This article will explain the most important valuation ratios and how to apply them in your value stock screener criteria.
What is Value Investing?
Value investing is an investing strategy that looks to buy companies trading below their intrinsic value in the stock market. The theory behind this is intuitive. Eventually the market will ‘realise’ its mistake and revise up the company’s valuation to the correct stock price. Thus, giving early value investors a healthy profit.
One of the ways value investors identify these so called ‘value stocks’ is by their cheap valuation metrics. The most efficient way to do this is through a stock screener, as it can quickly sift through a large database of stocks and find the ones that appear undervalued based on these metrics.
What are Valuation Ratios?
Valuation ratios present a shorthand expression of a company’s current ‘value’ relative to some underlying financial metric. They are calculated by dividing a measure of a company’s market value (market cap or enterprise value) by a financial metric such as net income, cash flow, or book value.
Therefore, a valuation ratio takes the following general form:
The financial metric in the denominator represents a fundamental driver of a company’s intrinsic value.
As such, it acts as a useful anchor to compare the market value against. The higher the valuation ratio is, the higher the market is willing to pay for that fundamental value driver. All else equal, we should therefore prefer companies with lower valuation ratios, as we get more ‘bang for our buck’.
In essence, valuation ratios help investors standardise the market value of every company. In doing so, investors can quickly make comparisons as to which companies offer the best value.
For example, knowing that company A has an enterprise value of $10bn and company B has an enterprise value of $15bn is no use to us if we’re trying to understand which company is better value. Knowing that both companies earn $2bn does help us though. The reason being that now we have a reference point to help us contextualise the two market values.
In this scenario, company A would appear more attractive as we get the same amount of earnings for less money.
How to Screen for Undervalued Stocks Using Valuation Multiples?
If you are new to stock screening, it might help to read this article about how to use a stock screener first.
Valuation multiples can help us screen for undervalued companies in three different ways.
- Screen for companies with the lowest absolute valuation multiples
- Screen for companies with lower multiples than their industry average
- Or, screen for companies with a lower multiple than their own historical average
I explain each of these three approaches below…
Lowest Absolute Multiples
One of the simplest ways to find value stocks is by screening for companies with the lowest valuation multiples in a stock universe.
This usually means setting a certain threshold to determine what we mean by ‘lowest’.
One example would be to get our stock screener to find the ‘cheapest’ 10% of stocks in the S&P 500 based on the price to sales ratio. Grouping stocks based on the percentile they fall into is how a lot of academic studies assign ‘value’ to stocks.
Alternatively, we could tell our stock screener to only return stocks that have a price to sales ratio below an arbitrary number, such as 1.5.
Comparable Company (“Comps”) Analysis
Comparable company analysis is a relative valuation technique. In essence, a company’s value is based on how similar, comparable companies (“Comps”) are valued by the market. These are usually companies in the same industry.
The median or mean valuation ratio of the industry peer group serves as the reference point to determine whether the company in question is good value or not.
The underlying assumption here is that comparable companies should trade at similar valuation multiples.
Therefore, one way we can find undervalued stocks is by screening for companies with a lower multiple than their industry average.
For example, if a company has a P/E ratio of 25 vs. the industry average of 30, then we might determine that the target company is cheap.
In practice, drawing conclusions like the one above requires more nuance. For example, if a company has historically traded at a 30% discount to the industry average because it is a lower quality company than its peers (less profitable, slower growth, volatile earnings), then at a P/E of 25 vs. 30 (17% discount) it would appear expensive.
Historical Multiples Analysis
This approach evaluates where a valuation metric currently stands in relation to its own history. It involves plotting a time series of the metric in question and comparing the most recent value to different statistical parameters like the long-term mean, or standard deviations from the mean.
For example, we could set our stock screener criteria to find companies with a current P/E that is X% or Y standard deviations below its five, or ten-year average P/E. Value investors might view these companies as ‘cheap’ because they trade at a discount to where they normally do.
Again, further analysis of a company’s fundamentals and business prospects should be carried out to determine whether a perceived mispricing is justified or not. That is, has anything fundamentally disrupted the business model that means it shouldn’t be valued as highly today as in the past?
The underlying assumption of this method is that valuations mean-revert over time.
Commonly Used Valuation Multiples
Valuation multiples can be broken down into equity multiples and enterprise value multiples.
Equity multiples use market capitalization, or share price, in the numerator and are therefore more relevant for measuring the equity value of a company. This makes them useful for shareholders looking to take a minority interest in a business (most investors).
On the other hand, enterprise value (EV) multiples use enterprise value in the numerator. Enterprise value is calculated by summing the market value of a company’s equity and debt, less cash. It tells us what the market currently values the operating assets of a company at, and is therefore seen as a measure of ‘takeover’ value. For this reason, EV multiples are most useful for investors looking to buyout a whole business, for example in M&A transactions.
Since enterprise value multiples consider debt, changes in capital structure don’t artificially distort them. This is not the case for equity value multiples. As such, EV multiples are generally better than equity multiples, particularly when comparing companies with vastly different capital structures.
Still, investors frequently use equity value multiples. One, because they are easy to calculate. And two, because they are readily available from most financial websites and newspapers. My Koyfin review showcases one of my favourite platforms for conducting valuation analysis.
Common Equity Multiples Used in Value Stock Screener Criteria
Price-to-Earnings (P/E) Ratio
One of the most commonly used valuation metrics is the price to earnings ratio. It divides a company’s stock price by its most recent years earnings per share (EPS), where EPS is net income divided by the number of shares outstanding. It is also known as the price multiple or earnings multiple.
Advantages
- Widely used: Probably the most frequently quoted valuation metric which makes comparisons between different companies easy.
- Easy to compute: Price and earnings data are readily available.
- Earnings drive share prices: Earnings are the residual claims leftover for shareholders after all other investors have been paid.
Disadvantages
- Easily manipulated: Accrual-based accounting can distort net profit.
Forward P/E Ratio
The forward price to earnings ratio divides a company’s share price by an estimate of its future earnings per share.
The earnings estimate is usually an average, or median, of sell-side analysts’ forecasts and can represent any year in the future e.g. this year’s earnings, next year’s, or earnings in five years’ time.
As such, forward multiples (which can be applied to any financial metric) take account of a company’s ability to grow in the future.
Since markets are forward-looking, forward multiples tend to encapsulate a truer sense of a company’s valuation vs. standard, trailing ratios that might reflect stale information. This is particularly the case for high-growth companies.
The caveat is that the further you look into the future, the more likely you are to experience forecasting errors.
Advantages
- Forward-looking: The stock market is a discounting mechanism, which makes forward earnings more relevant for valuation purposes.
- Captures growth: More reliable indicator for high-growth companies.
Disadvantages
- Forecasting errors: Estimates of earnings may turn out to be wrong.
PEG Ratio
The PEG ratio is calculated by dividing a company’s P/E ratio by its earnings growth rate. Standardising the P/E like this helps investors contextualise whether a company is priced fairly relative to its growth. This is especially useful for high-growth companies that will always look ‘expensive’ based on the standard P/E ratio.
The P/E in the numerator tends to be a forward P/E using an estimate of this year’s, or next year’s earnings, while the growth rate is usually an estimate of earnings growth over the next 3-5 years. Where earnings and growth estimates are not available, historical figures will work fine.
A PEG ratio less than 1 indicates a company that is cheap relative to its growth profile.
Advantages
- Prices growth: Helps investors assess whether they are over or underpaying for earnings growth.
Disadvantages
- Forecasting errors: Estimates of earnings and growth may prove to be inaccurate.
- Irrelevant for some companies: Growth is a trivial component of valuation for some companies e.g. low-growth dividend yielders.
Price-to-Sales (P/S) Ratio
The price to sales ratio divides the share price of a company by its sales per share.
This ratio is best for new companies without any earnings yet, or companies with temporarily depressed earnings e.g. because they are investing heavily to increase market share.
Sales also have the added benefit of not being as easily manipulated as net earnings.
Advantages
- Reflects reality: When net income doesn’t reflect a company’s true earnings potential, it is better to use sales.
- Less easily manipulated: Management has less discretion over reported sales compared to earnings.
Disadvantages
- Narrow measure: Sales ignore costs and therefore the profitability of a business.
Price-to-Book (P/B) Ratio
The price to book ratio divides a company’s share price by its book value per share (BVPS). Book value is calculated by subtracting the liabilities of a company from its assets, and is therefore otherwise known as ‘net assets’, ‘net worth’, or simply equity.
When using this metric, it is important to know that book value is an accounting estimate of a company’s net assets (equity), which in many cases can differ from their true, economic value.
Therefore, value investors must employ discretion when using this metric and assess the appropriateness of accounting conventions as well as the company’s own accounting policies with regards to how accurately they portray intrinsic value.
Accounting conventions tend to understate the value of intangible assets, for example. This makes price to book less appropriate for technology or healthcare companies with valuable intellectual property and patents.
Book value works best when there are readily available market prices for the majority of a company’s assets. This occurs when their assets trade in liquid markets, such as commodity companies (oil, metals, grains etc) or banks (financial securities).
Advantages
- Less volatile than earnings: Book values change slower than earnings, so price to book can be better for valuing cyclical companies.
- Best used for companies with liquid assets: Assets recorded at market prices closely reflect economic value.
Disadvantages
- Sensitive to accounting conventions: Accounting rules can lead to misleading asset values that differ from intrinsic value.
- Understates intangible assets: Makes price to book less relevant for companies with a high proportion of intangible assets e.g. companies with significant brand value.
Dividend Yield
The dividend yield divides a company’s annual dividend per share (DPS) by its stock price.
It differs from other value metrics because the price is in the denominator and the financial metric is in the numerator. Therefore, your value stock screener criteria should search for stocks with high dividend yields as opposed to low ones.
The dividend yield is most relevant for valuing low-growth companies. The reason being that the dividend (and not future growth) predominantly drives the value of these stocks.
Therefore, the dividend yield works best for low-growth industries such as utilities and banks. Or any companies in the later stages of their life cycle for that matter. Conversely, it has zero relevance for start-ups paying zero dividends, who instead reinvest their cash to fund growth.
Advantages
- Best for mature companies or low-growth industries: These companies are most likely to pay out dividends.
Disadvantages
- Irrelevant for early-stage companies: Many start-ups don’t pay dividends whilst financing their growth phase.
- Can be misleading: Yields can appear high because stock price has fallen.
Common Enterprise Value Multiples Used in Value Stock Screener Criteria
EV to Sales
The enterprise value to sales ratio divides the enterprise value of a business by its annual sales.
Since enterprise value considers both equity and debt, this ratio is generally better than price to sales. Sales is a pre-debt item (i.e. interest hasn’t been subtracted from it) and so belongs to both equityholders and debtholders.
It is useful to value start-ups that aren’t profitable yet or have negative cash flows. The fact that EV considers debt also means that a balance sheet assessment is being implicitly applied with this metric. This can be a large source of risk for young companies.
Advantages
- Good for valuing start-ups: Takes account of their depressed earnings and balance sheet risks.
Disadvantages
- Ignores profitability: Sales don’t take account of any costs which can make it a narrow measure of company performance.
EV to EBITDA
The enterprise value to EBITDA ratio divides enterprise value by annual EBITDA, which is shorthand for earning before interest, taxes, depreciation and amortisation.
EBITDA is a proxy for the cash flow that accrues to both shareholders and debtholders. If it is positive, then EV/EBITDA can be an improvement to EV/Sales, because we are considering costs and hence profitability.
EV/EBIT is a similar ratio that’s core to any magic formula investing screen. Specifically, it uses the inverse of this ratio, or the earnings yield.
Advantages:
- Considers profitability: Entails more information than sales.
Disadvantages:
- Ignores CAPEX: For a more complete measure of cash flow, it should consider capital expenditures.
Free Cash Flow Yield
The free cash flow (FCF) yield divides the annual free cash flow of a business by its enterprise value.
Free cash flow transforms accounting profits into cash profits. It is therefore widely seen as the truest reflection of the money available to shareholders after capital expenditures are accounted for.
The FCF yield also produces the best backtest results vs. other value metrics. Read the following article to see these backtests, and how to incorporate the free cash flow yield into a stock screener.
Advantages
- Clean measure: FCF gives the truest picture of the money available to reinvest into business or redistribute to investors.
Disadvantages
- Affected by non-core activities: Net profit affects FCF, which captures non-operating activities.
Summary
- Value investing is an investment style that aims to buy stocks currently trading below their intrinsic worth in the stock market.
- Valuation ratios present a shorthand expression of a company’s ‘value’ by standardising its market valuation against some intrinsic value driver (financial metric).
- As such, they form the building blocks of value investors’ stock screener criteria.
- We can find undervalued stocks by screening for those with: lower valuation multiples than their industry average, their own historical average, or with the lowest in a given stock list.
- Equity multiples are most relevant for shareholders, whereas enterprise value multiples are relevant for all investors.