Understanding Valuation Ratios in Stock Market

13. Valuation Ratios

Valuation ratio is conducted to decide whether the stock of a company is currently selling at attractive (cheap/undervalued), fair (rightly priced) or expensive (overvalued) valuations. It is done post-financial analysis, to select stocks for further analysis.

Once an investor has found a financially strong company by using the parameters highlighted in the financial analysis guide, she should do the valuation analysis to check whether the stock of the company is priced right.

If the shares of a company are overvalued then the investor should avoid investing in it, however good the company's financial position may be. Investing hard-earned money in overvalued stocks exposes the investor to higher levels of risk where the potential of future appreciation is limited but the risk of loss of money is high. Therefore, valuation analysis becomes paramount before taking a decision to buy any stock.

Valuation analysis compares the stock market values of the stock of a company with its financial parameters. Stock market values consist of the current market price (CMP), market capitalization (MCap) etc.

13.1 Price To Sales (P/S) Ratio

The Price-to-Sales Ratio (P/S) measures the value of a company in relation to the total amount of annual sales it has recently generated. Often referred to as the "sales multiple", the P/S ratio is a valuation multiple based on the market value that investors place on the revenue belonging to a company.

Price/Sales Ratio= Market Capitalization/ Annual Revenue

The price-to-sales ratio indicates how much investors are currently willing to pay for a rupee of sales generated by a company. This ratio tells us how much value the market places on the sales of a specific company, which is determined by the quality of revenue (i.e. customer type, recurring vs. one-time), as well as expected performance.

Higher P/S ratios can often serve as an indication that the market is currently willing to pay a premium for each rupee of sales. A low price-to-sales ratio relative to industry peers could mean that the shares of the company are currently undervalued.

The standard acceptable range of the price-to-sales ratio varies across industries. Hence, benchmarking the ratio must be done among similar, comparable companies. Alternatively, a ratio in excess of its peer group could indicate the target company is overvalued.

Let us calculate the same for Exide Industries. We will take up the denominator first:

Sales Per Share = Total Revenues / Total number of shares

We know from Exide Industries statement:

Total Revenue = Rs.10040.84 crs

Number of Shares = 85 Cr

Revenue per share = 10040.84 /85

Therefore the Revenue per share = Rs. 118.11

This means for every share outstanding, Exide Industries does Rs.118.11 worth of sales.

Price to Sales Ratio = 171 / 118.11

= 1.45x

P/S ratio of 1.45x times indicates that, for every Rs.1 of sales, the stock is valued Rs.1.45 times higher. Obviously, the higher the P/S ratio, the higher is the valuation of the firm. One has to compare the P/S ratio with its competitors to get a fair sense of how expensive or cheap the stock is.

13.2 Price To Book(P/BV) Ratio

The Price-to-Book Ratio (P/B Ratio) measures the market capitalization of a company relative to its book value of equity. Widely used among the value investing crowd, the P/B ratio can be used to identify undervalued stocks in the market.

Price-to-Book Ratio (P/B) Definition

Often referred to as the market-to-book value ratio, the P/B ratio compares the current market capitalization (i.e. equity value) to its accounting book value.

• Market Capitalization (Price):Calculated as the current share price multiplied by the total number of diluted shares outstanding

• Book Value (BV):The book value is the net difference between the carrying assetvalue on the balance sheet less the company's total liabilities

In short, the market capitalization represents the pricing of a company's equity according to the market (i.e. what investors currently believe the company to be worth). The book value, on the other hand, reflects the value of the assets that a company's shareholders would receive if the company were hypothetically liquidated.

Since the book value of equity is a levered metric (post-debt), the equity value is used as the point of comparison, rather than the enterprise value, to avoid a mismatch in the represented capital provider(s).

For the most part, any financially-sound company should expect its market value to be greater than its book value since equities are priced in the open market based on the forward-looking anticipated growth of the company.

Price-to-Book Ratio (P/B) = Market Capitalization / Book Value of Equity

The norm for the P/B varies by industry, but a P/B ratio under 1.0x tends to be viewed favourably and as a potential indication that the company's shares are currently undervalued. The P/B ratio is generally more accurate for mature companies, like the P/E ratio, and is especially accurate for those that are asset-heavy (e.g. manufacturing, industrials).

In addition, the P/B ratio is typically avoided for companies comprised mostly of intangible assets (e.g. software companies). In reality, very rarely is a company's book value of equity lower than its market value of equity.

If the market valuation of a company is less than its book value of equity, that means the market does not believe the company is worth the value on its accounting books.

Let us calculate the same for Exide Industries: From Exide Industries balance sheet, we know:

Share Capital = Rs.6893.51crs

Number of shares: 85crs

Hence the Book Value per share = 6893.51/85

= Rs 81.1 per share

This means if Exide Industries were to liquidate all its assets and pay off its debt, Rs.81.1 per shares is what the shareholders can expect.

Price per share is Rs.171

P/BV = 171/81.1

= 2.10

This means Exide Industries is trading over 2.10 times its book value.

13.3 Price To Earnings Ratio

The price-to-earnings ratio is a measure that reflects an organization's potential to make money. This potential is measured in terms of the value paid by equity holders for each stock unit. Thus, it indicates if a particular stock is cheaper or costlier than its competitors within the same industry. Additionally, the current price-to-earnings ratio can be compared to the company's past ratios to track its growth.

The formula for the P/E ratio involves dividing the latest closing share price by its earnings per share, with the EPS calculation consisting of the company's net income ("bottom line") divided by its total number of shares outstanding.

P/E Ratio = Share Price/Earnings Per Share

High & Low P/E Ratio - A lower P/E ratio means that companies are using their resources to produce the maximum amount of profit possible - which ultimately benefits investors. Investors are always looking for companies that increase in value due to their scrupulous use of shareholders money. A high P/E ratio could mean that a stock price is high compared to earnings and might be overvalued.

For Example- for Exide Industries-

PAT= Rs.758.28crs

Total Number of Shares = 85 Cr

EPS= 758.28/85= Rs.8.92

P/E= 171/8.92= 14.1x

This means investors are willing to pay 14.1 times for purchasing the equity shares of Exide Industries