Market Value or Valuation Ratio: Types and Formula

What is Valuation Ratios?

What do you mean by valuation? Well, in simple terms, it refers to determining the worth of something. Applying the same logic in investing, valuation refers to determining a company's worth to help make investment decisions. 

There are usually two approaches to valuation:

• Absolute valuation 
• Relative valuation 

The details of valuation and different approaches are discussed in upcoming chapters; however, just for this chapter, assume that you know beforehand that valuation ratios are part of the relative valuation approach. What is that approach?

Relative Valuation

Price multiples are one of the most widely used tools for valuation of equities. This includes comparing stocks’ price multiples that can help an investor judge whether a particular stock is overvalued, undervalued, or properly valued in earnings, sales, cash flow, or book value per share.

The method of comparables, i.e. relative valuation, values a stock based on the average price multiple of similar companies' stock. What’s the rationale behind this? Well, the Law of One Price asserts that two similar assets should sell at comparable price multiples (e.g., price-to-sales). Please note that valuation ratios are relative valuation methods, so we can only assert that a stock is overvalued or undervalued relative to benchmark value. 

Now, you should understand that this category of ratios is slightly different from the previous four categories studied in earlier chapters, as there is a lot of subjectivity here, and ratios can be twisted to give false impressions to investors. That’s why we need to have a holistic approach to understanding. Specifically for this chapter, we will also cover the shortcomings of each ratio so that you understand how and when to use the ratios. 

With that in mind, let’s start with the very first ratio:

1. P/E Ratio 

The price-to-earnings ratio or P/E ratio is one of the most used valuation ratios. It measures the number of times of earnings an investor has to pay to own a share of a company. Earnings here are the company's annual Earnings Per Share (EPS).

The general rule of thumb says the higher the P/E ratio, the higher the company's valuation. However, as we have seen in the previous chapters, there is no ideal ratio value. Peer comparison and comparison with one's historical value also work in the case of valuation ratios. 

This ratio assumes that EPS, a measure of earnings power, is the primary determinant of investment value. 

However, P/E ratios have several shortcomings: 

• Earnings per share can be negative, which produces a meaningless P/E ratio as any positive numerator divided by a negative denominator gives no result. 
• The volatile and transitory portion of earnings makes interpreting P/Es difficult for investors, especially in a cyclical industry. 
• Management discretion allowed accounting practices can lead to manipulation in reported earnings and thereby lessen the comparability of P/Es across various firms within an industry. 

It is interesting to note that the P/E ratio can have two versions: 

• Trailing
• Leading P/E

The difference between the two is how earnings, i.e. the denominator, is calculated. 

Trailing P/E uses earnings over the most recent 12 months in the denominator. The leading P/E ratio (or forward or prospective P/E) uses next year’s expected earnings, defined as earnings per share (EPS) for the next four quarters or expected EPS for the next fiscal year.

Trailing P/E ratio = Market price per share / EPS over the previous 12 months 

Leading P/E ratio = Market price per share / Forecasted EPS over the next 12 months 

However, both have their shortcomings too:

• Trailing P/E is not helpful for forecasting and valuation if the firm’s business has changed drastically (e.g., due to an acquisition). 
• Leading P/E may not be helpful if earnings are sufficiently volatile. This is so because next year’s earnings are not forecastable with any degree of accuracy. 

Another problem with the P/E ratio is that it is impacted by the risk and the growth rate of the company. The thumb rule that applies to this relationship is:

• There is a direct relationship between the P/E ratio and growth rate. Therefore, when the company's growth is high, the P/E ratio will be high. Please note here that by growth of the company, we mean earnings growth of the company. 
• There is an indirect relationship between the P/E ratio and risk. Therefore, when the company's risk is high, the P/E ratio will generally be low. 

That's when comparing the P/E ratios between the firms, even when they belong to the same industry, becomes difficult because of the difference in growth rate and risk. 

Is there any solution? Well, there is one ratio that can standardise the P/E ratio for companies even if they have different growth rates. That is the PEG ratio or P/E to growth ratio. 

The PEG ratio captures the relationship between earnings growth and P/E.  

PEG Ratio = P/E Ratio / Growth rate of earnings 

The PEG is defined as P/E per unit of expected growth. The PEG ratio, in effect, “standardises” the P/E ratio for companies with different expected growth rates. 

How do we interpret this ratio? The implied valuation rule is that stocks with lower PEGs are more attractive than stocks with higher PEGs, assuming that risk is similar. 

However, there are several drawbacks to using the PEG ratio too: 

• The ratio assumes the linear relationship between the growth rate and the P/E ratio. This means it assumes proportional and equal movement of growth and P/E ratio. However, we all can agree that, in reality, the relationship between P/E and g (growth rate of earnings) is not linear, making comparisons difficult. 
• The PEG ratio still doesn’t account for risk. And now we know that the PE ratio is impacted by the risk factor. 

2. P/B Ratio 

This ratio compares the number of times the book value per share an investor has to pay to own a share of a company. 

P/B ratio = Market value of equity / Book value of equity 

Where: 

Book value = [Total assets - Total liabilities] - Preferred stock 

The general rule of thumb for the P/B ratio is:

1. P/B Ratio < 1: The stock is trading at a value lower than its book value. This is usually an indication of undervaluation. Investors may see this as an opportunity to buy the stock at a discounted price. 
2. P/B Ratio = 1: The stock is trading at its book value. This is usually an indication of a fair valuation of a stock. 
3. P/B Ratio > 1: The stock is trading at a premium to its book value. This could mean the market is optimistic about a company's future earnings or growth prospects.

Advantages of using the price-to-book (P/B) ratio include: 

• Book value is a cumulative amount that is usually positive, even when the firm reports a loss and EPS is negative. Thus, a P/B ratio can typically be used when P/E ratios cannot. 
• In terms of stability, book value is more stable than EPS, so it may be more useful than P/E when EPS is particularly Volatile, high, or low. 
• Book value is an ideal measure of net asset value (NAV) for firms that primarily hold liquid assets (eg, finance, investment, insurance, and banking firms).
• P/B can be useful in valuing companies that are expected to go out of business or undergo a liquidation process. 

Disadvantages of using P/B include: 

• Book value does not reflect the value of intangible assets with economic value, such as human capital. 
• Ratio can be misleading when there are significant differences in the asset size of the firms under comparison because, in some cases, the firm’s business model dictates the size of its asset base (eg: Construction, heavy electricals, etc.) 
• A firm that outsources its production will have fewer assets, lower book value, and a higher P/B ratio than an otherwise similar firm in the same industry that doesn’t outsource. 
• Book value is not an accurate measure of the value of shareholders’ investment, as Inflation and technological change can cause the book and market values of assets to differ significantly. This makes it more difficult to compare P/Bs across firms.

3. Price-to-Sales Ratio

P/S multiples are computed by dividing a stock’s price per share by sales or revenue per share or by dividing the market value of the firm’s equity by its total sales. This ratio tells the number of times of sales per share an investor has to pay to own a share of a company.  

P/S ratio = Market value of equity / Total sales 

The advantages of using the price-to-sales (P/S) ratio include: 

• The P/S ratio is useful even for distressed firms since sales revenue is always positive. This is not the case with earnings. 
• Relatively, P/S ratios are not as volatile as P/E multiples. This may make P/S ratios more stable and reliable in valuation analysis, especially when earnings for a particular year are very high or very low relative to the long-run average. 
• P/S ratios are appropriate for valuing companies in mature or cyclical industries and start-up / new-age companies with no earnings record. 

The disadvantages of using P/S ratios include: 

• High growth in sales does not necessarily transform into high operating profits as measured by earnings and cash flow.  
• P/S ratios do not capture differences in pricing structures across companies. 
• Revenue recognition practices by management can still manipulate sales figures. For example, investors should look for company practices that increase revenue recognition. An example is sales on a bill-and-hold basis, which involves selling products and delivering them later. This practice accelerates sales into an earlier reporting period and distorts the P/S ratio.

4. EV / EBITDA 

The ratio calculates the value of a total company as a multiple of EBITDA, i.e. earnings before interest, tax, and depreciation. As discussed in the profit and loss statement chapter, EBITDA is a flow to equity and debt. Therefore, it should be related to a numerator that measures total company value. Here comes the importance of enterprise value. Consider enterprise value (EV) as a total company value. 

Enterprise value = market value of common stock + market value of preferred equity + market value of debt + minority interest - cash & cash investments

Are you wondering why cash is reduced even though we know it holds value in reality? The rationale for subtracting cash and cash investments is that an acquirer’s (purchaser) net price paid for an acquisition target would be lowered by the amount of the target’s liquid assets, i.e. cash and cash investments.

As you can see in the formula, enterprise value indicates the overall company's value and not just equity. 

EV / EBITDA ratio = Enterprise value / EBITDA 

EV/EBITDA is useful in several situations: 

• The ratio may be more useful than P/E when comparing firms with different degrees of financial leverage. This is so because using debt in the capital structure will affect the finance cost, ultimately impacting net profit and making comparisons between firms difficult. 
• EBITDA is useful for valuing capital-intensive businesses with high levels of depreciation and amortisation. E.g., Construction, defence, heavy electrical, etc.
• EBITDA is usually positive even when EPS is not. 

Where Can I Check Valuation Ratios on Angel One?

In order to check valuation ratios on Angel One, simply:
1. Click on the stock from the search bar or from the Watchlist.
2. Click on ‘Overview’ and thereafter, click on ‘Stock Details’.
3. Scroll down and you will find valuation ratios. 

How Do You Arrive at Final Decision-Making Using Valuation Ratios?

The basic idea behind valuation ratios is to compare a stock’s price multiple to a benchmark portfolio. Firms with multiples below the benchmark are undervalued, and firms with multiples above the benchmark are overvalued. However, an investor needs to ensure that the fundamentals of the stock are similar to the fundamentals of the benchmark before we can make direct comparisons and draw any conclusions about the stock's valuation.

In other words, we must ensure that we compare apples to apples. 

Let’s use the P/E ratio as an example. We know that the P/E ratio is positively related to growth rates and negatively related to the required rate of return and risk. Suppose we determine that the P/E of our stock is less than the benchmark. There are (at least) three possible explanations for this: 

• The stock is undervalued. 
• The stock is properly valued, but the stock has a lower expected growth rate than the benchmark, which leads to a lower P/E. 
• The stock is properly valued, but it has a higher required rate of return, i.e. higher risk than the benchmark, which leads to a lower P/E. 

To conclude that the stock is truly undervalued, we must ensure it is comparable to the benchmark; it should have similar expected growth and risk. 

Numerical Example with Solution

In the above section of this chapter, we discussed various valuation ratios. Applying and analysing the ratios on a company's actual financial statements is equally important. For this chapter, and going further we will be calculating and analysing the financial statements of XYZ Ltd. The financial statements of XYZ Ltd were discussed in detail in the financial statement chapters. The steps you need to follow to understand this section are simple:

Step 1 - Snapshots of the actual financial statements are provided below. These statements consist of the crucial financial statements of XYZ Ltd - Statement of profit and loss, balance sheet and cash flow statement. 

Step 2 - A table named ‘Data Extract’ is provided below the snapshot for easy understanding. This table will include all the important line items and related numerical data from the financial statements of XYZ Ltd. needed to calculate a particular category of the ratio, like in this chapter - valuation ratios. Please note all the amounts are in ₹ crores.

Step 3 - The solutions table is provided below the data extract table. This table includes the value of all the ratios taught in a particular chapter. However, you are expected to calculate the ratio value by yourself and then match your answers with the solution table to understand the concept better.

Step 4 - The analysis and interpretation section is provided towards the end. This includes the analysis of XYZ Ltd based on ratios calculated. 

Let’s start with the exercise:

Financial statements of XYZ Ltd 

Data Extract:

Extract of data needed for valuation ratios
	[Amount in ₹ crore]	[Amount in ₹ crore]
Particulars	March 2023	March 2022
Market Price [Assumption]	525
EPS (Diluted)	9.61
Growth rate of earnings (10 Years)	8%
Book Value per share (Given in the annual report)	50.6
Number of shares (In crores)	177.2
Revenue from operations	11,529	10,888
Sales per share	65.06
Enterprise value	94,081
EBIT (Operating profit)	2,296	2,307
Depreciation & amortization	310	252
EBITDA	2,606	2,559

Solution:

Value of valuation ratios:
P/E ratio	54.63
PEG ratio	6.75
P/BV ratio	10.37
P/S ratio	8.06
EV/EBITDA ratio	36.10

Analysis and interpretation 

• From the above solutions table, you can see that the P/E ratio is around 54. This means for every rupee of net earrings, you as an investor need to pay ₹  54, to buy a share of XYZ Ltd. This is usually considered a high P/E, but it may be justified when the company's growth is high or the industry it belongs to is a defensive industry.
• However, when we looked at the earnings growth rate, it was merely 8%, which is on the lower side. A lower growth rate also leads to a high PEG ratio, which is 6.7. 
  Even when we look at the price-to-book ratio, it's almost 10 times, which is still on the premium side. 
  In fact, for every rupee worth of sales, you need to pay ₹  8 to acquire a share in the company. 
  Lastly, the company's overall value trades 36 times Earnings Before Interest, Tax, Depreciation and Amortisation [EBITDA].
• All the valuation ratios show that XYZ's valuations are slightly premium. Now, your job as an investor becomes important to identify factors that justify XYZ’s premium valuation. It may be prospects, the company’s strong management, potential growth rate, monopoly business, nature of the industry, etc. Just like any other ratio, comparison with its historical value of ratios and peer comparison is equally important to conclude the findings. 

This was all about the valuation ratio chapter. And with this, we have come to the end of the ratio analysis module.