Last week, I explained why investors should take the time to value stocks before they buy…
And I broke down two popular financial ratios to help you get started: The price-to-earnings ratio (P/E) and the P/E-to-growth (PEG) ratio.
Today, I’ll explain three more useful ratios to help determine a stock’s value… and a few other important factors to consider before you invest.
When talking about ratios or valuation metrics, “price” is the stock price, or how the market values the company. We can weigh whether the market has it right using a handful of other variables. Last week we compared price to earnings and to earnings growth. This week, we’ll compare it to book value, sales, and cash flow.
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The price-to-book ratio is similar to the P/E ratio. Instead of focusing on earnings, this ratio looks at a stock’s “book value.”
Book value is essentially the value of a company based on its balance sheet. It’s the company’s total assets minus its outstanding liabilities. It represents the total amount of equity left to us after liquidating all the company’s tangible assets and paying all of its liabilities.
To calculate this ratio, you simply divide the stock price by its book value per share. Let’s use Tesla (TSLA) and eBay (EBAY) as examples again.
Tesla has a P/B ratio of 29.58. We get this number by taking Tesla’s current price of $685 and dividing by its book value per share of $23.15.
Tesla P/B = 685/23.15 = 29.58
eBay (EBAY) has a P/B ratio of 10.66. Again, we calculate this by dividing its market price of $55.56 by its book value per share of $5.21.
eBay P/B = 55.56/5.21 = 10.66
Price-to-book shows the difference between the market value of a company and the book value. It’s useful when valuing asset-heavy industries such as manufacturing companies and financial institutions. It’s also useful when a company shows negative earnings, since those companies can’t be compared using the P/E ratio.
A stock that has a P/B around 1 means it’s trading near book value. If a stock has a P/B of 0.5, it may be undervalued, since its market value is less than half its book value.
Both Tesla and eBay appear overvalued based on their price-to-book ratios alone. That’s why it’s better to look at multiple valuation levels.
Price-to-sales measures a company’s market value relative to its annual revenue. You can calculate it by dividing the stock price by the company’s sales per share.
Many investors and analysts consider price-to-sales to be an especially “pure” ratio. That’s because revenue is a straightforward number that’s difficult to manipulate. This is in contrast to earnings, which can move higher or lower as a company makes certain adjustments to its expenses.
Like the P/B ratio, it also comes in handy when earnings are negative, which makes it impossible to calculate the popular P/E ratio for a stock.
Here are example calculations using the same stocks. Tesla has a P/S ratio of 20.27. We get this number by taking Tesla’s current price of $685 and dividing by its sales per share of $33.80.
Tesla P/S = 685/33.80 = 20.27
eBay (EBAY) has a P/S ratio of 3.84. Again, we calculate this by dividing its market price of $55.56 by its sales per share of $14.47.
eBay P/S = 55.56/14.47 = 3.84
While there’s no line that separates an overvalued stock from an undervalued one using the P/S ratio, a lower ratio is better. This is because investors pay less for a company’s revenue if it has a low price-to-sales ratio.
Also, it’s important to note that revenue and profitability vary by industry. Stocks in the software industry tend to have higher price-to-sales ratios, while stocks in the energy industry have lower price-to-sales ratios.
For example, Microsoft (MSFT) has a P/S ratio of 11.60. We get this number by taking Microsoft’s current price of $234.65 and dividing by its sales per share of $20.23.
Microsoft P/S = 234.65/20.23 = 11.60
Chevron (CVX) has a P/S ratio of 2.21. Again, we calculate this by dividing its market price of $111.56 by its sales per share of $50.52.
Chevron P/S = 111.56/50.52 = 2.21
To get the most out of the price-to-sales ratio, you should use it to compare stocks in the same industry.
The final valuation metric we’ll look at is price-to-cash flow. This is a great metric for checking how much cash a company is generating relative to its market value. Similar to revenue, cash flow is harder for a company to manipulate than earnings.
To calculate the price-to-cash-flow ratio, take the stock price and divide it by cash flow per share. While book value per share and sales (revenue) per share can be found easily on Yahoo Finance, you need to go an extra step to find cash flow per share.
For example, to find Tesla’s cash flow per share, we divide the company’s operating cash flow ($5.94B) by its shares outstanding (959.85M). Both figures can be found on Yahoo Finance.
Tesla cash flow per share= 5.94B/959.85M = 6.19
Now, we take Tesla’s current stock price of $685 and divide by its cash flow per share of $6.19.
Tesla P/CF = 685/6.19 = 110.66
A low P/CF ratio indicates an undervalued company, and vice versa. As I mentioned above, cash flow provides a more accurate picture of a company’s business, since earnings can be easily manipulated and cash flow cannot.
Companies can manipulate earnings by charging less depreciation on assets, or increasing the lifespan of an asset. But cash flow removes the effect of non-cash items such as depreciation. That means it gives a more reliable indication of long-term returns.
In sum, cash flow reflects how the company is truly performing. If you’re looking at historical earnings compared to a stock’s price, you don’t know if the earnings have been manipulated. But if you’re looking at historical cash flow, you know the figures are reliable.
Here’s a quick recap of the ratios we covered today:
- P/B: Compares a company’s market value to its book value. Good for manufacturing and financial companies (where assets are easily accounted for).
- P/S: Compares a company’s market value to its total revenue. Good for companies with negative earnings, since those companies can’t be compared using the P/E ratio.
- P/CF: Compares a company’s market value to its cash flow. Good for a more accurate picture of a company’s business, since earnings can be easily manipulated and cash flow cannot.
Keep in mind that there’s no definitive “cheap vs. expensive” line for any of these ratios. If you’re comparing two stocks, all else being equal, the lower ratio is better.
Remember, valuation is just one piece of the puzzle. Buying a stock just because it’s cheap doesn’t always lead to big returns. We need to find out why it’s cheap. That means considering all the factors impacting the stock.
For instance, does the company have a healthy balance sheet? A healthy balance sheet means the company has more than enough liquidity to handle short-term obligations: Its current assets should be greater than its current liabilities.
Another factor is total debt. If a company has a low valuation and very high debt levels, I’d be less comfortable buying the stock. On the other hand, if a company has a healthy balance sheet (low debt) and a low valuation, it may just be out of favor, and you can buy it on the cheap.
You also want to look at a company’s historical growth in earnings or revenue (sales). If a stock has a poor history of growth, it’s probably cheap for good reason.
If a company has a strong history of growth but a bad quarter, it may be cheap temporarily… and worth a closer look. The same is true if a company has a strong history of growth, a healthy balance sheet, and a high valuation. A high valuation doesn’t mean it couldn’t go higher…
You now have five valuation ratios in your arsenal. As I’ve mentioned, it’s best to look at multiple ratios… you should never rely on a single one for your research. And it’s best to compare stocks within the same industry.
Again, valuation is just one tool for investors. Be sure to consider it against other factors. If a stock is cheap, there could be a good reason. If there’s not, the market may need to play catch up on its valuation… and it’s likely a good time to invest.
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