-Free Cash Flow (P/FCF)
- Enterprise Value/EBITDA (Enterprise Multiple)
Here is a breakdown of each and an explanation on how they can be used to analyze individual stocks.
Price to Book (P/B)
Calculation: (P/B) = Share Price/Book Value per Share
Definition: Book value is found on the balance sheet. It’s calculated as total assets minus total liabilities. In theory, book value is the amount of money available to shareholders if the company stopped operating. The formal name for book value is shareholder’s equity.
How it’s used: The P/B ratio compares a stock price to the net assets of a business. Since the purpose of a business is to make money from the assets it owns, a profitable company will be priced higher than its book value. A company with a negative outlook and declining profits could be priced below its book value.
Pros: Analyzing a company’s book value allows investors to know exactly what they are buying at a particular point in time. Net asset values are relatively stable and do not drastically change from one quarter to another.
Cons: Assets and liabilities are accounting figures which are subject to inexact measures and can easily be manipulated by dishonest managers.
Price to Earnings (P/E)
Calculation: (P/E) = Share Price/Earnings per Share
Definition: Earnings is found on the income statement. It’s calculated as total sales minus all expenses, including taxes and interest. Per accounting standards, earnings is a company’s total profit. Another name is net income.
How it’s used: The P/E ratio compares a stock price to the net profit of a business. Since investors are paying for future profits, a growing company will have a higher P/E ratio than a company with flat or negative growth.
Pros: Pricing a stock based on a company’s earnings gives investors an idea of what an investment will return to them in the form of profits.
Cons: Earnings are not the same as cash. The farther down an item is on the income statement, the more room there is for manipulation. Because earnings are the last line on the income statement, it does not give an accurate sense of a company’s operating profit.
Price to Sales (P/S)
Calculation: (P/S) = Share Price/Total Sales per Share
Definition: Sales is found on the income statement. It’s simply the total sales generated by the business. Another name for sales is revenue.
How it’s used: The P/S ratio compares a stock price to the total sales of a business. Typically, either growth or profit margins determine the level of a P/S ratio. If a company is growing rapidly or has large profit margins, the P/S ratio will be high. If a company has slow or no growth or has tight profit margins, its P/S ratio will be lower.
Pros: Sales is the top line on the income statement. This means there is very little opportunity to manipulate this number.
Cons: A company’s sales does not paint a full picture. It’s hard to grasp how much profit a business generates without accounting for its expenses.
Price to Free Cash Flow (P/FCF)
Calculation: (P/FCF) = Share Price/Total Free Cash Flow per Share
Definition: Free Cash Flow is found on the statement of cash flows. It’s calculated as operating cash flow minus capital expenditures. Unlike earnings, free cash flow accounts for all cash received and all cash spent by the business. It’s the amount of money leftover after the given operating period.
How it’s used: The P/FCF ratio compares a stock price to the net cash generated by a business. A growing company will have a higher P/FCF ratio than a company with flat or negative growth.
Pros: Because cash is cash, investors can be confident that the FCF amount listed is accurate. FCF is calculated after subtracting capital expenditures. This gives a really clear picture of how much money a business is actually generating.
Cons: FCF can change drastically from year to year depending on the purchases a business makes or the capital expenditures it invests in.
Enterprise Value to EBTDA (Enterprise Multiple)
Calculation: (EV/EBITDA) = Enterprise Value/EBITDA per Share
- Enterprise Value = Market Capitalization + Total Debt + Minority Interest + Preferred Stock – Cash, Cash Equivalents & Short-Term Investments
- EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization
In the previous four price ratios, price was equivalent to market capitalization. For the Enterprise Multiple, enterprise value is used in place of market capitalization. Per the equation above, enterprise value includes market cap, but it also accounts for debt and access cash.
EBITDA is essentially the operating cash flow of a business because it doesn’t include interest, taxes, depreciation, or amortization.
How it’s used: The Enterprise Multiple compares the total cost of acquiring a business to the operating cash flow the business generates. Similar to the P/E, P/S, and P/FCF ratios, a growing company will have a higher Enterprise Multiple than a company with flat or negative growth.
Pros: Enterprise value is a more accurate description of what a business costs than market capitalization. Where market capitalization prices the equity of a business, enterprise value prices the equity plus liabilities. By not including interest, taxes, depreciation, or amortization the metric compares the operational structure of the business, rather than letting a company’s financing, accounting, and tax structures affect its profitability.
Cons: Just as with sales, EBITDA does not paint a full picture of a company’s net profit. There are a lot of expense items not accounted for.
The Value Premium
The value premium is a phenomenon which says stocks with low price ratios consistently provide better returns than stocks with high price ratios. This phenomenon has been proven in numerousacademic studies over the last 25 years.
You can find stocks with low price ratios using any of the multiple stock screens atTheStockMarketBlueprint.com.
About Mitchell Mauer
Mitchell Mauer is the Founder of TheStockMarketBlueprint.com. The Stock Market Blueprint is a free site that finds value stocks for investors building long-term wealth. The site’s investment philosophy is anchored in principles established by Benjamin Graham and his most reputable followers over the last 100 years.