This is part of my intermittent series on price, one of the most important and commonly encounters considerations in investing and trading. For this post, I will discuss about the various financial ratios that has price as a component.
There are five main types of ratios with price as a major component, which I let Gemini AI handle the descriptions (output displayed in a different font):
1. Price-to-Earnings (P/E) Ratio:
- Formula: Market Price per Share / Earnings Per Share (EPS)
- Interpretation: A higher P/E ratio suggests that investors are willing to pay more for each unit of earnings, potentially indicating overvaluation or high growth expectations. A lower P/E ratio may suggest undervaluation or lower growth expectations.
- Example: If a company's stock price is $50 and its EPS is $5, the P/E ratio is 10 (50/5).
2. Price-to-Book (P/B) Ratio:
- Formula: Market Price per Share / Book Value per Share
- Interpretation: Compares the market price of a stock to its book value (assets minus liabilities). A P/B ratio above 1 suggests the market values the company higher than its net asset value.
- Example: If a company's stock price is $20 and its book value per share is $15, the P/B ratio is 1.33 (20/15).
3. Price-to-Sales (P/S) Ratio:
- Formula: Market Capitalization / Total Sales (or Price per Share / Sales per Share)
- Interpretation: Indicates how much investors are willing to pay for each dollar of a company's revenue. Lower P/S ratios may suggest undervaluation or that the company is not effectively utilizing its sales.
- Example: If a company's market capitalization is $100 million and its total sales are $50 million, the P/S ratio is 2 (100/50).
4. Price-to-Cash Flow (P/CF) Ratio:
- Formula: Market Price per Share / Cash Flow per Share
- Interpretation: Measures how much investors are willing to pay for each dollar of a company's cash flow. It can be a more reliable indicator than P/E ratio because cash flow is harder to manipulate than earnings.
- Example: If a company's stock price is $60 and its cash flow per share is $10, the P/CF ratio is 6 (60/10).
5. Price-to-Earnings-to-Growth (PEG) Ratio:
- Formula: P/E Ratio / Expected Earnings Growth Rate
- Interpretation: Helps to assess whether a stock's P/E ratio is justified by its future earnings growth. A PEG ratio less than 1 is generally considered favorable, suggesting the stock may be undervalued relative to its growth potential.
- Example: If a company's P/E ratio is 20 and its expected earnings growth rate is 25%, the PEG ratio is 0.8 (20/25).
These ratios are usually available from most stock screener sites, or one could calculate the numbers based from the stock market prices and financial statements.
Generally, the lower these ratios are, the better the company’s valuation is, ceteris paribus, though a whole lot of relativity and context are needed in an actual analysis. They should be utilized as a guideline, not as a major dealbreaker when selecting companies to invest in.
The All-In-One Price Ratio
Conversely, during my specialist diploma course days (read here for more details about my view and experience of the course), a lecturer had briefly spoke about using the various price ratios and aggregate them to a score, which I dubbed it as the “all-in-one price ratio”. While I did not get more details on this other than a short mention, perhaps this may be my next side project in deriving “the number”.
Check out the other post in my All About Price series.
All About Price: Introduction & Valuation of Value
All About Price: Buyer/Seller Remorse and Premorse
All About Price: The 52-Week High/Low
All About Price: Reversion To The Mean
All About Price: Bottom Fishing
All About Price: The (Price) Margin Of Safety
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