Market value ratios are tools used by investors and analysts to evaluate the valuation of public companies and compare them across industries. Market value ratios relate key financial metrics like earnings, assets, and sales with the market price of a company’s stock. Some of the most commonly used market value ratios include price-to-earnings ratio, price-to-book ratio, price-to-sales ratio, and dividend yield. These ratios provide a standardized and normalized way to compare company valuations and screen for potential investment opportunities.
Market value ratios help determine if a stock is undervalued, overvalued, or fairly valued relative to its own history and industry peers. Comparing trends over time also offers insights into changing investor sentiment. Ratios aid in financial modeling and estimating upside potential or downside risks. Screens based on market value ratios are routinely used to scan for attractively priced companies worth further research. While these ratios have some limitations due to dependence on market prices, they remain important analytical tools for investors when used judiciously along with other fundamental analyses. This article will explore the definitions, calculations, and uses of key market value ratios as well as discuss their limitations.
What are market value ratios?
Market value ratios are financial metrics used by investors to evaluate and compare stocks. Market value ratios relate the market price of a stock to some measure of the company’s financial performance, such as earnings, cash flow, book value, or sales. Market value ratios help investors assess the valuation of a stock – whether it is undervalued, overvalued, or fairly priced compared to peers. Common market value ratios include the price-to-earnings ratio (P/E), price-to-book ratio (P/B), and price-to-sales ratio (P/S).
For example, a stock trading at a P/E of 15 means investors are willing to pay Rs. 15 for every Rs. 1 of earnings per share. This P/E is compared to the company’s historical average, competitors’ P/E, or the overall market average to judge if it is under or overvalued. Market value ratios are widely used by investors for stock analysis and valuation as they provide a normalized way to compare the relative valuation of stocks across sectors and industries.
Why are market value ratios important?
Market value ratios like price-to-earnings and price-to-book value are important analytical tools for investors in the stock market as they provide insight into the relative valuation and financial health of companies.
The most basic use of market value ratios is to determine if a stock is undervalued, overvalued, or fairly valued. For instance, all other things being equal, Stock A probably has a more appealing value if it trades at a P/E of 10x while Stock B trades at 25x. Market value ratios provide a normalized comparison of valuation across different stocks. Without these ratios, comparing valuations would be much more difficult.
By comparing a stock’s current market value ratio to its historical average, investors see if the stock is trading above or below its normal valuation range. For instance, a company is sometimes undervalued if it has historically traded at an average P/B of 2x but is currently trading at 1.5x. Looking at historical market value ratios provides useful context for determining cheap versus expensive levels.
Market value ratios also enable comparison versus industry peers. A tech stock is sometimes overpriced in comparison to peers if its direct competitors trade at a lower P/S ratio than it does, with the tech stock having an 8x P/S ratio. Comparing ratios to those of peers is key for relative valuation analysis.
Certain sectors tend to have higher multiples than others based on growth, margins, and other factors. Market value ratios make it possible to consistently compare stocks across different industries. For example, consumer staples stocks will trade at a much lower P/E than high-growth tech stocks. The ratios control for this sector variance in multiples.
Ratios like P/E are also calculated for the overall stock market to derive market multiples. Comparing a stock’s ratio to the broad market average ratio provides perspective on relative valuation – a stock with a P/E of 20x when the market P/E is 15x seems overvalued versus market peers.
Trends in market value ratios over time provide clues into overall investor sentiment for a stock. For example, a rising P/B multiple sometimes indicates increasing investor confidence and optimism about the company’s growth prospects and future returns on equity. Falling ratios could signal concerns surrounding downside risks.
Valuation ratios feed into pricing models to help estimate both upside potential and downside risk. A higher possible stock price upside is indicated if the valuation means reverts or if ratios indicate undervaluation. High ratios suggest elevated valuation risk on the downside. The ratios help gauge the reasonableness of price targets.
Scanning for stocks with attractive market value ratios is a common technique investors use to generate investing ideas. For example, screening for stocks with low P/E and P/B ratios is a classic way investors look for potential value stocks. The ratios serve as useful screens to identify stocks for further research.
Movements and trends in market value ratios shed light on what factors are driving a stock’s price. For example, a surging P/E alongside flat earnings suggests price appreciation is expanding the multiple. This helps analyze the underlying stock price dynamics.
Certain ratios like P/E for the market are viewed as barometers for market cycles and investor sentiment. High market P/E historically has signaled heightened valuation risk, while low P/E points to pessimism and undervaluation. Comparing the current ratio environment to past market cycles aids analysis.
What are the different types of market value ratios available?
The price-to-earnings, price-to-book, price-to-sales and price-to-cash flow ratios are among the market value ratios that investors frequently use when evaluating businesses.
The market value per share is the current market price of a single share of a company’s stock. It represents the market’s valuation of the company on a per-share basis. The market value per share changes constantly during trading hours as the stock price fluctuates. It is calculated by taking the current market price and dividing it by the total number of outstanding shares.
The market Value per Share Formula is as stated below.
Market Value per Share = Current Market Price per Share / Number of Outstanding Shares
For example, let’s say a company has 100,000 outstanding shares, and the current market price per share is Rs. 50. To calculate the market value per share, we take the current market price of Rs. 50 and divide it by the total number of outstanding shares, which is 100,000.
Market Value per Share = Rs. 50 / 100,000
= Rs. 0.50
So, the market value per share in this example is Rs. 0.50. This means the total market capitalization of the company is Rs. 50,000 (100,000 shares x Rs. 0.50 per share). The market value per share is a measure of what the stock market believes the company as a whole is worth on a per-share basis at any given time when shares are actively trading. It fluctuates throughout the trading day as the market price changes.
The book value per share is the value of a company’s assets minus its liabilities, divided by the number of outstanding shares. It represents the theoretical value per share if the company was liquidated and paid off all its liabilities. Unlike market value, book value is based on a company’s balance sheet and not the current market price of its stock.
The book Value per Share Formula is as stated below.
Book Value per Share = (Total Assets – Total Liabilities) / Number of Outstanding Shares
For example, let’s say a company has total assets of Rs. 100 million and total liabilities of Rs. 20 million. The company also has 50,000 outstanding shares.
Book Value per Share = (Rs. 100 million – Rs. 20 million) / 50,000
= Rs. 80 million / 50,000
= Rs. 1.60
So, the book value per share in this example is Rs. 1.60. This indicates that the remaining value per share would be Rs. 1.60 if the corporation were to theoretically liquidate all of its assets and pay off all of its obligations. Book value gives an indication of the tangible accounting value of a company, unlike the market price, which fluctuates daily.
Earnings per share (EPS) is an important metric that measures a company’s profitability and is closely watched by investors in the stock market. EPS represents the portion of a company’s net income that is allocated to each outstanding share of common stock.
The formula for calculating EPS is as stated below.
EPS = Net Income / Average Outstanding Shares
Where Net Income is a company’s total net profit after taxes for a period, and Average Outstanding Shares is the average number of shares of common stock outstanding during the same period.
For instance, a company’s EPS would be as follows if its net income for the previous 12 months was Rs. 2 million, and during that same period, it averaged 5 million shares of common stock outstanding.
EPS = Rs. 2,000,000 / 5,000,000 = Rs. 0.40
This means the company earned Rs. 0.40 in profit for each share of common stock outstanding. Investors use EPS to gauge a company’s profitability on a per-share basis. Higher EPS generally indicates greater value creation for shareholders. Comparing EPS over time and against industry peers gives investors insight into a company’s financial health and growth prospects in the stock market.
Cash earnings per share (Cash EPS) measures a company’s profitability based on its operating cash flow rather than net income. It provides an alternative view of earnings that focuses on cash generation rather than accounting profits.
The formula for calculating cash EPS is as stated below.
Cash EPS = Operating Cash Flow / Average Outstanding Shares
Where Operating Cash Flow is the cash a company generates from its core business operations, and Average Outstanding Shares is the average number of shares of common stock outstanding during the period.
For instance, a company’s cash EPS would be as follows if it had Rs. 3 million in operational cash flow during the previous year and 5 million average shares outstanding.
Cash EPS = Rs. 3,000,000 / 5,000,000 = Rs. 0.60
This means the company generated Rs. 0.60 per share in operating cash flow over the last year. Unlike net income, cash flow figures are more difficult for companies to manipulate. So, cash EPS provides investors with a clear picture of the company’s ability to generate cash.
5. Dividend yield
Dividend yield measures the cash dividends paid by a company relative to its stock price. It represents the return on investment for shareholders in the form of dividend income.
The formula for calculating dividend yield is as stated below.
Dividend Yield = Annual Dividends per Share / Share Price
Annual dividends per share are the total dividends paid over the last 12 months, and share price is the current market price of one share of stock.
For instance, a company’s dividend yield would be as follows if it had paid Rs. 1 in dividends during the previous year and its share price was presently Rs. 25.
Dividend Yield = Rs. 1 / Rs. 25 = 0.04 or 4%
This means investors are earning a 4% dividend yield on their investment in the stock. The higher the dividend yield, the more dividend income shareholders receive for each rupee invested.
6. Market-to-book ratio
The market-to-book ratio (MTB) compares a company’s market valuation to its book value or net assets. It provides a way to gauge whether a stock is overvalued or undervalued by the market.
The formula for calculating the market-to-book ratio is as stated below.
MTB = Market Capitalization / Book Value
Market capitalization is the current total market value of a company’s outstanding shares (Share price x shares outstanding), and book value is the total value of a company’s tangible assets less its total liabilities, as stated on the balance sheet.
The market-to-book ratio of a firm with a Rs. 5 billion market capitalization and a Rs. 2 billion book value, for instance, would be as follows.
MTB = Rs. 5 billion / Rs. 2 billion = 2.5
This means the company’s market value is 2.5 times larger than its book value. A higher market-to-book ratio generally indicates that investors expect higher growth and future profits from the company.
7. Price-earnings ratio
The price-earnings ratio compares a company’s current share price to its per-share earnings. It shows how much investors are willing to pay for each rupee of the company’s earnings.
The formula for calculating the P/E ratio is as stated below.
P/E Ratio = Share Price / Earnings per Share (EPS)
Share Price is the current market price of a single share of the company’s stock, and EPS is the net income per share over the last 12 months.
For instance, a company’s P/E ratio would be as follows if its share price is Rs. 50 and its EPS for the previous 12 months was Rs. 2.
P/E Ratio = Rs. 50 / Rs. 2 = 25
This means investors are willing to pay Rs. 25 for every Rs. 1 of the company’s earnings per share. The higher the P/E, the more investors expect earnings growth in the future.
8. Dividend payout ratio
The dividend payout ratio is a financial metric used to measure the percentage of net income that a company pays out to its shareholders in the form of dividends. It shows the proportion of earnings distributed as dividends versus the portion retained by the company for reinvestment or other purposes. The dividend payout ratio is an important indicator of how well a company balances rewarding shareholders with retaining profits to fund growth opportunities.
The formula for the Dividend Payout Ratio is stated below.
Dividend Payout Ratio = Annual Dividends per Share / Earnings per Share
Annual dividends per share is the total dividends paid out over the last 12 months per outstanding share, and earnings per share is the company’s total net income earned over the last 12 months per outstanding share.
For example, Company A had annual dividends per share of Rs. 1.00 and earnings per share of Rs. 2.00 over the past year.
Dividend Payout Ratio = Rs. 1.00 / Rs. 2.00 = 0.50 or 50%
This means Company A paid out 50% of its earnings to shareholders as dividends over the last year. The other 50% was retained by the company.
9. Price-to-sales ratio
The price-to-sales ratio is a valuation metric used to compare a company’s stock price to its revenue. It is calculated by dividing a company’s market capitalization by its total sales or revenue over the last 12 months. The price-to-sales ratio shows the multiple sales that investors are willing to pay for each rupee of revenue. It is used to compare valuations between companies in the same industry. A lower P/S multiple indicates that investors are paying less for each unit of sales, which suggests the stock is undervalued.
The formula for the Price-to-Sales Ratio is as stated below.
Price-to-Sales Ratio = Market Capitalization / Total Revenue
Market capitalization is the total market value of a company’s outstanding shares (share price x number of shares outstanding), and total revenue is the total sales or revenues generated by the company over the last 12 months.
For example, Company A has a share price of Rs. 50, 5 million shares outstanding, a market capitalization of Rs. 250 million, and total revenue over the last 12 months of Rs. 100 million.
Price-to-Sales Ratio = Rs. 250 million / Rs. 100 million = 2.5
Therefore, Company A is trading at a P/S ratio of 2.5x. This means investors are willing to pay Rs. 2.50 for every Rs. 1 of Company A’s revenue over the last year.
10. Enterprise value
Enterprise value is a measure of a company’s total value, including both equity and debt components. It provides a more complete picture of a company’s actual worth than just looking at market capitalization.
The formula for calculating enterprise value is as stated below.
Enterprise Value = Market Capitalization + Debt – Cash and Cash Equivalents
Market capitalization is calculated by multiplying a company’s share price by the number of shares outstanding, while debt is the total liabilities on the balance sheet, and cash & cash equivalents are assets that can quickly be converted to cash.
For example, Company B has a share price of Rs. 20, 10 million shares outstanding, Rs. 100 million in total debt, and Rs. 20 million in cash and cash equivalents.
Company B’s enterprise value would be calculated as given below.
Market Capitalization = Rs. 20 x 10 million = Rs. 200 million
Debt = Rs. 100 million
Cash = Rs. 20 million
Enterprise Value = Rs. 200 million + Rs. 100 million – Rs. 20 million = Rs. 280 million
So, Company B’s enterprise value of Rs. 280 million represents its comprehensive worth, factoring in both stock market value and balance sheet debt and assets. This provides a more accurate picture than just the market capitalization alone.
The key market value ratios like price-to-earnings, price-to-book, price-to-sales, dividend yield, and enterprise value provide investors with metrics to analyze a company’s financial health, valuation, and profitability on a per-share basis to make informed investment decisions.
What is an example of market value ratio calculation?
Housing Development Finance Corporation (HDFC), once a stalwart of the Indian housing finance scene, merged with HDFC Bank in July 2023, creating a financial behemoth with a wider range of offerings.
To understand this valuation, we turn to key ratios like price-to-earnings (P/E), price-to-book (P/B), and price-to-sales (P/S). However, a crucial point to remember is that these ratios require adjustments to account for the merger. For instance, the earnings per share (EPS) needs to reflect the combined entity’s performance, which is currently estimated to be around Rs 145.
Similarly, the book value per share and sales per share need adjustments based on the merged financial statements. Once we adjust the figures, the P/E ratio comes in at 21.4x, a significant jump from the pre-merger 17.9x. This rise signals investor optimism about the synergies and growth potential unlocked by the merger. However, a fully informed picture requires further analysis of the P/B and P/S ratios after incorporating the adjusted financial metrics.
Where to find market value ratios?
Investors will be able to find market value ratios on Strike. Strike is a stock analysis platform that provides financial metrics and valuation ratios for all listed companies. It offers metrics like P/E, P/B, EPS, and more to help evaluate the value of preferred stocks relative to history and competitors.
What are the limitations of market value ratios?
The most basic limitation of market value ratios is that they rely on current market prices. The market price of a stock on any given day sometimes does not accurately reflect the true underlying value of the company. Market prices are influenced by investor sentiment, hype, momentum, and other factors not directly related to fundamentals. As a result, market value ratios derived from current market prices overstate or understate the true valuation of a stock.
This limitation applies to all market value ratios, including P/E, P/B, and price-to-sales. Another major limitation is that market value ratios like P/E and P/B are based on historical financial data. The P/E ratio uses trailing 12-month earnings, while P/B relies on the latest book value. However, investors are more concerned about a company’s future prospects. So, while historical market value ratios offer useful insight, they sometimes do not accurately depict the future earnings potential or asset values of a company. Investors need to look beyond these ratios and examine factors like expected growth, competitive position, management quality, and industry trends to evaluate a stock properly.
Market value ratios also have specific limitations depending on the metric. The P/E ratio is skewed by one-time events like asset write-downs, which artificially depress earnings in a single year. Companies going through a turnaround often have abnormally low P/E ratios that imply undervaluation but fail to account for the earnings risk. The P/B ratio is less useful for service, technology, and IP-driven companies that have few tangible assets on their balance sheets compared to capital-intensive sectors like manufacturing, utilities, and financials. Comparing P/B across industries makes little sense.
Another drawback of market value ratios is that they lack absolute benchmarks to define overvaluation or undervaluation. A technology stock with a P/E of 40 is considered overvalued in general but inexpensive compared to its industry peers. On the other hand, a utility stock with a P/E of just 12 looks attractively priced on an absolute basis despite trading at a premium to its historical average valuation. Investors should compare market value ratios to a company’s historical averages, industry peers, and broader market indexes to properly contextualize the ratios. Relying solely on absolute ratio thresholds often leads to flawed conclusions.
Market value ratios also fail to account for differences in growth outlook, risk profile, and quality of the underlying business. Stocks with identical P/E or P/B ratios are seldom equally attractive investments. A company with better growth prospects, a lower risk profile, and stronger competitive advantages deserve a higher valuation. However, market value ratios give no insight into these qualitative factors. Investors using these ratios need to look at other indicators of quality and risk beyond just the market valuation measures.
Accounting practices also affect market value ratios, limiting their comparability across companies. Issues like capitalization versus expense, changes in inventory valuation, depreciation, and amortization conventions, treatment of acquisitions, and pension accounting create large differences in earnings and book values used in P/E and P/B ratios. Companies in the same industry have very different accounting treatments, rendering their market value ratios less useful for comparison. Normalizing accounting helps improve comparability.
Market value ratios also have limitations for certain types of securities. Real estate investment trusts (REITs), master limited partnerships (MLPs), business development companies (BDCs), and other specialized investments are structured differently than regular corporations. Applying traditional P/E and P/B ratios to these securities results in misleading conclusions. Investors need to use more applicable valuation metrics tailored to each security type. The standard market value ratios are less reliable valuation tools for such specialized niches.
How are market value ratios used in financial ratio analysis?
Market value ratios are used in financial ratio analysis to relate a stock’s market price to key financial metrics, helping investors evaluate whether the shares are overvalued or undervalued compared to underlying fundamentals. The price-to-earnings ratio (P/E), a crucial financial ratio, is one of the most widely used market value ratios. It compares a company’s share price to its earnings per share (EPS), calculated by dividing the current stock price by the EPS over the last 12 months. The P/E ratio, an essential financial ratio, gives a sense of how much investors are willing to pay per rupee of the company’s earnings. A higher P/E suggests investors expect higher growth and are willing to pay more for the shares. Comparing P/E ratios between companies in the same sector or to historical averages for that company indicates if the share price is overvalued or undervalued. However, the P/E ratio doesn’t take into account future earnings projections or growth potential, so it should not be used in isolation.
The price-to-book ratio (P/B) compares the market capitalization to the company’s book value or net assets. Book value represents the company’s estimated value if all assets were liquidated and liabilities paid off. The P/B ratio measures whether the current stock price aligns with this underlying asset value. A ratio below 1.0 suggests the shares are undervalued compared to net assets, while a higher ratio means investors expect the company to generate value beyond its current asset base. Comparing P/B ratios helps identify value stocks – those trading lower relative to book value. However, book value is less useful for service, technology, or brand-driven companies where much value comes from intangibles.
The price-to-sales ratio (P/S) compares a company’s market cap to its total sales or revenues over the last 12 months. A high P/S ratio suggests the stock price is expensive relative to sales, while a low ratio could indicate an undervalued stock. Investors use the P/S ratio to screen for stocks within sectors or to value IPOs that have no earnings yet. However, revenue-based ratios like P/S have limitations for profitless high-growth companies like biotech startups, where future earnings matter more than current sales.
A stock’s dividend yield measures how much it pays out in dividends relative to its share price. It is calculated by taking the annual dividend per share and dividing it by the stock price. Mature companies often have higher dividend yields, while growth stocks tend to reinvest earnings and pay little or no dividends. Investors are looking for dividend income screens for stocks with higher yields. However, yields should be assessed relative to historical averages, as unusually high yields signal financial distress. Stocks with unsustainable high yields sometimes see dividend cuts in the future.
The market-to-book ratio compares a company’s market capitalization to its book value, similar to the price-to-book ratio. However, the market-to-book ratio uses the total market cap, while the price-to-book uses just the value of common equity. The market-to-book ratio, therefore, also incorporates the market values of preferred shares and debt. A ratio greater than 1 suggests the company has created a market value above its asset base. Startups with little physical assets tend to have high market-to-book ratios.
Is the market value ratio necessary for fundamental analysis?
Yes. Fundamental analysis examines a company’s financial health and operations to determine its intrinsic value, and the market value ratio, which compares a company’s market capitalization to its book value, provides useful insights but is not strictly necessary for conducting fundamental analysis of a stock. Fundamental analysis is a method of evaluating a stock by analyzing the underlying financial health and viability of the company. It involves looking at both qualitative factors like management, products, and competition, as well as quantitative metrics from the financial statements. Market value ratios are one type of quantitative metric used, but there is debate over whether they provide meaningful insights for stock analysis.
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