Stock screening is a vital part of any portfolio that has an interest in long term investments, which is why we’re answering “How to value a business?” with 8 of the most important financial ratios for value investing.
Financial ratios provide vital metrics to for value investors who are looking to valuate companies for long term investments. They should be the cornerstone of your valuation process and fundamental analysis. That’s why we’ve investigated 7 of the most important financial ratios for you.
How to Value a Business: 7 of the Most Important Financial Ratios
1. Price to Earnings Ratio
The price-to-earnings ratio (a.k.a. the P/E ratio) is calculated by dividing a stock's share price over its earnings per share. This results in a representation of how much the company’s investors are willing to disburse for each pound of the company's earnings.
Equation: Stock share price / Earnings per share
The P/E ratio is vital because it allows you a measuring stick to compare valuations across companies (however, specifically not across industries).
2. Price to Book Ratio
The price-to-book ratio (or P/B ratio) is calculated by dividing a stock’s share price over its net assets (assets less intangible items). This gives a representation of what investors are willing to disburse for each pound of the company's assets.
Equation: Stock share price / Net assets
Valuating less the intangible assets (such as goodwill or intellectual property) is an vital element of the price-to-book ratio. It means that the P/B ratio indicates what investors are paying for real-world tangible assets, making it quite a safe (conservative) metric to value by.
3. Debt Equity Ratio
The Debt Equity Ratio is calculated by dividing the total liabilities of a company over the shareholders’ equity. This creates a fairly firm measurement of the company’s financial leverage.
Equation: Total liabilities / Shareholders' equity
The D/E ratio indicates how much debt a company is using to finance its assets relative to the amount of value represented in shareholders’ equity.
4. Price to Free Cash Flow
The Price to Free Cash Flow ratio is calculated by dividing the marketing capitalisation value of a company over its total free cash flow. This value represents how much cash a company actually possesses after capital investments.
Equation: Market capitalisation value / total free cash flow
A company's reported earnings doesn’t often match up with their cash flow, as most companies report earnings on an accrual accounting system and not on the balance of their bank account. Free cash flow solves this problem.
5. PEG Ratio
The price/earnings to growth ratio (or PEG ratio) is calculated by dividing the price to earnings ratio by the earning’s growth rate. The PEG ratio gives an indication of the growth potential of a stock coupled with its P/E value.
Equation: Price to earnings ratio / Earnings growth rate (which can be found here)
Valuating stocks on their PEG ratios will help to find companies that are potentially undervalued and give an idea of the growth potential.
6. Enterprise Multiple
The Enterprise Multiple ratio (or EV/EBITDA) can be calculated by dividing the enterprise value of a company by its EBITDA (Earnings before interest, taxes, depreciation, and amortization). The EV/EBITDA ratio is used to firmly value a company, while considering the company’s debt.
Formula: Enterprise Value / EBITDA
The most fantastic element of this ratio is that it takes debt into account, unlike other ratios (like the P/E ratio). That's why, when you're wondering how to value a business, this is one ratio to keep in mind.
7. Price to Sales
The price to sales ratio can be calculated by dividing the company’s market capitalisation by its total sales over any 12-month period. This contrasts a company’s revenue (sales) against its stock price, hence representing the value for each dollar of a company’s sales.
Equation: Market capitalisation / total sales over a year
A low ratio may suggest the possibility of an undervalued company, where a high ratio may suggest an overvaluation.
If you’d like to see how you can put these ratios to use in stock screening, then download one of our eBooks or schedule a free STRIDE demo.