Market Buzz - Using Key Ratios to Analyze Stock Investments

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 cheap or expensive a stock is relative to its earnings or cash flow. To compare the valuations of different companies, investors can use a collection of ratios, also commonly referred to as valuation multiples.

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 and trade at different share prices. In a way it is telling you how much you are paying for every dollar of earnings the company generates. If Company A were to trade for $20 per share and generates $2 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 of annual earnings). If Company B were to trade at $10 per share and generates $2 per share in earnings (same as company A), then it would have a PE ratio of 5. If the growth and risk level of both companies were identical we could easily surmise that Company B is more attractively valued than Company A. After all, why would you pay $10 for $1 of annual earnings when you could pay $5 for an identical $1 of earnings? Where things get complicated is that, in the real world, no two companies are perfectly identical. It is highly likely that the future growth and overall risk levels are quite different from Company A to Company B. For example, the earnings of Company A may be expected to grow in the future while the earnings of Company B may be expected to decline. In that event, Company 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. In that case you are paying more money per $1 of higher quality earnings. Where valuation analysis moves from pure science to a science and an art, is when you have to determine what constitutes an appropriate valuation for a company with a given level of growth and risk.

Price-to-Cash Flow (P/CF)

One of the problems with relying on the P/E ratio is that net earnings are an accounting figure and do not necessarily reflect the true economic profitability of the company. Earnings quality is always a major consideration when performing valuation analysis. High earnings quality essentially means that reported earnings are in line with actual cash flow. Many analysts and investors will wisely make adjustments to the net earnings figure on the income statement to create a better picture of the economic reality. 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. 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 in the exact same way as the PE ratio only 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 effectively telling you how much you are paying for each $1of annual cash flow generated by the business.

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 to shareholders of the company after payment of capex.

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 expenditures 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.

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

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 $1of 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 shareholders (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 excludes Goodwill and Intangible Assets, is often used in the equation as a replacement for standardized shareholder’s equity. This adjustment does help to improve the usefulness 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 disposal, 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 comparable companies. 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 use 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). Whether you use earnings, cash flow, or free cash flow, it must be consistent across all data in the comparison or the valuation will be highly misleading.