Stock Valuation Ratios

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Video Transcription:

Hello traders, welcome to the stock trading course and the sixth module, investing: stock picking. In this lesson, we’re going to learn everything about the valuation ratios. So let’s start by defining what a valuation ratio is. Valuation ratios will give an idea to investors if the price of a company’s stock doesn’t reflect its fundamental value. So basically, what we’re looking for here is to determine if the stock is overpriced or underpriced. These ratios can be used by investors to determine how attractive a stock is. Valuation ratios attempt to simplify the valuation process by comparing relevant data that will help investors estimate a valuation of the company, or the company’s stock.

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So let’s start by looking at price to earning ratio. The PE ratio is a ratio for evaluating a company that measures its current price, its current share price relative to its earnings per share. This ratio indicates the dollar amount that an investor can expect to invest in a company to receive $1 of the company’s earnings. So this ratio is referred to as the multiple, because it shows how much investors are willing to pay per dollar of earnings. Now the formula for the PE ratio is simple: you just divide the stock price by the earnings per share, and the average PE ratio is between 20 and 25 times the earning per share.

Generally, a high or rising PE ratio will indicate that investors are expecting higher earnings growth in the future because they are paying more for today’s earnings in anticipation of future earnings. So basically, if you are looking at the PE ratio of a company, you are going to want a high or a rising PE ratio from previous quarters, because companies with low PE ratios suggest that investors have more modest expectations of future growth. And remember, when we are investing a company, we are looking for growth stocks.

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The second valuation ratio that we are going to go through is price to sales ratio. This ratio measures the price of a company’s stock against its annual sales, and it’s basically like the PE ratio, but the PS ratio reflects how many times investors are paying for every dollar of a company’s sale. Since earnings are subject to accounting estimates and management manipulation, many investors consider a company’s revenue a more reliable ratio component in calculating a stock price multiple. So basically, what we’re going to do here is we’re going to be calculating how many times an investor is paying for every dollar of a company’s sale. The formula is simple: the stock price divided by the net sales per share.

Like the PE ratio, a high PS ratio is a bullish indicator, and a low PS ratio is a bearish indicator. Now, the PS ratio should not be used by itself to valuate a company’s stock price. Since it provides another perspective, it should be used in compliment with other valuations ratios as a whole analysis methodology.

The third valuation ratio that we are going to learn is the price to cash flow ratio. And to be honest, I think that this is one of the more important valuation ratios that we are going to learn. This ratio compares the stock price to the amount of cash flow the company generates on a per share basis. It compares the company’s market value to its cash flow, with a formula of stock price divided by operating cash flow per share.

Now, here comes the interesting part of the price to cash flow ratio. A high PCF ratio indicates that a company is trading at a high price but not generating enough cash flow to support the multiple. So a high price to cash flow ratio should be looked at as unattractive. But, investors prefer smaller price to cash flow ratios because they indicate a larger injection of capital to the company, or a larger cash flow, that is not yet considered in the current stock price. So, a smaller price to cash flow ratio might indicate that the stock is undervalued and that the company’s cash flow is in fact rising.

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And the last valuation ratio is the dividend yield. This ratio indicates how much dividend income you will earn from a one dollar investment in a company. This ratio is the less used valuation because investors give more emphasis on stock price appreciation than a higher dividend payment, but still, it’s important to understand it. The formula is dividends per share divided by stock price, times 100. A higher dividend yield could mean that the stock is underpriced, or the company’s future dividends could be higher. Conversely, a low dividend yield can indicate that the stock is overpriced and future dividend payments are going to be lower. So investors are going to be looking for a high dividend yield when they are running their valuation ratios to determine how attractive an investment really is.

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