Canto 13

Stock Valuation Ratios

Stock analysts use several different ways of measuring the value of a company's stock in terms of other financial numbers for the company. Some of them are helpful for understanding discussions of "investment styles" like growth investing and value investing, so I'm going to provide some quick definitions of a few of the more popular ones.

P/E Ratio

The price/earnings ratio (P/E) is a popular way to measure how highly valued a stock is. It is the ratio of the price (P) of buying one share divided by how much profit (net earnings - E) the company makes per share. Put another way, it is the total cost of buying all the shares in the company divided by how much profit the company makes per year. Sometimes people use the trailing P/E, which is the share price divided by the earnings for the preceding 12 months, and sometimes people use the forward P/E, which is the share price divided by the future estimated earnings for the next 12 months. If the profit from the previous year was $5 per share and it costs $100 to buy a share, the trailing P/E ratio is 20.

Earnings yield is a related term and is the reciprocal of P/E ratio. It is the company's earnings per share divided by the price of buying one share. For the example above, the earnings yield is 5%.

A P/E ratio of around 10 would be considered fairly low. The average market P/E ratio in the US markets tends to be around 20-25. A P/E ratio of around 50 would be considered fairly high.

A stock with a low P/E ratio is sometimes called a "value" stock, because it is relatively cheap to buy a unit of earnings if you buy that stock. Often old, well-established industries without much growth potential include a lot of big, old companies whose stocks have low P/E ratios. Sometimes a small company that not many people know about will have a low P/E ratio and might be a bargain. Sometimes a company is really a dud and there is good reason its stock is so cheap compared to its earnings. Obviously, P/E ratio is not a sufficient reason to buy a stock - you have to find out more about a company if you are considering buying shares.

A stock with a high P/E ratio is sometimes called a "growth" stock, because the high price per unit of earnings typically comes from investors' expectations that the company will grow. Industries like high technology typically have high P/E ratios. Investors might also be taking other things into account when deciding what they are willing to pay for a unit of earnings. These might include the value of an established brand, the human capital in the company, or the barriers to other players entering that company's industry. Sometimes a stock with a high P/E ratio is overvalued, because investors have become overly enthusiastic about it. Again, you have to find out more about a company if you are considering buying shares.

Dividend Yield

Some stocks pay dividends. Companies with net earnings can basically do two things with the money: give it back to the shareholders or invest it in back in the business. If they decide to give some of it to the shareholders, the most common way is to pay a dividend amount for each share. Dividend yield is the ratio of the dividend amount per share divided by the price of buying one share. In the example above, if the company earning $5 per share decides to distribute a $2 dividend, and the share price is still $100, the dividend yield is 2%.

The total investment return you can expect from a stock includes the dividend and amount you hope the shares will go up in price. All things being equal, you can expect companies that put most of their earnings back into the business to grow more (though that isn't always true). Conservative investors often lean towards stocks that pay dividends, because you can count on that return with a bit more certainty - especially in old, established industries like utilities or banking. More adventurous investors often lean towards stocks that don't pay dividends, because they don't need immediate income and they have more time to wait for the stocks to grow.

If you divide dividend yield by earnings yield, you get something called the dividend payout ratio. In the example above, it is 2%/5% = 40%. This is a company that is distributing 40% of its earnings in dividends. A low ratio might indicate a company that is intent on growth. A ratio well above 100% (meaning the company is distributing more in dividends than it actually earns) is probably not sustainable for very long.

Dividend yield for a stock can be compared to the dividend yield of a bond, which is the amount of dividend interest it is supposed to pay per year divided by the price of buying it. Typically, a bond will pay a higher yield than a stock, but its market price won't fluctuate as much and will always ultimately end up at the face value of the bond when it matures.

Price to Book Ratio

Another common way of valuing company shares is to divide the price of a share by the "book value" of the company per share. Book value is the value of all the assets the company owns minus all the debts it owes. It's basically what would be left over if you sold off everything the company owns and paid off the creditors with the proceeds. It's also an approximation of what the shareholder would actually get if the company went bankrupt and everyone got paid off. Some stocks trade above book value and some trade below.

Some investors use this ratio as a way to find companies that appear to be cheap compared to what they are worth. For companies in industries with a lot of tangible assets (like paper mills), this is probably a worthwhile approach. Intangible assets, such as brand value, good will, patents, or other intellectual property, are not included in the book value, however. That means the price to book ratio is not a very good way to evaluate a company like Microsoft.

Including These Ratios in Your Investing

I have been talking about these ratios in terms of investing in individual stocks. If you are planning to use individual stocks in your portfolio, you should definitely get to know these ratios and understand what they mean.

They may also come into play when you choose mutual funds or ETFs for your portfolio. Often, a mutual fund or ETF will claim to follow a particular investment style. For example, it might invest in large capitalization growth stocks that trade on the US stock exchanges. You can expect the stocks that fund owns to have a high average P/E ratio. If the fund invests in large cap value stocks, you can expect its holdings to have a low average P/E ratio.


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Last Updated: 17 December 2017
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