The Five Horsemen of Valuation Ratios

The Five Horsemen of Valuation Ratios

No, this isn’t an article about pro wrestling, Ric Flair and his sidekicks. Rather, it’s an introductory piece on the different ratios used to assess whether or not a stock is trading at a value relative to its history, its peer group or the overall market. We often talk about valuation ratios in our articles and we assume that readers understand them, but sometimes that assumption isn’t a fair one. In this article, I wanted look at some of the commonly used valuation ratios. I’ve coined these as the “five horsemen” (vs. the “four horseman” from the old school wrestling days) of valuation ratios and I set out to answer the following questions:

  • What does each ratio measure?
  • What financial statement (balance sheet, income statement, cash flow statement) does the denominator come from?
  • What are the ratios’ strengths and weaknesses?
  • What are key thresholds, or levels, investors should consider when using each?
  • What guru models on Validea utilize each valuation metric as one of the criteria within their strategy?

Price-to-Book (P/B)

  • What does it measure: The P/B ratio compares a firm’s market capitalization to its book value. It’s calculated by dividing the company’s stock price per share by its book value per share. Book value is typically defined as the firm’s assets minus its liabilities found on its balance sheet (its equity). Typically, the lower the P/B ratio the better from a valuation standpoint.
  • Financial Statement: Balance Sheet
  • Strength: Price/Book is the ratio most often used in academic research so there is significant long-term research to support it. Assets on the balance sheet can be more consistent than cash flows or earnings, which can lead to lower turnover in portfolios compared to other metrics. P/B is useful for capital intensive industries that carry high levels of assets on their balance sheet.
  • Weakness: Does not adequately measure intangible assets and does not account for the fact that assets often have a different market value than their book value. Also, companies buying back shares, which is a capital allocation decision that can be good for investors, would see book value fall after share buybacks.
  • Strategy Example: In the strategy we run based on Joseph Piotroski’s work, the P/B is used as a threshold in defining the universe. The strategy only looks at stocks in the lowest 20% of the market based on the P/B ratio.
  • Strategies on Validea:

Price-to-Earnings (P/E)

  • What does it measure: The P/E ratio measures a company’s current share price relative to its earnings per share. Earnings per share are usually TTM (trailing 12 month) earnings or forward earnings, which takes analyst earnings estimates into consideration. The inverse of P/E is known as the “earnings yield”, so a stock with a P/E of 10 has an earnings yield of 1/10, or 10%. Generally speaking, a lower P/E (or higher earnings yield) is better from a value standpoint.
  • Financial Statement: Income statement
  • Strength: The ratio is very understandable for most investors. Saying a company trades at 10x earnings is a concept that most investors can conceptualize. The ratio also provides a good sense of investor expectations relative to the market or other stocks. A company with a P/E of 5 clearly has lower expectations than a stock that carries a P/E of 40.
  • Weakness: Earnings can be subject to many adjustments, which make earnings noisy and less valuable than figures that aren’t as susceptible to tweaks. Interest expense, depreciation and amortization are accounting adjustments that impact a firm’s bottom line. In some sectors and industries, like cyclicals and energy, you can have stocks with very low P/Es (based on low stock prices and lofty trialing 12-month profits), but that can be deceptive and lead investors to buy them at the wrong part of the cycle.
  • Strategy Example: Our Ben Graham model multiplies the P/B by the P/E ratio and rewards stocks where the result of that formula is 22 or less. The model we base on Peter Lynch uses the P/E to penalize expensive stocks (i.e. stocks with a P/E above 40) that may have difficulty maintain lofty growth rates.
  • Strategies on Validea:

Price-to-Sales (P/S)

  • What does it measure: The P/E ratio measures a company’s current share price relative to its sales (or top line revenue) per share. A low P/S is an indicator of value.
  • Financial Statement: Income statement
  • Strength: Since earnings can be impacted by a number of adjustments, the P/S ratio can give us a cleaner picture of a firm’s valuation. The P/S can be used when profits are not as important to investors. Take Amazon for example, the company has very rarely shown a profit but investors are willing to value the company based on other measures and the P/S is one way to look at the retailer.
  • Weakness: The P/S fails to capture the cost structure or capital structure. A business with lots of debt or very high costs may not ever have a chance to making money. It also doesn’t differentiate between highly profitable firms and firms with low margins. While revenue is less prone to accounting gimmicks, it’s not completely foolproof. For instance, revenue recognition policies can book revenue now that may have very little chance of being recognized in the future.
  • Strategy Example: The model we run base on Ken Fisher books rewards noncyclical companies and technology stocks with a P/S less than 1.5 and cyclical stocks with a P/S of 0.8 or lower.
  • Strategies on Validea:

Price-to-Cash Flow (P/CF)

  • What does it measure: The P/E ratio measures a company’s current share price relative to its cash flow per share. It gives you an indication of the multiple investors are willing to pay given the cash flow being generated by the business. In some instances, free cash flow is used. Free cash flow tends to be even more stringent than cash flow since free cash flow subtracts capital expenditures from total operating cash flow. The lower the better from a P/CF standpoint.
  • Financial Statement: Cash Flow Statement
  • Strength: The P/CF not susceptible to adjustments like earnings, or even sales. As one web site stated: “cash flow is simply cash flow – it is a concrete metric of how much cash a firm brought in within a given period”. P/CF is useful when comparing companies in similar industries. For example, companies in a rapidly growing industry may be investing heavily into the business, thus reducing cash flow, whereas a mature business may not need to make heavy investments back into the business. As a result, the P/CF levels may vary depending on the growth potential of a business.
  • Weakness: Since there are different types of cash flow calculations, it is important that the same type of formulas be used when calculating cash flows. This ends up being more complex than some of the other ratios. In addition, cash flow does not take into consideration deferred revenue, and while that is a negative, it is also one of the positives.
  • Strategy Example: The Warren Buffett based strategy likes to see companies generating free cash flow and so if P/CF is positive that helps companies achieve top ranked scores.
  • Strategies on Validea:

Enterprise Value to EBITDA (EV/EBITDA)

  • What does it measure: Measures the value of a company, based on what a private buyer would pay, relative to the earnings before interest, taxes, depreciation and amortization (EBITDA), which is also known as operating earnings. Like all of the other metrics, a lower figure indicates value.
  • Financial Statement: Income statement
  • Strength: Unlike market capitalization, enterprise value tells you what a private buyer might pay for the company when you take into consideration cash on the balance sheet and debt levels. In a private transaction, you would have to add debt to the purchase price (since the buyer assumes the debt) and subtract cash (the cash immediately becomes the buyers on the purchase and should be netted out of the cost to buy the company). In addition, by using EBITDA you are adjusting for interest, taxes and other non-cash adjustments and getting a clean view of operating earnings.
  • Weakness: One pitfall is the EV/EBITDA ratio doesn’t include capital expenditures, which for some companies can be a large expense.
  • Strategy Example:  In the Acquirers Multiple model stocks are percentile ranked based on the EV/EBITDA formula. The top 1-2% of stocks are the best using this value ranking.
  • Strategies on Validea:

As you look to learn and incorporate these into your investment process, I hope this article provides some value (no pun intended) on commonly used value ratios that seek to identify companies that are cheap based on assets, profits, cash flows and more.

Photo: Copyright: / alliedcomputergraphics

Justin J. Carbonneau is VP at Validea & Partner at Validea Capital Management.
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