Key Ratios for Fundamental Analysis of Stocks: Investment Valuation (Part 1)

Introduction to a possibly exhaustive set of ratios used to evaluate the quality and fundamentals of a company’s stock in the equity markets.

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Objective

The main objective of this article is to understand what are the various financial ratios that can be used to judge the intrinsic value/valuation of a stock (used alternatively with share/equity going forward), understand the profitability, liquidity, other fundamentals of it and its future prospects from a long term view. Various fund managers use a lot of the ratios that we will look at, to update (+/-) the percent allocation of the stocks they hold or add any new prospective stock to their various funds. Each ratio that we will look at will have a different objective (i.e. indicate a particular feature of the stock). A combination of multiple ratios performing well, will indicate that stock looks good for investing and vice versa.

Prerequisites

The given prerequisites are good to have. I will try to explain most of the terms in detail as much as possible.

1. The basic terms (Revenue, Assets, Liabilities etc) used in the balance sheet of a company.
2. Basic understanding of what equity markets are and how they work.

Let us put that lens (Photo by Scott Graham on Unsplash)

Introductory Terms and Points

1. The time period used to calculate these ratios is annual (usually). Although, one can calculate the ratio for any time period (quarterly, monthly and so on). Certain ratios can also be calculated using a TTM methodology (trailing twelve months). There are various other ways in which these ratios can be calculated and looked at.
2. I would recommend reading through this quick article if you are not familiar with the basic balance sheet terms. It has most of the terms explained which I was going to write here.

Investment Valuation

Investment Valuation is basically the tools and techniques used for determining the value of an asset (in our case the stock). It is basically the derivation of the amount that one should ideally pay for an asset. We will look at the various ratios that can be used to determine whether a stock is overvalued or undervalued.

Investment Valuation Ratios

1. Price Earnings Ratio (P/E Ratio)

Earnings Per Share (EPS) is calculated by dividing the profits of the company by its current share price.

Famously known as P/E ratio, it is the most commonly used ratio which indicates whether a share is overvalued or undervalued.

The P/E ratio helps us understand the market value of a stock as compared to the company’s earnings. In essence, the price to earnings ratio indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company’s earnings.

Although, there are many interpretations of this ratio but the most common is that a high P/E ratio indicates that the share is overvalued (pay more for the share as compared to its earnings) and a low P/E ratio indicates that it is undervalued (pay lesser for the share as compared to its earnings) and has more potential to grow. Also, there is no specific range of this ratio. Usually a company’s P/E is compared with the average P/E ratio of its peers in the same industry to understand its valuation.

2. Price Book Value Ratio (P/B Ratio)

The market capitalization (company’s value) is its share price multiplied by the number of outstanding shares. The book value is the Total assets — Total liabilities and can be found in a company’s balance sheet.

The P/B ratio compares a company’s market capitalization, or market value, to its book value. Specifically, it compares the company’s stock price to its book value per share (BVPS).

In other words, if a company liquidated all of its assets and paid off all its debt, the value remaining would be the company’s book value.

Typically, companies with this ratio less than 1 are considered to be undervalued but this again varies from industry to industry and depends on the running model of that type of company or industry.

3. Price Earnings to Growth Ratio (PEG)

Expected Growth is basically the CAGR (Compounded Annual Growth Rate) of the company or in simple terms how much the company earnings are growing annually.

The PEG ratio(price/earnings to growth ratio) is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company’s expected growth.

In general, the P/E ratio is higher for a company with a higher growth rate. Thus, using just the P/E ratio would make high-growth companies appear overvalued relative to others. It is assumed that by dividing the P/E ratio by the earnings growth rate, the resulting ratio is better for comparing companies with different growth rates.

Typically a value of PEG lower than 1 suggests that the stock is undervalued, higher than 1 is overvalued and equal to one suggests that the stock is fairly priced. In simple terms, if the company’s stock price is rising in sync with its growth rate, it means that the market is replicating the actual growth of the company to the market value of its share.

4. Price Cash Flow Ratio (P/CF)

Operating cash flow is the amount of cash generated by a company’s normal operations. If a company can generate a positive cashflow, it means that it can maintain and grow its operations or else it needs to find external financing for expansion.

Source: https://corporatefinanceinstitute.com/resources/knowledge/accounting/operating-cash-flow/

The price to cashflow (P/CF) ratio is a measure of the value of a stock’s price relative to its operating cash flow per share.

The price-to-cash flow ratio measures how much cash a company generates relative to its stock price, rather than what it records in earnings relative to its stock price, as measured by the price-earnings (P/E) ratio. The price-to-cash flow ratio is said to be a better investment valuation indicator than the price-earnings ratio because cash flows cannot be manipulated as easily as earnings, which are affected by accounting treatment for items like depreciation and other non-cash charges. Some companies may appear unprofitable because of large non-cash expenses, for example, even though they have positive cash flows.

P/CF is especially useful for valuing stocks that have positive cash flow but are not profitable because of large non-cash charges. There is no specific range for this ratio since it depends on the sector and industry of the company. A relatively lower ratio indicates undervalued stock and vice versa.

This is one of my favourite ratios and also very less known ratios. The major reason of me liking this is the inclusion of operating cash flow of the company which is a key component of whether things are moving well in the company or not and whether there are future growth prospects or not. A stagnant or decreasing cashflow is very dangerous for a company.

5. Price Sales Ratio (P/S)

The P/S ratio is pretty straightforward. It is the ratio of the stock price to the annual revenue generate per share or equivalently the ratio of market cap to the annual sales/revenue of the company.

P/S ratio varies from sector to sector and hence a comparison can be made with its peers. Usually a ratio less than 1 suggests that the share is a good buy since the investor is paying less for each unit of sales.

However, a company might be unprofitable and have a low P/S. Hence, along with this ratio there are other metrics to be looked at. This ratio can be used to compare the performance of stock with itself in the past few years and also with its peers in the same industry.

6. Enterprise Value Multiplier Ratio (EVM)

Enterprise Value = Market capitalization + Total Debt− Cash/Cash equivalents

EBITDA = Earnings before interest, taxes, depreciation and amortization​

Enterprise value (EV) is a measure of the economic value of a company. It is frequently used to determine the value of the business if it is acquired. It is considered to be a better valuation measure for Mergers and Acquisitions than a market cap since it includes the debt an acquirer would have to assume and the cash they’d receive.

EVM, also known as the EV-to-EBITDA multiple, is a ratio used to determine the value of a company. EVM takes into account a company’s debt and cash levels in addition to its share price and compares that value to the company’s cash profitability.

This ratio varies from industry to industry. Usually, high growth industries show high EVM and industries with slow growth show lower EVM.

A relatively low EVM indicates undervaluation of the stock. Also, it is better to look at not only the historical value of this ratio but also the expected values going forward for better assurance of the company’s prospects.

7. Dividend Yield Ratio

Investing is not only growth based. There are also a set of income based investors who prefer consistent dividend realization from the company which helps protect the capital and also the stock works as a fixed asset for them (like a FD).

Higher the dividend yield, better is the quality and growth prospects of the stock as it encourages investors to stay invested in the stock and also helps bring in more money/investors. It is important to verify that the dividend disbursement and yield is consistent over a significant period of time (few years).

Let’s say FD interest rate is 5% and the dividend yield from a stock with CAGR = 3% is also 5% (like a PSU company). It would make more sense to invest in this company and get the same interest as dividends along with the stock appreciation.

Summary

I love the concept of how going public increases the possible growth prospects of a company. It depends on how the company and promoters approaches the faith of retail investors (general public), FIIs, DIIs and work harder to grow the company. These ratios and indicators help us as the general public to understand whether a company shows good prospects of consistent growth and hence invest in them.

Disclaimer: These ratios are not the only thing that investors look at before investing. A lot of time the sentiment, promoters long term goals and many other factors play an important role. As suggested earlier, fundamental analysis is majorly used for investing long term rather than short term. Finally, investing in markets is risky and one should be wary of that. I am no expert in the stock markets but I am keenly interested in it and inherently curious, hence keep updating myself.

Note 1: Since this article was getting too big, I decided to discuss the other financial ratios I learned in the upcoming parts. I personally think that reading through all the ratios in one go can become overwhelming.

Note 2: I am thinking of creating a library/module that can calculate all these ratios for all listed companies whose data we can get in an automated manner. In case someone is interested to collaborate, please hit me up on Linkedin.