The equity ratios are the main tool for any investor in bag valuation method used as the relative valuation which I already talked on this blog recently. The objective of this article is to serve as a brief introduction to stock market analysis to begin to get used to its use. For this, in this article, we will see what are the stock ratios, how to use them and the 5 most important stock ratios that every investor should know with their respective formulas and examples.
What are Stock Ratios?
Stock ratios are tools that serve to determine the financial or business situation or the valuation of a listed company. This type of financial ratios is often using to determine whether a company is quoting at a good price. But can also be used for other purposes. Such as determining a company’s indebtedness, liquidity or the average time is taken to collect from its creditors.
Precautions when using stock ratios
The important thing to keep in mind is that stock ratios are just tools. So they are not everything in the valuation of companies and should be handled with caution. The ratios can be a good indicator that we are facing a great investment opportunity, but a deep analysis will always be necessary.
Followers of value investing should be able to go beyond these indicators and delve into the underlying businesses. This implies understanding the business that hides behind each action, its strengths, weaknesses, competitive advantages, etc. In other words, we must reconcile financial analysis with a competitive analysis in order to have a solid valuation of the company and be able to obtain the intrinsic value as accurately as possible.
The PER: Joining price and benefits
The PER (“Price to Earnings Ratio”) is undoubtedly the most popular stock ratio for its simplicity and ease of use. This stock ratio relates the stock market capitalization of a company with its net profit or, what is equivalent. Its earnings per share with its price per share. Therefore, its formula will be as follows:
PER = Market capitalization / Net Profit = Price per share / Earnings per share
To give an example, a company that quoted at a price of 40 euros per share and has a profit per share of 2 euros, its PER will be 20 times (40/2).
The average historical PER of the stock exchanges is around 15, so that “in principle” if a stock trades with PER well below these levels will be cheap and if it trades with a higher ratio will be expensive. Of course, I say “in principle” because it will depend on each company and its future prospects, so we must use this stock ratio very cautiously.
Price / Book Value: A classic of stock ratios
The ratio price/book (also known as PVC, “Price / Book Value” or P / BV) is classic to evaluate actions from a theoretical standpoint ratio. It is obtaining by dividing the price of a share by its theoretical book value, or what is equivalent, dividing the market capitalization between equity. Here is the formula:
PVC = Market capitalization / Equity = Price per share / Theoretical value per share
Its calculation is simple. Suppose that a company is listing with a market capitalization of 100 million euros, the book value of its own funds were 50 million euros. Then your PVC ratio will be 2 times (100/50).
Normally the PVC ratio is usually in the range of 1.5 to 2.5. A company with PVC less than 1 is usually of companies with high chances of bankruptcy although we may also be cases of good investment opportunities.
P / FCF: Beyond the benefits
The P / FCF ratio (“Price to Free Cash Flow”) is the ratio that relates the stock market capitalization of a company to its free cash flows. While a company’s net profit figure is somewhat “artificial,”. Since it can be made up with different accounting gimmicks, free cash flow is a target value. Therefore, this ratio can consider more objective than the PER, although it requires a more complex calculation.
Its formula is as follows:
P / FCF = Stock Cap / Free Cash Flow = Price per Share / Free Cash Flow per Share
Assume that a company has a free cash flow of 100 million euros while it is quoting with a market capitalization of 1.2 billion euros. Its P / FCF ratio will be 12 times (1,200 / 100).
EV / EBITDA: Beyond the price
The EV / EBITDA ratio is possibly a complete ratio of the 5 stock ratios we are analyzing. This ratio relates the company value (“Enterprise value” in English) of a company with its EBITDA (Earnings Before Interests, Taxes, Depreciation, and Amortization, or “Earnings Before Interest, Taxes, Depreciation, and Amortization”). Its formula is simple:
EV / EBITDA = Company Value / EBITDA
Suppose that a listed company has a company value of 1500 million euros and an EBITDA of 300 million euros. Its EV / EBITDA ratio will be 5 times (1500/300).
This ratio is usually the ratio most used by venture capital companies to decide whether to invest in a company or not as it reflects in a more complex way the value of a company than the rest of stock market ratios.
Profitability by Dividend: From the company to the shareholder
It is no use if a company makes a lot of money. In case, this money is not distributing sooner or later to its shareholders. The dividend yield (“Dividend Yield”) measures the percentage of the price action goes to shareholders as dividends each year. It is calculating as follows:
Profitability per Dividend = (Dividend per share / Price per share) * 100
As an example, suppose that a company that is listed at 10 euros per share distributes a dividend of 40 cents per share each year. Its dividend yield would be 4% ((0.4 / 10) * 100).
Dividend Profitability is express as a percentage, which usually fluctuates between 2% and 5% although it will depend as with other ratios, on the type of company and its future prospects. It is common for high-growth companies not to distribute dividends to their shareholders. This is because instead of dividing profits among shareholders, what they do is reinvest them in the company to grow in the future.
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