VALUATION RATIOS

WHAT ARE VALUATION RATIOS ?

A valuation ratio is a measure of how cheap or expensive a security (or business) is, compared to some measure of profit or value Valuation ratios help us figure out how the current stock price of the company compares to its performance. This, in turn, will help us make buying or selling decisions. The point of a valuation ratio is to compare the cost of a security (or a business) to the benefits of owning it.

 Valuation ratios help you evaluate what youre paying . They work very much like the signs at the supermarket that tell you how much youre paying for every ounce of a product.
Valuation ratios calculate how much youre paying for every rupee of sales. They also calculate how much youre paying for every rupee of earnings, cash flow, and book value.

TYPES OF VALUATION RATIOS

P/E RATIO

PEG RATIO

EV/EBIDTA RATIO

P/B RATIO

P/B RATIO INTERPRETATION

P/B ratio, this is a good matrix to value stocks of companies with large tangible assets in their balance sheets. A lower P/B ratio can mean that the stock is undervalued or something is fundamentally wrong with the company. If P/B is less than one, it normally tells investors that either the market believes the asset value is overstated, or the company is faring very badly in terms of returns on its assets.

EXAMPLE
P/B ratio is very much dependent on Industry Type. For a Capital Intensive Industry,
Maruti Suzuki India has a P/B ratio of 2.65 which is greater than 1 which means that the stock is overvalued,hence the return on assets of Maruti is more.

It means that the company is Fundamentally doing good.

EXAMPLE
Non capital intensive industry:
HCL technologies has a P/B ratio of 4.98 which is also greater than 1. Being a technology industry , there is not much requirement of capital other than human capital,hence it has a P/B ratio of more than 1.

Banks also require a lot of capital such as deposits , bonds etc. therefore they also have a low P/B ratio.

WHICH RATIO SHOULD BE USED WHERE?

P/E RATIO P/E is most easily understandable and meaningful for stable and /or defensive Cos. Eg: grocery chains or utilities, which tend to have earnings or revenues that grow slowly but steadily PEG RATIO It is meaningful for fast growing and cyclical companies.

The PEG is the price of growth that an investor is willing to pay, but it can only be used for companies in similar industries with relatively high levels of growth

P/E v/s PEG

Lets assume Company A is trading at P/E of 20 while Company B is trading at a P/E of 15, Company A is growing at 15% and Company B is growing at 10%. Which company is more expensive? Does the higher growth of Company A compensate investors for the higher valuation of A? By using the PEG ratio on both companies, we can quickly calculate that the PEG for Company A is 1.33(P/E/G=20/15), while Company B has a PEG ratio of 1.5.

So while the P/E ratio for Company A is actually higher, on a growth basis Company B is actually more expensive with a higher PEG ratio.
But PEG ratio is only a comparative ratio,i.e. to be used only for similar companies.