Investors use valuation ratios to help decide whether a security looks reasonably priced. This chapter focuses on two common ratios:
Price to earnings (PE) ratios help investors judge whether a company’s stock price looks high or low relative to its earnings.
Earnings are reported on a corporate income statement.
A higher PE ratio generally suggests the stock is priced more expensively relative to current earnings. For example, a PE of 100 means the stock price is 100 times the company’s annual earnings per share. Unless investors expect profits to grow substantially, a very high PE can indicate the stock is overpriced. As a rough reference, PE ratios often fall in the 15-25 range, depending on the company and industry.
Growth companies typically have higher PE ratios. These companies are expected to increase profits significantly in the future. That can make the stock look “expensive” today, but investors may still consider it attractive if they believe earnings will rise.
For example, Roku stock (symbol: ROKU) reflected a PE ratio of 180 as of October 2021. That means the stock price was 180 times its annual earnings per share. If you bought the entire company and earnings stayed the same, it would take about 180 years (in earnings) to recoup the purchase price. Investors accept a PE that high only if they believe profits will grow substantially.
Value companies typically have lower PE ratios. These businesses are often large, established firms with a long history of profits. Because investors usually don’t expect dramatic growth from mature companies, they’re generally less willing to pay a high multiple of current earnings.
For example, Allstate stock (symbol: ALL) reflected a PE ratio of 6 as of October 2021. That means the stock price was 6 times its annual earnings per share. If you bought the entire company and earnings stayed the same, it would take about 6 years (in earnings) to recoup the purchase price. Compared with Roku, Allstate appears much cheaper based on PE.
Because value companies tend to grow more slowly, value stocks often have lower potential for large capital gains. So where can returns come from? Many value companies pay cash dividends. Allstate is an example; it has consistently paid quarterly dividends to shareholders.
There are several ways to estimate a company’s value. Book value uses accounting measures - especially assets and liabilities - to estimate what the company is worth. There are multiple ways to calculate book value, but the details aren’t important for the exam. In general, you can think of book value as the company’s value from an accountant’s perspective.
The price to book ratio compares the stock’s market price to its book value. You’re unlikely to be asked to calculate it, but here’s the formula:
A higher stock price relative to book value produces a higher price-to-book ratio. High price-to-book ratios may indicate a company is overvalued. For example, if an accountant estimates a company is worth $2 million (book value), but the market values it at $100 million (market price), the price-to-book ratio would be 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.
A lower stock price relative to book value produces a lower price-to-book ratio. Low price-to-book ratios may indicate a company is undervalued. For example, if book value is $2 million but the market price is $1 million, the price-to-book ratio would be 0.5, well below the S&P 500 average of about 3.
After a corporation pays cost of goods sold, operating expenses, interest and principal on outstanding debts, and taxes, it has net earnings (profits). To see how this works, here’s 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
In this example, the corporation has $55,000 of net income (net earnings). When a company earns a profit, it can use that profit in one of three ways:
Growth companies often retain profits to fund expansion. Value companies, which tend to be larger and more established, often distribute part of their profits as cash dividends and retain the rest for future business needs. It’s rare for a company to distribute 100% of its earnings to shareholders.
Because of this, investors often want to know a company’s dividend payout ratio. Here’s the formula:
With that in mind, here’s the same income statement with two additional lines:
| 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, you need two numbers: net income and dividends paid. The corporation reported $55,000 in net income and paid $20,000 in dividends.
You may also see this calculation using per-share figures. Here’s 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 the information is presented this way, the dividend payout ratio formula is written as:
Earnings per share (EPS) measures profitability on a per-share basis. For example, a company with $10,000,000 of net earnings and 1,000,000 shares outstanding would report EPS of $10.
Now go back to the dividend payout ratio 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
What is the stock’s dividend payout ratio?
Can you figure it out?
Answer = 40%
Watch the timing: the dividend is quoted quarterly, but the dividend payout ratio uses annual dividends.
Now apply the formula:
In summary, the dividend payout ratio measures how much of a company’s profits are paid out to shareholders. 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.
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