Analyzing Valuation Ratios to Find Undervalued Stocks

Introduction

Valuation ratios are mathematics tools used to determine a company's financial worth, based off of available information. In an attempt to obtain a company's intrinsic value, these methods offer investors and analysts an insight into whether a specific stock is undervalued. An analysis of these ratios can reveal great potential in a stock, so it's a valuable tool in the investment process.

In this blog post, we'll analyze the different types of valuation ratios, discuss the benefits of valuating stocks and how to identify undervalued stocks. We'll also look at the importance of keeping track of your investments and why it's necessary to update your models when the market changes.

Price to Earnings Ratio

Price to earnings (PE) ratio is one of the most popular metrics used by investors to understand a stock's performance or potential. It is calculated by dividing the current share price of the stock by its earnings per share (EPS) over the course of the past 12 months. Therefore, this ratio helps investors compare the current performance of a company relative to its historical performance.

How to calculate

The formula to calculate PE ratio is as follows:

• PE ratio = Current market price of the stock / Earning per share (EPS) over the past 12 months.

Advantages

The primary advantage of using the PE ratio is that it is easy to calculate, understand and use. Investors can compare the current performance with the past performance of a company to assess whether the company is utilising its investments to generate profits for shareholders or not. This helps them to identify undervalued stocks that can offer higher returns in the future. Additionally, PE ratio also helps investors make decisions in a short time as the information is easily available in the public domain.

Limitations

While PE ratio can be a useful metric in assessing the performance of a company, it has certain limitations. PE ratio is known to be sensitive to market sentiments and often misleads investors. This is because the data used to calculate the PE ratio may not always reflect the company’s true performance or potential. Moreover, PE ratio does not account for the company’s future performances, which makes it difficult to assess the stock accurately.

Price to Book Ratio

Definition

Price to book (P/B) ratio is a valuation metric used to compare a company's current market price to its book value. It is calculated by dividing the current closing price of the stock by the current book value per share. It is essentially a measure of the premium paid for a particular stock compared to its 'intrinsic value'.

How to Calculate

Calculating price to book ratio requires two values: the current market price of the stock and the book value per share. The book value per share can be obtained from the company's financial statements. Once these two values are obtained, simply divide the current market price by the book value per share to get the P/B ratio.

Advantages

The P/B ratio is a useful tool to identify undervalued stocks, as it shows the value placed on the company by the market. A low ratio indicates that the stock may be undervalued and thus an attractive investment. Additionally, the ratio can be applied across different companies in industries to compare relative value.

Limitations

Price to book ratio is not without its limitations. It should not be used in isolation to make investment decisions, as it does not take into account the company's future prospects or other important factors. Additionally, it can be affected significantly by other items on a company's balance sheet such as intangible assets which may not be accurately reflected in the numbers.

• It should not be used in isolation to make investment decisions
• It may be affected significantly by intangible assets on the balance sheet which may not accurately reflected in the numbers

Price to Sales Ratio

Price to Sales Ratio is a method investors use to measure the price they are paying for a company’s stock in comparison to the revenue generated by that company. This ratio is not as commonly used as others such as the Price to Earnings (P/E) Ratio, but it can be helpful in assessing the potential growth of a company.

Definition

The Price to Sales Ratio is calculated by dividing the market price of a company’s stock by its total sales over the past 12 months. This number can then be compared to other companies in the same industry to help investors determine if a stock is undervalued or overvalued.

How to Calculate

The formula for the Price to Sales Ratio is: Market Price Per Share / Revenue per Share. To calculate the revenue per share, simply divide the company’s total sales over the past 12 months by the number of shares outstanding. This will give you the revenue per share, which can then be divided by the market price per share to get the Price to Sales Ratio.

Advantages

One of the key advantages of the Price to Sales Ratio is that it takes into account sales rather than earnings, which are often unpredictable and can be manipulated. This means investors can get a more accurate picture of the company’s future potential. Additionally, the ratio is easy to calculate and can be used to compare companies in the same industry to assess potential growth potential.

Limitations

There are some limitations to using the Price to Sales Ratio. For instance, the ratio does not take into account the effects of debt, making it difficult to accurately compare companies that are in different financial situations. Additionally, the ratio does not take into account changes in the company’s competitive position, which can have a huge impact on the company’s growth potential. As such, it should not be used as the sole method for assessing a company’s stock value.

Dividend Yield

Dividend yield measures the ratio of dividend per share divided by the price per share. It is a way to measure how much dividend income is generated relative to the market value of owning a particular stock. It is typically expressed as a percentage.

How to Calculate?

The calculation for dividend yield is quite simple. It is one of the most basic analytical tools used when investing in stocks. The formula to calculate dividend yield is:

• Dividend yield = Annual dividend per share / Price per share

Advantages

Dividend yield can be useful for investors who want a steady stream of income from their investments. By finding stocks with high dividend yields, investors can increase their portfolio income with less volatility than investing in stocks with no dividends.

Limitations

Dividend yield might not be the most accurate indicator of whether a stock is undervalued or not. It is important to remember that dividend yield can be affected by factors such as the company’s earnings, dividend policy, and the financial health of the business, which may not always be reflected in the stock’s price.

Price to Cash Flow Ratio

Definition

Price to cash flow ratio (P/CF) is a financial metric used to determine the value of a stock by comparing the market price of the stock to the cash flow generated by it. This metric provides an investor with a better insight into the underlying asset’s fair worth and helps identify potentially undervalued stocks.

How to Calculate

The formula used to compute the price to cash flow ratio is the market price of the stock divided by the cash flow per share:

P/CF = Market Price of Stock / Cash Flow Per Share

Advantages

The primary advantage of the P/CF ratio is that it’s a more reliable indicator of a company’s true worth when compared to P/E ratio. It is because the price to cash flow ratio considers the overall cash flow generated by the company, while price to earnings ratio only considers the earnings per share. This allows investors to better assess the fair value of the company and identify potential investments.

Limitations

Price to cash flow ratio is not without limitations. The primary limitation of this ratio is that it does not take into account the amount of debt a company carries. Thus, investors should consider other ratios and metrics in conjunction with the P/CF ratio to get a complete view of the company’s valuation.

Conclusion

Using valuation ratios is a powerful tool investors can use to identify potential undervalued stocks for their portfolio. While investors will still make decisions based on their risk tolerance, an analysis of these ratios can help in the decisions as there are more data points to consider when analyzing a stock.

Summary

This blog has focused on the analysis of various valuation ratios to identify potentially undervalued stocks to add to an investor’s portfolio. We described the four main types of valuation ratios and the ways in which they can be used to analyze individual stocks and the market at large. We detailed the ways to properly analyze each ratio and the assumptions and measures of patience needed when making buy and sell decisions.

Impact on portfolio decisions

As demonstrated, an investor conducting a thorough analysis of these valuation ratios can have a positive impact on their portfolio. Knowing how to properly look at the different components of each ratio and evaluate stocks accordingly can lead to better buy and sell decisions. Additionally, having patience when awaiting the outcome of the market or a stock is important as well when using these ratios.

Valuation ratios are just one tactic for assessing value for individual stocks but understanding the technique and properly evaluating the results can assist the investor when making buy and sell decisions. Armed with this knowledge investors may be able to find potential undervalued stocks and add them to their portfolio.