Market Buzz - Using Key Ratios to Analyze Value

Individuals that have followed the markets for any period of time have probably heard the term “valuation” spoken on countless occasions. It is a term we use repeatedly at KeyStone. When we refer to valuation we are talking about how over or undervalued a company is as a function of their current share price relative to their earnings or cash flow. To aid in this assessment it is common to use a number of valuation ratios (discussed below) to assign an actual number to the respective valuation.

Price-to-Earnings (PE)

The PE ratio is the most common valuation ratio tossed around investment circles. You determine the PE ratio by dividing the share price (SP) by the earnings per share (EPS).

PE Ratio = Share Price / EPS

The result is a number that can be used to compare different companies that generate different earnings per share. In a way it is telling you how much you are paying for every dollar of earnings. If company A were to trade for $20 per share and generate $2.00 per share in earnings then their PE ratio would be 10 (you can look at it as if you are being asked to pay $10 for every $1.00 of earnings). If company be were to trade at $10 per share and generate $2.00 per share in earnings (same as company A) then it would have a PE ratio of 5. With everything else about companies A and B being equal (risk of business, growth, size, financial position, etc.), we would surmise that company B is more attractively valued than company A because you are being asked to pay less ($5 for company/$10 for company) for every $1.00 of earnings that you are acquiring. However, everything else is never equal and different companies vary widely in term of future growth and overall risk. If for example, the earnings of company A were expected to grow in the future while the earnings of company B were expected to decline then A could actually have the more attractive valuation even though the nominal PE ratio is higher. Companies with higher expected growth rates and less risk will typically (and should) trade at higher PE multiples than companies with lower growth and higher risk.

One of the drawbacks of using net earnings in the valuation is that it is an accounting figure and does not necessarily reflect the true profitability of the company. For this reason, it is often necessarily to make adjustments to the earnings reported in the financial statements in order to get a more accurate picture of the economic profits of the company. This is commonly referred to as adjusted earnings.

Price-to-Cash Flow (P/CF)

Earnings quality is always a major consideration when performing valuation analysis. We discussed that reported net earnings on the income statement do not always provide a realistic picture of economic profitability. While some may find it useful to make adjustments to the reported earnings, others find it more useful to just go straight to the cash flow statement. High earnings quality essentially means that reported earnings are in line with actual cash flow. If a company is reporting positive earnings on the income statement but does not show the commensurate operating cash flow in the cash flow statement then the concern is that the earnings are in fact not real. In many cases it is actually better to ignore net earnings and focus purely on cash flow.

The price-to-cash flow ratio is calculated the exact same way as the PE ratio only with using cash flow per share as the divisor.

P/CF Ratio = Share Price/Cash Flow per Share

As with the PE ratio, the P/CF ratio allows you to compare the relative value of different stocks with different cash flow per share. It is telling you how much you are paying for each $1.00 of cash flow that the business generates.

Price-to-Free Cash Flow (P/FCF)

Just like with the PE ratio, the P/CF ratio has some limitations as well. The main weakness is that operating cash flow does not subtract capital expenditures which are considered an investing expenditure and not an operating expenditure. Capital expenditures, or capex, are cash outlays on the purchase of new assets and upgrades of existing assets. For some companies, capex is substantial which means that normal operating cash flow will not adequately reflect the cash flow that is available for shareholders of the company after payment of capex.

P/FCF Ratio = Share Price/Free Cash Flow per Share

To address this situation it is often advisable to utilize free cash flow instead of operating cash flow. Free cash flow (FCF) is most commonly defined as the cash flow that is available to shareholders after all expenditure required to maintain the productive capacity of the business. The capex that we discussed before can be separated into growth capex and maintenance capex. Therefore FCF is typically calculated as operating cash flow less maintenance capex. FCF is the cash flow retained by the business that can be used for investing in growth, paying dividends, retiring debt, and buying back shares. In our view, free cash flow is the most appropriate metric for reflecting the economic value generated by a business for its shareholders.

Price-to-Book Value (P/BV)

Another common (although less so) valuation metric is the price-to-book value ratio. This is calculated simply as the share price divided by the book value (or shareholder’s equity) per share.

P/BV Ratio = Share Price/Book Value per Share

In the case of the P/BV ratio, you are not finding out how much you are paying for each $1.00 of earnings or cash flow. This is an asset based multiple that tells you how much you are paying for every $1.00 of assets that are owned by the shareholder (shareholder’s equity). A P/BV of less than 1 tells you that for less than $1.00, you can buy $1.00 worth of shareholder’s equity. A P/BV of more than 1 tells you that you will spend more than $1.00 for $1.00 worth of shareholder’s equity.

In reality, the P/BV ratio is probably the least reliable of the valuation tools we have discussed. The main reason for this is that asset values reported in a company’s balance sheet do not typically reflect the real value the company would receive by selling those assets in the market. The balance sheets of many companies also include items just as Goodwill and Intangible Assets, which are accounting terms and may have no relevance outside of the balance sheet. To address this issue Tangible Book Value, which exclude Goodwill and Intangible Assets, is often used in the equation as a replacement for standardized shareholders equity. This adjustment does help to improve the validity of the P/BV ratio; however, the ratio itself is largely unreliable as a standalone assessment of value.

Putting it all Together

Now that you have a few tools at your exposure you’re probably wondering how you can put them into action. As we said before, these valuation ratios are largely used as a comparison tool. Once you have the PE, P/CF, or P/FCF ratio of a company you can start comparing it to other similar companies in the market, the industry average, the market average, and historical averages for both the company you are researching and the comparable. Ratio analysis is not meant to be the end game in valuation. All the numbers will provide is a general sense of how that individual company is being valued in the market. It is up to the investor or analyst to determine if that valuation is attractive or expensive based on the merits of the individual company.

One point that is important to make is that when performing valuation analysis it is crucial that the comparison be apples-to-apples. For example, if you are adjusting the net earnings then you must apply a standardized methodology that you apply to all companies in the comparison. Some analysts will use earnings over the previous four quarters (trailing earnings) and others will use forecasted earnings over the upcoming four quarters (forward earnings). Whatever earnings or cash flow you decide you use it must be consistent across all data in the comparison.

2013 KeyStone Financial Publishing Corp.