The first financial ratios we will investigate will be price ratios. We will look at others later on. Financial ratios are great instruments that can tell us a lot about the company’s fundamentals that we want to invest in. This gives us a quick screen-shot of how the stock is being valued in a value investing stand point. Financial ratios can tell us if the stock is being overpriced or undervalued.
-If a company is overpriced then there is a great possibility it may correct itself (the price readjust to a fair valuation) in a near future, causing the stock price to drop.
*Usually high ratios indicate that the stock is being overvalued, meaning that there is incredible optimizing about a company’s future performance. The risk is that if the stock doesn’t satisfy Wall Street’s expectations it tends to drop down in value, causing the stock to drop.
-If a company’s stock if being undervalued then there is a chance than when the stock corrects it will appreciates in value, making the stock price to soar to it’s equilibrium price.
Price to Earnings Ratio
a.k.a. Price-earnings Ratio, P/E Ratio, P/E, PE
P/E ratio is widely known between financial analysts, it suggest how much investors are willing to pay for the expectation of growth of the company.
The P/E Ratio tells you how long it will take in years (assuming no changes in earnings) for the company to earn back its price. A P/E of 3 will take three years. A P/E of 20 will take twenty years.
P/E ratio calculation:
Current Price (of the stock) divided by Earnings per Share
Current Market Price
P/E Ratio = ––––––––––––––––––––––––––
Earnings per Share (EPS)
[quote style=”1″] The most popular stock market statistic! Historically, P/E ratios were in the 5 to 12 range for mature companies and 14 to 20 range for growing companies. Greater than 20 was unusual. In the 1990’s, it was commonplace. Now, P/E ratios are all over the map[/quote]
A company’s P/E Ratio was supposed to match its growth rate. If a company was growing at 20% per year, then a P/E of 20 was justified. During the Internet bubble, many companies had P/E ratios in the hundreds
eBay’s P/E was 10,000 for a time during the mania!
At that P/E, it would take eBay 10,000 years to earn its price
EPS (Earnings Per Share)= All the earnings reported in a quarter or year, Divided by Total shares outstanding of the stock (How many shares are out there of the company).
“Growth” stocks typically have high-P/E Ratios
“Value” stocks typically have low-P/E Ratios
But remember a “value” stock might not necessarily be a good value!
Price-to-Cash Flow Ratio
It is calculated this way:
Current price (Stock) divided by current cash flow per share
Cash flow often differs from earnings per share, for several reasons – one major reason is…
Depreciation is not an actual cash expenditure, but there are many reasons cash flow & earnings differ “Good quality” versus “poor quality” earnings.
Price-Cash Flow Ratio = ––––––––––––––––––––––––
Cash Flow per Share
[quote style=”1″]During the Internet mania, many companies were reporting record earnings. At the same time, their cash flow was negative. Huh? How could that be? Example: Lucent Technologies[/quote]
The Book Value of a stock is the value of the assets the company possesses. Historically, it was fairly close to the price of the stock. Today, it is rarely close to the price of the stock
It is calculated: Current price divided by book value
[quote style=”1″]Historically, if the Price-to-Book Ratio was greater than 1.0, then shareholders believed that the firm was creating value above and beyond the physical assets of the corporation[/quote]
Price-to-Book Ratio = ––––––––––––––––––––––––––
Book Value per Share
It is calculated:Current price divided by annual sales per share
[quote style=”1″]Historically, a higher Price-to-Sales Ratio suggested a higher sales growth And a lower Price-to-Sales Ratio suggested a lower sales growth[/quote]
Price-to-Sales Ratio = –––––––––––––––––––––––––––––
Annual Sales per Share
Download WSC’s Valuation Formulas pdf HERE
Price Multiple Models:
Price to Earnings per Share (P/E):
Expected Price= Historical Price to Earnings per Share (5yr average) * Earnings per share (EPS) * (1+Expected Grow)
Price to Cash flow per Share (P/CF):
Expected Price= Historical Price to Cash Flow per Share (5yr average) * Cash flow per share (EPS) * (1+Expected Grow)
Price to Sales per Share (P/S):
Expected Price= Historical Price to Sales per Share (5yr average) * Sales per share (EPS) * (1+Expected Grow)
Applications of Price Ratio Analysis
To Predict future stock price using price ratios, multiply a historical price ratio by the expected future value price-ratio denominator (“What? Huh?”)
(Watch the video below)
Price-to-Earnings Per Share Example:
Intel Corp (INTC) – Price-to-Earnings (P/E) Analysis
Late-2009 stock price= $19.40
Late-2009 EPS= $0.92
5-year average P/E ratio= 20.96 P/E
EPS growth rate= 8.5%
Expected stock price = Historical P/E ratio (5yr Average) * Current EPS * (1+Expected Growth rate)
$20.92 = 20.96(5yr Average) x $0.92(Late 09 EPS) x (1 + 0.085(EPS growth rate))
*projected EPS = current EPS * (100% + expected EPS growth rate)
You can apply the same model to the next Ratio Analysis below.
Download the P/E Valuation Model by Clicking Here
Price-to-Cash Flow Per Share Example:
Intel Corp (INTC) – Price-to-Cash Flow (P/FCF) Analysis
Late-2009 stock price $19.40
Late-2009 CF/PS $1.74
5-year average P/FCF (Free Cash Flow) ratio 10.85 P/CF
Cash Flow Per Share growth rate 7.5%
Expected stock price = historical P/CF ratio (5 yr Avg.) * Cash Flow per Share * (1+Expected Growth rate)
$20.29 = 10.85 x $1.74 x(1 + 0.075)
*projected CFPS = Current CFPS * (100% + expected CFPS growth rate)
Source: MSN Money
Price-to-Sales per Share Example:
Intel Corp (INTC) – Price-to-Sales (P/S) Analysis
Late-2009 stock price $19.40
Late-2009 SPS (Sales per Share) =$6.76
5-year average P/S ratio 3.14 P/S
Sales Per Share growth rate 7.0%
Expected stock price = Historical Price to Sales per Share (5yr average) * Sales per share (EPS) * (1+Expected Grow)
$22.71 = 3.14 x $6.76 x (1 + 0.07)
*projected SPS = current SPS * (100% + expected SPS growth rate)
Can we reasonably assume that the formulas on the previous ratios will give us realistic figures?
For many companies, yes
For many companies, no
For the record, the price of Intel one year later in late-2010 was around $20.50