Investors can utilize a number of valuation ratios to determine if a security is a worthwhile investment. We’ll discuss two specific ratios in this chapter:
Price to earnings (PE) ratios are used by investors to determine if a company is overvalued or undervalued. The price references the market price per share of the company, while the earnings represent the profits made by the company on a per-share basis. Earnings are a line item on a corporate income statement.
The higher the PE ratio, the more likely that an investment is overvalued. For example, if the PE ratio is 100, the company’s market price is 100 times what it makes in annual earnings. Unless the company’s profits are expected to grow considerably, this investment may be overpriced. On average, PE ratios range between 15-25, depending on the company and industry.
Growth companies typically maintain higher PE ratios. These businesses usually have an evolving and expanding business, and are expected to make larger profits in the future. Therefore, the investment may seem “overpriced” today, but it may be a good deal in the long term.
For example, Roku stock (symbol: ROKU) reflects a PE ratio of 180 as of October 2021. The company’s stock price is 180 times the amount it makes in annual earnings. If you were to purchase the entire company and they maintain the same earnings level, it would take 180 years to recoup your original investment. While it sounds overpriced, what if Roku could substantially increase its profits in the next few years? Their investors are betting on this occurring, which is the only justification for investing in a company with a PE ratio this high.
Value companies typically have lower PE ratios. These businesses are usually large, well-established, and with a long track record of profits. Given their large size, investors don’t expect value companies to increase in size significantly. Without a reason to bet on large future growth, investors are generally unwilling to “overpay” for a value stock, which leads to their lower PE ratios.
For example, Allstate stock (symbol: ALL) reflects a PE ratio of 6 as of October 2021. The company’s stock price is only 6 times the amount it makes in annual earnings. If you were to purchase the entire company and they maintained the same profit level, it would take only 6 years to recoup your original investment. This is a stark difference as compared to Roku stock, making Allstate stock seem cheap and undervalued.
Value companies don’t grow as fast as growth companies, and therefore value stocks don’t typically experience high levels of capital gains. So, how do investors make a return? Value companies commonly pay cash dividends. Allstate is an example, which consistently pays quarterly dividends to shareholders.
There are a number of methods to calculate a company’s value. Book value utilizes the company’s accounting measures (in particular, assets and liabilities) to determine its worth. There are numerous ways to calculate book value, but the specifics aren’t important for the exam. Generally speaking, assume book value represents a company’s overall value from the perspective of an accountant.
The price to book ratio compares a company’s stock price to its book value. Although it’s unlikely you’ll be asked to perform a calculation, here’s the formula:
The higher a company’s stock price in comparison to its book value, the higher its price-to-book ratio. High price-to-book ratios may indicate a company is overvalued. Think about it - what if an accountant thought a company was worth $2 million (book value), when it was being sold for $100 million (market price)? This example would result in a price-to-book ratio of 50. For reference, most stocks don’t exceed a ratio of 5:1, and the average ratio in the S&P 500 is roughly 3.
The lower a company’s stock price in comparison to its book value, the lower its price-to-book ratio. Low price-to-book ratios may indicate a company is undervalued. Think about it - what if an accountant thought a company was worth $2 million (book value), when it was being sold for $1 million (market price)? The example would result in a price-to-book ratio of 0.5, well below the average ratio of 3 in the S&P 500.
After corporations pay for the cost of goods sold, operational expenses, interest & principal on outstanding debts, and taxes, it has net earnings (profits). To better understand this, let’s look at the sample income statement from the Fundamental analysis chapter:
| Line item | Amount |
|---|---|
| Sales revenue | +$200,000 |
| Cost of goods sold (COGS) | -$80,000 |
| Gross profit | $120,000 |
| Operating expenses | -$30,000 |
| Income from operations (EBIT)* | $90,000 |
| Interest (bonds & loans) | -$25,000 |
| Income before taxes (EBT)* | $65,000 |
| Taxes | -$10,000 |
| Net income | $55,000 |
*EBIT = earnings before interest & taxes
*EBT = earnings before taxes
The corporation in this example has $55,000 of net income, better known as net earnings (profit). When profits exist, corporations can utilize them in one of three ways:
Growth companies tend to retain profits so they have capital (money) to expand the business further. Value companies, which tend to be large and profitable, typically distribute part of their profits to shareholders by cash dividends and keep part of their profits for future business expenses. This is common for dividend-paying companies. In fact, it’s very rare to find a company that distributes 100% of its earnings to shareholders.
In these circumstances, investors are often interested in knowing their company’s dividend payout ratio. Here’s the formula:
With this formula in mind, let’s re-share the example income statement, but with two added lines at the bottom:
| Line item | Amount |
|---|---|
| Sales revenue | +$200,000 |
| Cost of goods sold (COGS) | -$80,000 |
| Gross profit | $120,000 |
| Operating expenses | -$30,000 |
| Income from operations (EBIT)* | $90,000 |
| Interest (bonds & loans) | -$25,000 |
| Income before taxes (EBT)* | $65,000 |
| Taxes | -$10,000 |
| Net income | $55,000 |
| Dividends paid | -$20,000 |
| Retained earnings | $35,000 |
*EBIT = earnings before interest & taxes
*EBT = earnings before taxes
Can you calculate the dividend payout ratio?
Answer = 36.4%
To calculate the dividend payout ratio, we need two items - net income and dividends paid. The corporation reported $55,000 in net income, but only paid out $20,000 in dividends. Now we can perform the calculation:
It’s possible to be asked to perform this calculation with components displayed on a per-share basis. Let’s look at an example question:
An investor is researching a stock and performing several calculations to determine its quality. They find the following pieces of data:
- Quarterly dividend = $1.00
- EPS = $10.00
When information is presented in this manner, the dividend payout ratio formula slightly changes:
Earnings per share (EPS) measures the profitability of a corporation on a per-share basis. For example, a company reporting $10,000,000 of net earnings with 1,000,000 shares outstanding would report an EPS of $10. Here’s the formula for EPS:
Now that we’ve covered EPS, let’s go back to the original question on the dividend payout ratio:
An investor is researching a stock and performing several calculations to determine its quality. They find the following pieces of data:
- Quarterly dividend = $1.00
- EPS = $10.00
What is the stock’s dividend payout ratio?
Can you figure it out?
Answer = 40%
Be careful here! Dividends are reported on a quarterly basis, but the dividend payout ratio is measured on an annual basis. If the stock pays a $1.00 quarterly dividend, it must pay a $4.00 annual dividend. The EPS is already stated on an annual basis, so no adjustment is needed to our EPS of $10.00.
Now, do the formula:
In summary, the dividend payout ratio measures the level of profits shared with investors. Growth companies tend to have low dividend payout ratios (or no DPR if they don’t pay dividends), while value companies typically have higher payout ratios.
Sign up for free to take 5 quiz questions on this topic