Discover the second in the series below about the 5 financial ratios you know best as an investor. How do you know which company to invest in? How can you evaluate the performance and especially the valuation of a stock? Discover 5 ratios that can make your investor life easier.
- Price-Book Value (Price/Book)
Why?
With this ratio, you can easily gain insight into whether a stock is undervalued or overvalued. The ratio is especially useful for comparing the valuation of companies in the same sector.
How to calculate?
At the price-book value, the current price is divided by the book value. The book value is obtained by dividing shareholders’ equity by the number of outstanding shares (excluding preference shares).
How to interpret?
If the book value is greater than the current price (ratio < 1), that could mean that the stock is currently valued cheaply. Conversely, if the book value is lower than the current price (ratio > 1), this may indicate an expensive share. Growth stocks are generally allowed to trade at a higher price-to-book value, as well as companies with cyclical activities. If the ratio is low, always check what could explain the possible low valuation.
This ratio is very sector sensitive. For example, for banks and real estate companies, the book value is a good reference for the value of the company as a whole, while this is much less the case for holding companies and software companies: the book value of the assets often differs greatly from the sales value.
- Price Earnings (Price/Earnings)
Why?
This ratio is useful for comparing the valuation of companies in the same sector, especially for industrial companies. It is above all a good first indicator.
How to calculate?
The expected P/E ratio is calculated by dividing the current share price by the expected net earnings per share for the current fiscal year.
How to interpret?
A high P/E ratio indicates that investors are willing to pay a lot of future profit upfront. In general, at such high ratios, you need to be extra careful and a low number indicates a cheaper valuation. But what is high and what is low? A rule of thumb states that you should use the average price/earnings to distinguish cheap from expensive.
This ratio is a good first indicator but is best used in combination with other ratios. For example, growth prospects are not taken into account (investors are usually willing to pay higher prices for stronger growth) and certain financial elements (a company’s net profit can be embellished with one-off elements).
By the way, did you know that the price-earnings ratio of American equities is consistently higher than that of European equities, due to structurally higher profitability and higher expected earnings growth?
- EV/EBITDA
Why?
This ratio includes the debt position of a company in scope and is, therefore, an excellent additional valuation indicator to compare companies from the same sector.
How to calculate?
The ratio is calculated by dividing the enterprise value by the EBITDA.
Enterprise value = enterprise value . This figure gives a more realistic picture of company value because it adds financial debt and net cash to market capitalization. Because both figures are easy to find on the balance sheet or in press releases, the EV is relatively easy to calculate.
EBITDA = operating cash flow. It is the abbreviation for Earnings Before Interest, Taxes, Depreciation, and Amortization or operating income without taking into account interest, taxes, depreciation, and amortization. The operating cash flow can also be calculated by subtracting the costs for personnel, raw materials, and services from the turnover. It is therefore a good approximation of operating cash flow and lays the foundation for more in-depth stock analysis.
How to interpret?
A lower EV/EBITDA ratio indicates a cheaper valuation. A shareholder will receive a higher return for every euro invested than with companies with a high ratio. The ratio is therefore a mirror of the operational health of a company.
The advantage of the EV/EBITDA ratio is that it takes into account differences in capital structure and is not influenced by differences in tax rates. Capital-intensive companies will be favored because depreciation is not included, while differences in the tax rate often explain why peers quote a different EV/EBITDA.
A disadvantage is that this ratio does not take into account the future growth of the operating result. Investors are more than happy to assign a higher ratio to companies whose operating profits are growing faster than slow growers.
Why?
4. Return on Equity
Return on Equity is a measure of how efficiently a company uses the available resources. The ratio is best used to compare mature companies from the same sector and is, therefore, less suitable for, for example, technology and biotech companies that often make losses in their early years.
How to calculate?
The figures for this ratio are easily found in any financial publication of the company.
The ratio is calculated by dividing net profit (after tax) by shareholders’ equity.
A company’s equity is the resources that the shareholders have made available to the company.
How to interpret?
The credo also applies here: the higher, the better. Suppose a company has an ROE of 20%, this means that the company realizes 20 euros in net profit for every 100 euros in equity.
However, this ratio is also not unambiguous because it does not take into account the way in which a company finances itself. A company with a large debt burden compared to equity can significantly increase its return on equity compared to peers. But a higher debt ratio does carry an increased risk of bankruptcy, especially when a weak economy can cause a sharp drop in profits. It is, therefore, best to also look at the ratio between debt and equity. A healthy balance between the two is desirable, although that balance strongly depends on the sector in question.
Why?
These ratios provide insight into a company’s liquidity or a company’s ability to meet short-term payment obligations.
How to calculate?
5. The current ratio is calculated by:
current assets (stocks, receivables, cash, and easily convertible investments) against short-term debt (invoices to be paid, loans, credits, etc.). Sometimes, when calculating the current ratio, receivables over 12 months are deducted from the current asset. This so-called ‘limited’ current asset offers a more fair comparison with the short-term liabilities.
The quick ratio is calculated by:
(Current Assets – Inventories) / Short Term Debt
This alternative liquidity measure is stricter than the current ratio because it only includes the most liquid elements on the balance sheet. For example, stocks, orders in progress, and receivables after more than one year are not taken into account.
How to interpret?
If the current assets are larger than the loan capital, the ratio will exceed 1, so that short-term obligations can be met. A current ratio of less than 1 can indicate potential liquidity problems and should be classified as a serious problem.
Also for the quick ratio, a ratio greater than 1 must be interpreted positively by the tire. After all, it indicates that the company is able to finance its debts within one year with the assets that are easiest to sell.
Both ratios take a photo at a specific point in time (usually at the end of a quarter or semester) and are therefore subject to a skew effect. At the end of the financial year, companies will make maximum use of cash resources to reduce short-term debt to credit institutions in order not to take on cross-credit positions. This increases both ratios but often does not represent a real improvement in the liquidity position.
A very high ratio is also not fantastic. After all, it can indicate excessively high inventories and trade receivables or – worse – a non-optimized financing method.
