Ratios can be essential tools for evaluating potential investments. Individual investors and professional analysts both use them, and there are numerous ratios to choose from. Typically, valuable ratios play a critical role in this, as they are something on which investors rely directly. Valuation ratios are some of the most frequently referenced and simply applied criteria for determining a company's investment attractiveness. These measurements generally incorporate a company's publicly traded stock price to inform investors about the company's market value.
A valuation ratio is one of the various computations used to assess whether a security is inexpensive or costly in comparison to another metric, such as profits or enterprise value. In other words, a valuation ratio enables an investor to calculate the cost of an investment in relation to its worth or advantages.
Ratios of valuation are important in establishing a company's value. A valuation ratio expresses the link between a company's market value or equity and a basic financial statistic (e.g., earnings). The purpose of a valuation ratio is to demonstrate the cost of acquiring a stream of earnings, revenue, or cash flow (or other financial valuation metrics).
Because valuation measurements are most effective when considering the future, the financial ratios we use for valuation should be based on what the market consensus predicts in terms of earnings, cash flow, and so on. While your view of profit potential may differ from the market's, it's important to understand what is factored into the pricing.
Investors are the key element for any founders as they pull up the venture with their investment. Investors' ownership position and return are affected by valuation. The greater the valuation, the smaller the investor share and the lower the rate of return on the investor share.
Additionally, valuation will affect investors' appetite if, for example, you foresee needing extra capital in the future to fuel company growth. Growing sales, market penetration, and cash flow will boost the worth of your business and enable you to acquire further capital at a higher valuation. This is beneficial for investors, but due to the dilutive effect of future rounds, your current investors will not catch the whole valuation rise. This phenomenon is referred to as the divergence effect.
As a result, investors will be attentive to the value at which they enter, as an excessively high pre-money valuation could have significant adverse effects if you fall short of your aims and are forced to raise funds at a lower valuation. So, in order to get your company going in a precise way, having a valuation ratio is indeed necessary.
Numerous valuation metrics exist for valuing stocks. The price-to-earnings ratio (P/E ratio) is a frequently used illustration. Here are the valuation ratios that founders need to know:
Price-to-book value ratio
The price-to-book ratio (P/B ratio) compares a company's stock price to its book value (shareholder equity). We arrive at this figure by dividing the current Price by the book value of each share. Alternatively, market capitalization is divided by book value.
Pros:
Stable unit of measurement. Because the basis metric (book value) is relatively stable, this ratio does not fluctuate as much as others, such as P/E.
Cons:
You want to compare organizations with similar business models, as valuing firms with few tangible assets (tech firms, service providers) versus those with a lot of inventory or equipment makes little sense (retailers, equipment sellers).
Price-to-sales ratio
The price-to-sales ratio (P/S ratio) compares a company's stock price to its sales. Two pieces of data are required to calculate it. The first consideration is the stock price. The second metric is earnings per share. To calculate sales per share, we divide the company's revenue for the preceding 12 months by the total number of outstanding shares. Thus, the ratio indicates how much investors paid for the stock in comparison to the company's revenue.
Pros:
Metric that is quite steady. Revenue is more constant (usually) than earnings, which can be more unpredictable.
Cons:
Price-to-cash-flow ratio
The price-to-cash-flow ratio (P/CF ratio) compares the stock price to the cash flow generated by the business. In contrast to the P/E ratio, the P/CF ratio uses a more realistic indicator, namely cash from operations (CFO), rather than net income, as the divisor. As a result, it is less manipulable than net income under accrual accounting.
The P/CF ratio is calculated by dividing the share price by the CFO per share. Meanwhile, we get the final one by dividing CFO by the number of outstanding common shares.
Pros:
Not open to manipulation. Cash flow is more difficult to manipulate than earnings because it is not accrual-based.
Cons:
Acquiring future cash flow predictions is difficult. While profits and revenue forecasts are readily available for free on websites such as Zacks, cash flow forecasts are typically more difficult to obtain without a Bloomberg or FactSet subscription.
Numerous methods for calculating cash flow measures. As a result, apples-to-apples comparisons may be impossible.
Dividend Yield
The dividend yield is a ratio that links the stock price to the dividends paid. We calculate it by dividing the annual dividend per share by the share price per share of the corporation.
Pros:
This makes it easy to determine the rate of return a shareholder might expect on their investment.
Cons:
Stock Market Fluctuations Are Deceptive
Inadequate as a Return on Investment Metric: Additionally, dividend yield should not be the single criterion used to evaluate a company.
EV-to-EBITDA
The EBITDA multiple is a financial ratio that compares a business's Enterprise Value to its annual EBITDA (which can be actual or forecast/estimated). This multiple is used to calculate a firm's worth and compare it to the values of comparable enterprises.
EBITDA Multiple = Enterprise Value / EBITDA
Pros:
Covers a balance sheet.
Cons:
Price to earnings ratio
The price-to-earnings ratio (P/E ratio) compares the share price of a firm to its net income. Divide the share price by the earnings per share to arrive at this figure. Earnings per share are calculated as net income divided by the number of outstanding common shares during the last 12 months.
Pros:
Frequently used: Because P/E ratios are so extensively utilized, they enable rapid comparisons and contrasts with other equities. Additionally, you can interact rapidly with other investors, as everyone has their own P/E heuristics.
Simple to use: Both sides of the ratio are rather straightforward to locate, assuming you do not wish to alter the earnings figure. Yahoo Finance always has the most up-to-date prices, and earnings are the most forecasted metric.
Cons:
Valuation ratios can reveal a wealth of information about equities, particularly when compared across businesses, industries, and ratios. There is not always one that is capable of unlocking the key. When all of the puzzle pieces are put together, though, several interesting business drivers become apparent.
There are numerous business valuation techniques available. Some are more complicated than others, and different methodologies might result in very different assessments of the same underlying asset. The most appropriate business valuation technique for you is determined by a number of criteria, including the reason for the value.
Additionally, it is vital to evaluate if a business is asset-intensive or service-oriented. If a business has a high asset base, the net book value method may be the most appropriate. Also, investors must be familiar with industry standards. Businesses in specific sectors are frequently valued using a particular approach or several that best captures their value.