Valuation Metrics
A valuation metric for a stock is basically a tool used to help determine whether a stock is high priced, fairly priced or a bargain. There are more valuations metrics out there than there are trophies on Tiger Woods’ mantle, but the most important thing to remember is not to put too much weight on any particular valuation metric. In this section we’ll discuss the most prominent valuation metrics: the p/e ratio, price/book, and price/sales. All of these metrics are quite easy to calculate.
The p/e Ratio
The p/e ratio is the most known of any valuation metric. The p/e is found by dividing the price by the earnings. Investors often use the past year’s earnings or future earnings that analysts estimate to calculate the p/e. Remember from our previous discussions how deceptive earnings can be. Often times the best way to use the p/e is for comparison purposes. Comparing the p/e ratio of a company to its past can be helpful to determine how reasonably priced a company is at a current point in time. The New York Times Business section provides the p/e for a company’s history under the charts section. You can also check with your broker.
Also, it can be helpful to compare a p/e of a particular firm to that of industry. If you find a company with a p/e below that of industry you might have a potential bargain on your hands. It is important to not to compare companies of different industries. Studying the p/e of a steel company and then comparing it to the p/e of a finance company doesn’t make sense.
The most important use of the p/e could be a comparison with the growth rate. Normally, you expect the growth rate to be equal to the p/e ratio. If the growth rate is much higher than the p/e then the stock may be a very attractive investment.
Price/Book
The price/book ratio compares the price to the “book value.” The book value is the value or worth of all of the company’s assets. The price/book is calculated by dividing the price by the book value. The idea here is essentially very simple. If the price to book is less than 1, then the company’s asset are worth more than the actual company and you have an asset play on your hands. You have to be very careful when considering book value. Sometimes, the book value doesn’t represent the true value of the firm’s assets. Consider a tech company with a bunch of inventory that it counts as book value. If this inventory is a year old then this inventory may be worthless due to changes in the technological landscape. When looking for an asset play, investors try to find items that are understated compared to their book value like land.
Price/Sales
The price/sales ratio is similar to the p/e except you use a company’s sales instead of earnings. This metric is used instead of the p/e mostly when a company doesn’t have positive earnings. Like the p/e, it is best to compare the price/sales with the industry averages as well as a company’s history.
Price/Free Cash Flow
Price/Free Cash Flow is the least well known of all of the metrics we have talked about. To find Price/Free Cash Flow you take the price and divide it by Free Cash Flow (FCF). Price/FCF is best used when you are comparing companies in the same industry. Unfortunately, industry statistics on this metric are often hard to find. Often times, we use Price/FCF to compare a company with its top competitors to determine if the firm is attractively priced.