Important Ratios Required for Valuing Business
Often valuation is done for business, which is a financial process for determining the worth of the company or the business owned. There are multiple valuation ratios that are used for putting 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 P/E Ratio an understanding can be gained with regard to 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, Earning 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 the point of taking off for valuing nearly all companies,
– When the company wants to compare a number of companies for seeing 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 same is easy to find assuming company does not want to adjust the earning 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 more 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 which is placed by the market on the book value of the company. The formula here is;
P/B Ratio = Dividing Current Price per Shareby 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 the same was 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 which is above1 is implying in a general normspotting that the market is willing to pay more than the equity per share, while a ratio which is below 1 implies that the market is willing to pay less.
When to use P/B Ratio
This is mostly used by banks for measuring the market’s valuation of a company relative to its book value. A companycan use this also when they are in the period of making negative earnings.
Advantages
It provides a stable metric as it does not fluctuate like the other ratios like 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 available or laid down.
Price-to-Sales
The Price-to-Sales Ratio or P/S Ratio shows how much the market values the earnings of the company. For this, the market capitalization 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 finding and spotting the possiblesituations of recovery or even for double-checking and also ensuring if the company’s growth has not become overvalued.
Advantages
A stable metric as revenue is more stable compared to earnings, which is more volatile.
Disadvantages
This does not consider the profitability of the entity into consideration, which is a major 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 which is generated by the company. For calculating this the market capitalization 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 the shares that have a cash flow. And despite of having a positive cashflow is not profitable.
Advantages
This cannot be easily manipulated as earnings, due to the reason that this is not based on the accrual basis of accounting.
Disadvantages
– Varying ways to calculate cash flow measures which create comparisons between different cashflows.
– It is difficult to acquire future cash flow estimates.
EV-to-EBITDA
Enterprise value to earnings before interest, taxes, depreciation, and amortization 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 its fundings.
Advantages
It accommodates the balance sheet items also.
Disadvantages
It is difficult to compute as more computation and work are required for computing EBITDA.
Hence, we can now conclude that each of the above-stated ratios for valuation should be chosen by the company based on their use and what exactly they are looking for.
