The Top 5 Valuation Ratios Every Investor Should Know

Introduction

Valuation ratios are a fundamental tool used by investors to assess the financial performance, operating efficiency, and growth prospects of a company or industry. These are ratio calculations derived from publicly available financial data such as the company’s financial performance, market activity, capital structure, and debt levels. The ratios are used to assess how much a company or industry is worth and compare it to investment alternatives.

Valuation ratios provide key insights for any investor looking to accurately assess a company's potential for long-term success. By understanding the various valuation ratios which are available, investors can unlock a wealth of information that can help them make more informed investment decisions. In this article, we will be exploring the top five valuation ratios that every investor should familiarize themselves with.

Price to Earnings Ratio

The price to earnings ratio (P/E) is a key ratio used to evaluate stock prices. It is often used to compare different companies in a sector or industry. Simply put, P/E ratio shows a company's stock price relative to its earnings per share.

How to calculate the P/E ratio

P/E ratio can be calculated by dividing the stock price of a company by its earnings per share (EPS).

• Price of the Stock / EPS = P/E ratio

What a Low P/E Ratio Means

A low P/E ratio generally implies that the stock is undervalued. This can mean that the company is undervalued in the market, or that its stock has room to grow because of potential future earnings.

What a High P/E Ratio Means

A high P/E ratio implies that the stock is overvalued in the market and its price is higher than its current or expected earnings. This can mean that earnings expectations for the company or sector are high or that the stock market has overestimated the potential for future earnings.

Price to Sales Ratio

The price to sales ratio (PSR or PS ratio) is a financial ratio used to compare a company's market value of equity to the company's sales. It is used to compare companies that have different examples of accounting and has become a widely used financial ratio when comparing companies since it excludes the impact of different accounting methods.

How to Calculate the Ratio

The price to sales ratio is calculated by taking the market capitalization of the company, which is the number of outstanding shares of the company multiplied by the share price, and dividing it by the company's total sales. This results with a ratio showing the company's market capitalization in relationship to its sales.

What a Low PS Ratio Means

A low PS ratio can be indicative of two different factors. First, it could mean the company has a strong outlook and is therefore trading at a discount. This could be a great investment opportunity as the upside potential may be higher. Additionally, a low PS ratio may indicate that the company's sales are suffering or that the market has an overly negative view on the company's prospects.

What a High PS Ratio Means

A high PS ratio, on the other hand, can be indicative of two different factors. It could be a sign that the market is overly optimistic about the company's prospects, making it too expensive to buy; this is known as being overvalued. Additionally, it may indicate that the company's sales are doing very well and their market value is increasing as a result.

Price Earnings Growth Ratio

The price-earnings growth, or PEG, ratio is used by investors to measure a stock's value relative to its earnings growth potential. In short, the PEG ratio helps investors understand if a stock appears overpriced or undervalued, comparing a stock's price-to-earnings ratio to the expected growth rate of its earnings. The PEG ratio is expressed as a multiple. A ratio of 1 would indicate that the price of the stock is exactly the same as the projected growth rate. A ratio below one suggests a bargain, whereas a ratio higher than one suggests expensive stock.

The PEG ratio can be calculated by dividing the stock’s Price to Earnings Ratio (P/E Ratio) by its Earnings Growth Rate (EGR).

• PEG Ratio = P/E Ratio / EGR

A low PEG ratio suggests that the stock is trading at a discount while a high PEG ratio suggests the stock is overvalued. A PEG ratio of 1 indicates that investors should expect a return equal to the rate of growth of the stock.

When the PEG ratio is low, it indicates that the stock is undervalued and may have future potential to increase in price. On the flipside, when the PEG ratio is high, it indicates that the stock is overvalued and is likely too expensive for the stock’s potential growth.

Debt to Equity Ratio

Debt to equity ratio, also known as D/E ratio, is an important valuation metric used to measure a company’s leverage potential. This ratio is essential for the investors to measure a company's financial health and assess its ability to repay its debt in a timely manner.

How to Calculate the Ratio: Debt to Equity ratio (D/E) is calculated by dividing the total liabilities of a company by its total shareholders’ equity. The formula to calculate the ratio is as follows:

• D/E ratio = Total Liabilities / Total Shareholders’ Equity

What a Low D/E Ratio Means

A low D/E ratio indicates a healthier financial situation, as it implies that the business is well-positioned to meet its liability obligations and that it has a healthy balance sheet. When a company has low leverage, it has relatively more financial flexibility and less risk associated with it.

What a High D/E Ratio Means

A higher D/E ratio implies that the company is taking on a lot of debt and its ability to repay its debt may become more reliant on third-party financing. A high D/E ratio may also signal potential financial distress, as it can indicate a lack of liquidity.

Return on Equity Ratio

Return on Equity (ROE) ratio is a popular measure for investors when deciding if a company is a desirable investment. It measures the rate of return a company generates on the capital that shareholders have invested in the company. ROE measures how well a company uses investments to generate profit.

Definition

Return on Equity (ROE) ratio is a metric that measures the rate of return a company generates on its shareholders equity investment. It is calculated by taking the net income of a company and dividing it by the total amount of equity owned by shareholders. This ratio can then be used by investors to compare similar companies and evaluate whether one company is making more efficient use of its equity investments.

How to Calculate the Ratio

The Return on Equity ratio can be calculated by using the following formula:

• ROE = Net Income / Shareholders Equity.

What a Low ROE Ratio Means

A low ROE ratio indicates that the company is not generating a significant amount of income from shareholders' equity. This may be caused by several factors, such as a low-margin business model, lack of efficient management or too much debt. Low ROE also signals that the company may not be generating sufficient returns to justify its investments, or that the company is overvalued.

What a High ROE Ratio Means

Conversely, a high Return on Equity ratio indicates that a company is successfully using investors’ capital to generate profit. This is an indication that the company is well-managed, efficient and making good decisions with investments. High returns can also signal that the company may have the potential to grow and expand further, making it attractive for investors looking for long-term growth opportunities.

Conclusion

Valuation ratios are an important part of the decision-making process when it comes to investing. By understanding and analyzing the different valuation metrics available, investors can make more intelligent, profitable decisions. Whether evaluating individual stocks or entire markets, it's essential to have a solid understanding of these essential tools.

Recapping, the five most important valuation ratios investors should be familiar with are the following:

• Price-to-Earnings Ratio
• Price-to-Sales Ratio
• Price-to-Book Ratio
• Enterprise Value to EBITDA Ratio
• Dividend Yield Ratio

Armed with the knowledge of how to use these ratios and how to interpret the analysis, investors can make the best decisions with their hard-earned money. Each context is unique, and the best ratios to use may vary depending on the situation. However, these five ratios provide a solid foundation upon which a successful investing career can blossom.