When it comes to investing, most people will attempt to buy low and sell high. That is clearly a sound way to approach buying and selling shares, but how do you go about determining whether a companys share price is low or high? In other words, how do you go about valuing shares with a view to buying or selling them?
Price To Earnings
The most commonly used ratio when it comes to valuing a company is the price to earnings (P/E) ratio. It simply divides the current share price by last years earnings per share, with next years earnings per share (i.e. the forecast) potentially used so as to generate the forward P/E ratio.
The benefits of the P/E ratio are that it is easy to compute, universally understood, and can be applied to all profitable companies in all sectors. Clearly, if a company is loss-making then the P/E ratio will not be of much use, and many investors find that the best means to use a P/E ratio is on a relative basis. This essentially compares the P/E ratio of your chosen company to others in its sector, to the sector, or even to the wider index. A lower P/E ratio indicates better value for money.
Price To Book
For companies that are loss-making, a useful valuation ratio is the price to book (P/B) ratio. This divides the share price by net assets per share, with net assets being total assets minus total liabilities. The P/B ratio does not use the income statement, rather it focuses on the balance sheet, and essentially compares the price of a company to its liquidation value.
Of course, the net assets of most companies can be used to generate a profit, and so their P/B ratios are generally greater than 1. And, while P/B ratios can be useful for valuing asset-rich companies such as energy companies, other companies that have few assets (but which generate large profit) such as media companies, can be negatively affected in terms of having a high P/B ratio. As such, it can be useful to use the P/B ratio alongside other valuation ratios.
Price To Sales
The price to sales (P/S) ratio simply divides a companys share price by sales per share, and is commonly used to value retailers and other stocks for whom sales growth is a key driver of their share price. Certainly, it is a useful guide, but a company can appear to be cheap based on its P/S ratio and, for example, be a loss-making business with little scope to return its net profit to positive territory. As such, other valuation ratios should be used alongside it.
Price To Cash Flow
The old adage revenue is vanity, profit is sanity, cash is reality holds true for all businesses, since sales tell us nothing about the future sustainability of a business, while profit can include various non-cash items that do not have a positive impact on the business. As such, dividing a share price by cash flow per share can be a very accurate way to determine if a company offers good value with regard to the most important aspect of any business: cash flow.
For many investors, dividend yields are a starting point in deciding whether a companys share price is low or high. Certainly it provides an indication, but can be skewed if, for example, a company pays out nearly all of its profit as a dividend. As such, and while dividends are a very important part of the total return for most investors in the long run, it is important to look beyond a high yield and question its sustainability and future prospects.
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