Ratios, Ratios and More Ratios

What determines the value of a company? The short answer is supply and demand, but to further the question, what influences supply and demand? A company’s owners are called its shareholders and a company’s ownership unit are called shares (a.k.a stock). The demand for a companies stock is determined by many factors such as earnings, earnings growth, dividends and risks associated with the company. There are countless ways to view and measure a company’s intrinsic value. Investors look to compare that perceived intrinsic value of a company’s shares compared to the current share price to determine if the company stock is over or under-valued. In the classic 1934 edition of Benjamin Graham and David Dodd’s book “Security Analysis”, there are over 700 pages devoted to dissecting the methods in trying to determine undervalued companies. This article will offer an overview of some of the more commonly used ratios in evaluating a company’s stock.

Yield is calculated by dividing the amount of dividends paid on a yearly basis by the current stock price. For example, if a XYZ company is paying $1 per share per year in dividends, and the current share price is $25, the current yield is 4% (1/25). Yield should not be confused with total return of a stock which also factors in the increase or decrease in share price. Yield, and the sustainability of that yield, is often important to investors seeking investment income. P/E ratio is also called “Price Earnings Ratio”. This is a metric used to examine the amount of earnings per share (EPS) a company makes in comparison to current share price. EPS is determined by dividing the total earnings of a company into the total number of shares outstanding. The P/E ratio takes the market price per share divided by the earnings per share. All else remaining equal, would you rather own a company with EPS $5/ share and a stock price of $50 (50/5 = 10 P/E ratio), or a company that reported EPS of $1/share with a stock price of $25/share (25/1 = 25 P/E ratio)?

One flaw with the P/E ratio is it doesn’t factor in future estimated earnings growth or current dividends paid. To take the P/E ratio one step further, the PEGY ratio factors in expectations for earnings growth as well as the dividend paid. “Expectations” being the key word in this ratio. Certainly nobody knows what amount of earnings a company will make in the future. Investors seek data from various sources (company guidance, economic projections, demand forecasts, etc) to try and determine expected earnings. The PEGY ratio is the P/E ratio of a company divided by the expected earnings growth rate plus the dividend yield. All else remaining equal, a company with a lower PEGY ratio is considered more desirable.

The book value of a company is the value of its net assets (plant, property, equipment, goodwill, etc less liabilities). The Price to Book ratio is the total market capitalization of a company (number of outstanding shares multiplied by current share price) divided into the total net assets of a company (book value). If a company’s Price to Book ratio is below 1, it is often considered “better off dead” as, in theory, share owners would gain more value if the company discontinued operations, sold all assets, paid creditors, and distributed the remaining value of the company to shareholders in cash. However, securities with low Price to Book ratios may offer potential future gains if these securities are temporarily undervalued and mispriced.

Correct input data needs to be used for these ratios. Reliable data sources can often be found in publicly filed company reports. “Normal” ratios may vary across industry sectors and may be influenced by other factors such as the perceived value of an alternative investment such bond yields. This article only scratches the surface of security valuation and analysis. However, it is a modest attempt to help the reader understand some of the more commonly used ratios in security analysis.

Adam Smit is CERTIFIED FINANCIAL PLANNER™ with Adam Smit Investment Management LLC and a registered principal of LPL Financial. This article is for general information only and not intended to provide specific advice or recommendations for any individual. Adam Smit Investment management LLC and LPL Financial do not provide tax or legal advice. Securities offered through LPL Financial. Member FINRA/SIPC.