Most investors are familiar with the price-earnings ratio, or P/E, a quick and easy guide to whether a stock or index is expensive or cheap. But experts have produced a raft of other ratios, such as price-book and enterprise value-EBITDA.
Which ones to you really have to understand to buy and sell stocks without flying blind?
“Using ratios to value companies can be a powerful way to characterize the attractiveness of an investment,” says Aash Shah, a senior portfolio manager at Summit Global Investments in Salt Lake City.
His top five list has ratios used by most professional stock pickers: price-earnings, price-book, enterprise value-EBITDA, price-sales and price-free cash flow.
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Price-earnings. P/E is the big dog in this kennel. “It measures what investors are willing to pay for each dollar of earnings of a company,” Shah says.
It is the stock’s current price divided by the company’s earnings for the past 12 months. Forward P/E uses expected earnings. A $100 stock with $5 in earnings would have a P/E of 20. If 20 was common for his stock and the share price soared to $200, for a P/E of 40, it would be more expensive and riskier, because the price would have to fall by half to get back to the normal level of 20. At $50, a P/E of 10, the stock would look like a bargain.
Wall Street observers often talk about how the 500 stocks in the Standard & Poor’s 500 index have a P/E of around 15 over the long term. Higher P/Es indicate the market is riskier, lower ones that it’s cheap and relatively safe. Many experts say a slightly higher P/E makes sense, however, when interest rates are low, because earnings as a percentage of price (earnings yield) compete better with stingy fixed-income investments.
History shows that investors ignore P/E at their own risk, as during the dot-com bubble of the early 2000s, when investors paid top-dollar for internet stocks that had no earnings at all. A company with no earnings or a sky-high P/E might have a good future anyway, but would still be considered very risky.
“Generally, a lower valuation ratio is preferable for an investment, because it means one is paying a lower price,” Shah says, while noting a high ratio isn’t necessarily bad. “In fact, some of the best-performing companies, such as Amazon (ticker: AMZN)or Netflix ( NFLX), have not exhibited low valuation ratios in many years, yet have been stellar performers. This is primarily because investors view these higher valued companies as having greater future growth opportunities.”
Price-book. This is the current share price divided by book value per share. Book value is the value of the company’s assets minus liabilities and the value of intangibles, such as patents and goodwill.
This ratio “is a running score of the management effectiveness over time and generally gives a good picture of the business,” says Shailesh Kumar, portfolio manager at valuestockguide.com, an investment newsletter.
While a stock is generally more attractive if its ratio falls, it can be misleading to use price-book to compare stocks in different industries, he says in a report on various ratios.
“In general, the industries that depend heavily on capital equipment and inventory, such as manufacturing, commodities processing, etc., will have much of their market value determined by the amount of assets in the business,” Kumar says in the report. “Therefore, the price-book ratio for these industries will be lower. On the other hand, for industries that depend less on assets to generate revenue (for example, service industries where employee skills may be the primary revenue generator), the price-book ratio will be high. One way to think of this is that for asset light industries, the market price of the stock depends more on other attributes of the business and less on the physical assets.”
[See: 8 ETFs for Investors Who Love Value.]
Enterprise value-EBITDA. This is another way to compare a company’s performance to its value. Enterprise value accounts for the value of shares outstanding, liabilities and other factors to determine the company’s value — like the price it might fetch in a sale. EBITDA is earnings before interest, tax, depreciation and amortization, a measure of the company’s performance.
Dividing enterprise value by EBITDA, “is a more useful ratio for companies that have relatively high depreciation and amortization expenses,” Shah says. “Depreciation is a non-cash expense that may suppress earnings per share. Excluding depreciation gives a better estimate of the operating performance of the company, adjusting for the level of indebtedness.”
Price-sales. The current price divided by the annual sales per share. Obviously, a low ratio is better because it means higher sales revenue relative to what you’d pay for the stock — like paying X for a corner grocery with lots of sales revenue rather than a little.
“This ratio can be more useful for some comparisons because revenue is more difficult (although not impossible) to manipulate from an accounting standpoint than earnings,” Shah says.
Price-free cash flow. Free cash flow is cash coming in minus various adjustments like capital expenditures. Dividing it into the share price indicates how much money the company has available to invest for growth. Again, a lower ratio is better.
“Free cash flow generated may be used to reinvest in the company or pay dividends to shareholders,” Shah says.
In fact, S. Michael Sury, CEO of Indorus Holdings, a family office, and adjunct professor of economics at the University of California-Santa Cruz, favors various ratios that use cash flow rather than earnings, because cash flow is less susceptible to accounting variations.
“More recent academic studies have found the predictive power of cash flows to be much stronger than that of accounting-defined earnings,” he says.
While the ratios mentioned, and others, can be valuable tools for investors, they are just a start, Shah says.
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“Numerous other factors, such as management quality, market opportunity, industry competitiveness, market share, return on invested capital, revenue growth, earnings growth, level of indebtedness, etc. are also important for a more complete analysis of a company,” he says.
Investors should also keep in mind that ratios can be skewed by temporary factors, says, Jason A. Cooper, portfolio manager at Stuyvesant Capital Management in Armonk, New York.
“Does a low price-to-earnings ratio indicate that the security is cheap or that their earnings have hit a cyclical high?” he says. “Can a company maintain its juicy dividend yield or will it be cut? Financial ratios should not be seen as a shortcut, but merely a tool in assessing individual investments.”
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5 Ratios Investors Need to Know originally appeared on usnews.com
