When a stock analyst wants to understand how other investors value a company, they look at market ratios. These measures all have one factor in common; they're evaluating the current market price of a share of common stock versus an indicator of the company's ability to generate profits or assets held by the company.
In this article, we're going to be examining market ratios, which are indicators an analyst can use to understand how investors feel about a certain company. That discussion will include a brief overview of each ratio, including price to earnings, dividend yield, cash flow ratio, and price to book. We'll provide a definition of each term, its calculation, and how to interpret the value. Then we'll finish up with the pros and cons of these measures.
Stock Prices and Market Value
Since each of these market ratios contains the price per share of common stock, they provide the analyst with a sense of investor sentiment towards a particular company. For example, when Facebook first launched its IPO, they were targeting a price of nearly $40 per share. With earnings per share in the $0.39 range, the price to earnings ratio (P/E) target was close to 100. In that same timeframe, Google's P/E ratio was 17.6. Clearly, investors valued Facebook stock, since they were willing to pay such a large premium to own it.
That's how these market ratios help the analyst. They'll provide insights into the "premiums" investors are willing to pay; likely with the expectation the company is going to grow earnings at a rate that justifies this premium.
Price to Earnings
Also known as the P/E ratio, this first metric tells the analyst the cost to acquire $1.00 of the company's earnings. For example, if a company is reporting $1.00 in annual earnings and the stock's current market price is $20.00, then the price to earnings ratio is 20.0.
Formula
Price to Earnings = Market Value per Share / Annual Earnings per Share
Interpretation
Generally, stocks that are expected to grow earnings will have a higher P/E, while companies with lower growth will have a lower ratio. If two companies have similar earnings growth outlooks, the company with the lower P/E is said to be undervalued by the market. Some investors look for these "ignored" stocks and believe they represent "bargains."
Forward and Trailing P/E (ttm)
While the typical convention is to report the P/E in terms of past earnings, it's important for an analyst to understand the exact calculation behind this value. To clarify this point, the ratio is often reported as:
Trailing P/E (ttm): the trailing twelve months (ttm) of earnings; therefore, is a historical account of this ratio.
Forward P/E: a forecast of earnings over the next twelve months, thereby providing the analyst with a forward-looking metric.
PEG Ratio
As just mentioned, when an analyst finds a company with a relatively high P/E ratio, that value is typically justified by a high earnings growth rate. The price to earnings growth ratio, or PEG ratio, corrects the P/E for this growth rate. In doing so, it "normalizes" the data and allows the analyst to make more accurate value judgments.
Formula
PEG Ratio = Price to Earnings / Annual EPS Growth
Where:
Annual EPS Growth is stated as % x 100
Interpretation
The calculation of a PEG ratio is such that a stock with a P/E of 15 and an earnings growth rate of 15% would have a PEG of 1.00. In the weeks after the launch of Facebook's shares, its stock traded with a P/E of around 70. At that same time, its PEG ratio was 1.35. This implies an annual EPS growth rate of 70 / 1.35 or around 50%. When comparing the value of two companies, the one with the lower PEG ratio is considered the better value.
For example, if FB retained its EPS growth rate of 50%, but its P/E was closer to 40, then its PEG would be 40 / 50, or 0.80. To sell at a P/E of 40, the FB price per share would be $0.39 x 40, or $15.60. Clearly Facebook is a better value when it's selling at a price of $15.60 versus $0.39 x 70, or $27.30.
Dividend Yield
While dividend payments are extremely important to some shareholders, they are of secondary consideration for others. Some investors seek a regular stream of income from a stock, while others invest with the hope of securing capital gains. The dividend yield allows the analyst to quickly compare the merits of these alternative investment opportunities.
Formula
Dividend Yield (%) = (Market Price per Share / Dividends per Share) x 100
Interpretation
If the investor is looking for a source of income, then stocks with high dividend yields will maximize the opportunity to receive these payments. Essentially, these companies are returning a high proportion of earnings back to investors in the form of a dividend payment.
This benefit also comes with a warning. Companies that are providing such high payouts are admitting they do not have enough internal opportunities to invest those profits on behalf of their shareholders. (They are providing a dividend instead of using the money to increase earnings).
Price to Book or Market to Book
This next metric can be calculated two ways, both with the same result. The measure is used to understand the price, or market value, of a company relative to its worth (assets). For example, if a company's market capitalization was $10B and its assets were equal to $10B, its market to book would be 1.0.
Formula
Price to Book = Market Price per Share / Book Value per Share
Where:
Book Value per Share = (Total Shareholder Equity - Preferred Equity) / Common Shares Outstanding
Alternatively:
Market to Book = Total Market Capitalization / Total Book Value
Where:
Total Book Value = Total Shareholder Equity - Preferred Equity
Interpretation
The price to book ratio is used to determine if a company's stock is undervalued. The price to book ratio can vary significantly by industry. Generally, higher ratios are preferred. A price to book below 1.0 indicates a problem exists; whereby the market is not valuing a company correctly. A share of stock is worth more (in terms of net assets) than it is selling for in the marketplace.
Pros and Cons
Market ratios allow the analyst to understand how other investors feel about owning a share of a company's stock. They demonstrate the relationship between the price per share and its earnings, growth and assets. As such it's a good indicator of the relative value of a company.
While some investors might feel an undervalued business represents an opportunity to buy a stock at bargain prices, others feel it's a warning sign the company may not perform well in the future relative to expectations (it will disappoint). As is the case with nearly all financial ratios, benchmarks and comparisons should be made relative to companies in the same industry.
Additional Resources
- Anyone learning how to invest in the stock market has probably seen terms like price to earnings and leverage. These are financial ratios, and understanding what they say about a company can mean the difference between picking a winning stock and a loser.
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