Often, valuation is done for a business, which is a financial process for determining the worth of the company or the business owned. Multiple valuation ratios are used to gain insight into the context of the company’s share price, and here they function as useful tools for evaluating investment potential. Some of the commonly used ratios for valuing business include:
Price-to-Earnings Ratio
Price-to-Earnings Ratio or P/E Ratio looks at the relationship between the company’s share price and the earnings. With the P/E Ratio, an understanding can be gained about what the market will be willing to pay for the company’s earnings. Here, the formula will be:
P/E Ratio = Current Share Price of the Company/EPS
EPS here stands for Earnings Per Share.
For example:
If a company is currently trading at INR 100 per share and its earnings over the last 12 months are INR 30 per share, the P/E ratio for the stock would be 3.33 (INR 100/INR 30). As the P/E goes up, it shows that current investor sentiment is favourable, and a reducing P/E is an indication that the company is out of favour with investors.
When to use P/E Ratio
– This is the point of taking off for valuing nearly all companies,
– When the company wants to compare a number of companies to see what others are seeking.
Advantages
– This is a widely used ratio, making it quick and easy to compare and contrast with the other shares.
– It is easy to use as the same is easy to find, assuming the company does not want to adjust the earnings number.
Disadvantages
– It can be manipulated easily as earnings are computed on an accrual basis of accounting, due to which the company’s discretion on the same becomes greater when compared to the cash flow.
– This does not consider the balance sheet items. It does not consider debt amount also.
Price-to-Book value
Price-to-Book Value Ratio or P/B Ratio is the measurement that looks at the value that the market places on the book value of the company. The formula here is;
P/B Ratio = Dividing Current Price per Share by Book Value per Share [Current Price per Share/Book Value per Share
The book value of the company is the difference between the balance sheet assets and liabilities. This actually is an estimation of the value of the company if it were liquidated.
Say a company with a share price of INR 75 and a book value of INR 70 per share would have a P/B ratio of 1.07. A ratio above 1 implies, in a general normspotting, that the market is willing to pay more than the equity per share, while a ratio below 1 implies that the market is willing to pay less.
When to use P/B Ratio
Banks mostly use this for measuring the market’s valuation of a company relative to its book value. A company can also use this when they are in a period of incurring losses.
Advantages
It provides a stable metric as it does not fluctuate like the other ratios, such as P/E.
Disadvantages
The differences in accounting can make it difficult to compare, and it becomes less useful when companies classify items on their balance sheet differently due to different interpretations of accounting rules.
Price-to-Sales
The Price-to-Sales Ratio or P/S Ratio shows how much the market values the company’s earnings. For this, the market capitalisation should be taken, and it should be divided by the company’s total sales during the year. For computing a company’s market cap, the number of shares issued should be multiplied by the share price. When a company has incurred a loss, the P/S ratio can be used in place of the P/E Ratio.
When to use P/S Ratio
It is used for identifying potential recovery situations or even for double-checking and ensuring that the company’s growth has not become overvalued.
Advantages
A stable metric, such as revenue, is more stable than more volatile earnings.
Disadvantages
This does not consider the profitability of the entity into consideration, which is a significant disadvantage.
Price-to-Cashflow
The price-to-Cashflow Ratio or P/CF Ratio helps in evaluating the price of the company’s shares in relation to the cash flow that the company generates. For calculating this, the market capitalisation of the company is taken and divided by the operating cash flow of the company during the year. Another manner for computing the P/CF Ratio is:
P/CF Ratio = Share Price per Share/Operating Cash Flow per Share
P/CF Ratio is an alternative to P/E Ratio.
When to Use P/CF Ratio
This is a ratio that is useful for stocks or shares that have a cash flow. And despite having a positive cash flow, it is not profitable.
Advantages
This cannot be easily manipulated as earnings, because this is not based on the accrual basis of accounting.
Disadvantages
– Varying ways to calculate cash flow measures, which create comparisons between different cash flows.
– It isn’t easy to acquire future cash flow estimates.
EV-to-EBITDA
The enterprise value to earnings before interest, taxes, depreciation, and amortisation ratio or EV-to-EBITDA Ratio, is the one where
Enterprise value (EV) = Market Capitalization + Preferred Shares + Minority Interest + Debt – Total Cash
This ratio tells the user how many multiples of the EBITDA one would have to pay for acquiring a business.
When to use EV-to-EBITDA
It is good for capital-intensive industries where the balance sheet tends to hide the majority of their funding.
Advantages
It also accommodates the balance sheet items.
Disadvantages
It isn’t easy to compute as more computation and work are required for computing EBITDA.
Hence, we can now conclude that the company should choose each of the above-stated ratios for valuation based on their use and the specific needs they are seeking.
