Rationalising ratios

Rationalising ratios
Rationalising ratios: how to get the most out of investment ratios.
Paul Allison, CFA
Published
July 26, 2022

There are lots of stats and measures used in investing and some are more useful than others. Knowing what to watch out for and what to avoid can help you get the most out of the terms bandied around in investment circles. 

Time to demystify. 

Beta

Whenever you hear a Greek letter in investing, it usually refers to a type of risk. Investors not schooled in mathematics might be put off. But using logic vs equations can help investing theory jump out of the textbook and into the real world.

For stocks, there are two types of risk: market risk, and stock-specific risk. 

Market risk includes factors that impact all companies and cannot be avoided, like politics or global economic trends. Stock-specific risk applies only to the individual company, like a management change or a takeover.  

Beta measures a stock’s level of market risk and looks at how exposed a company is to broad factors that impact the whole market. A booming US economy, for example, would probably be a positive factor for all US companies. Said another way, that means it’s positive for the market.

The beta of a stock is an indication of how an individual company is exposed to all the market factors together. The market might be represented by an index like the S&P 500.

How is Beta used?

In general, the higher the level of risk the greater the potential for positive returns. This works both ways though, as higher risk also means a greater chance of losses. 

Stocks with a beta of more than one might be expected to experience price movements that exceed the market, again in either direction. Stocks with a beta of less than one should rise and fall by less than the market.

So the higher a stock’s beta, the greater its exposure to the market’s risk and return potential. A stock with a beta of two, for example, might be expected to experience a price move that is twice that of the market, either up or down.

What to watch out for

A stock’s beta only explains one element of its risk and return profile, that being its exposure to market factors.

Other stock-specific factors will impact risks and returns irrespective of the market. A stock’s specific risk is measured by its alpha

There have been multi-year periods of rising stock prices where low-beta stocks, those with a beta less than one, have outperformed the market due their alphas being higher. 

The important point is that investors shouldn’t use beta as a shortcut when assessing a stock’s risk and return profile. Alpha matters too.     

P/E ratio

A P/E ratio, or price to earnings ratio, is used to assess a stock’s price relative to its earnings per share (EPS). It’s calculated by dividing the stock price by EPS, where EPS is the company's total after-tax profit divided by the number of shares outstanding.

How are P/Es used?

P/Es are used by investors to assess a company’s stock price alongside its earnings per share (EPS). 

Valuing shares is a relative exercise. It’s about what you get for the price you pay, so the absolute cost of a share is irrelevant when it comes to valuation.

Each share in a company represents fractional ownership and entitlement to one share’s worth of company profits or EPS. So, comparing the price you pay for the share to the EPS you are entitled to is a way of assessing the value of the share.

For example, company A and B are identical in every way except company A has a price of £10 and B has a price of £20. 

Both are expected to earn £1 in EPS this fiscal year. So company A has a forward P/E of 10 and company B a forward P/E of 20. P/Es are usually expressed as a multiple, so A has a P/E of 10x and B has a P/E of 20x. In this example company B is twice as expensive as company A.

Two firms are never identical, though, so direct comparisons are not always useful.

What to watch out for

In practice, a P/E ratio is often compared to a firm’s historic P/E to assess its valuation today relative to its past. If a firm has a lower P/E today than it did a year ago, for example, but its prospects for growth are better, then it might be said the stock is cheaper today than last year.

P/Es are also used to compare firms in the same industry that might share certain characteristics like growth prospects, or profitability. The more similar the businesses the more useful the comparison.

A P/E in isolation only tells half the story, though. 

A high P/E, say more than 30x, doesn’t necessarily mean a stock is expensive. And a low P/E, say less than 12x, may not mean the stock is cheap.

This is because P/Es need to be considered alongside a firm's growth prospects and risks. A stock might have a P/E of 5x, but the firm’s EPS might be declining rapidly and if no improvement in fortunes is in sight, this is likely to make for a bad investment.

On the other hand, a stock might be trading on a P/E of 40x but the company could be facing strong EPS growth prospects of 40% or more.

It’s also important to think about what might happen to the P/E in the future. In the case of that 40% grower you paid 40x P/E for, it might trade on a much lower P/E in the future if its growth slows for example. If in a few years its P/E has slipped to 10x, that’s a pretty big hit to the total return to the investor. 

A P/E is a way to compare a stock price relative to its EPS, but for a full picture, an assessment of growth prospects and risks is also needed and a healthy dose of long-term thinking. 

P/Es are a snapshot, but profits and cash flows happen over a firm’s lifetime. And as a long-term investor, you need to take stock of the big picture too.

P/B ratio

A P/B ratio, or price to book ratio, is a valuation measure used to assess a stock’s price relative to its book value per share (BVPS). It’s calculated by dividing the stock price by a firm's BVPS. BVPS is common equity divided by the number of shares outstanding.

Common equity is the difference between assets (things a company owns like buildings or cash in the bank) and liabilities (what is owed like debts). It’s generally considered to be the amount shareholders would get if a company was liquidated. 

How are P/Bs used?

Book value is a snapshot of a firm's assets minus its liabilities. In any given year the assets of a firm (machines, factories, shops, stock etc.) will generate profits or losses impacted by many factors. This can make profits variable and difficult to predict, especially for firms that operate in highly cyclical industries.

Because the values of assets and liabilities are less variable though, the book value of a firm tends to be more stable than other measures like profits or cash flows.

A comparison of a firm’s stock price to its book value (per share) is therefore useful for companies that have volatile profitability.

P/B ratios are also useful for companies that are performing poorly with limited profitability. 

Often P/B ratios are used by value investors trying to assess the net asset value of a firm (assets minus liabilities) that has poor prospects for profit growth. In this sense, using a P/B ratio is more about how a company’s doing today than it is about the future. 

What to watch out for

P/B ratios are often used when valuing financial companies, like banks, where profits are highly volatile. Book value and its growth are used to assess the performance of a bank over time, rather than earnings or profits which can change dramatically from one year to the next.

P/B is less useful for companies that don’t rely on assets to generate profitability. Services companies whose primary assets are people tend to have limited assets on their balance sheets. In some cases, book value can be negative for companies that have few assets but also have debt. But these companies can still be profitable and valuable.

It’s difficult to use P/B when comparing companies from different industries because levels of assets and liabilities differ quite a bit from one industry to another. 

Market capitalisation

Market capitalisation is the total market value of a company and it’s calculated by multiplying a firm’s stock price by the number of shares outstanding. 

How is market capitalisation used?

Because market capitalisation is calculated using the current stock price, it incorporates investors’ expectations and views, and the valuation they attach to the firm.

Often investors split an investable universe by the size of companies, then build portfolios of stocks that cover a wide range of those sizes in order to get better diversification. 

Often, but not always, firms with large market capitalisations are multinational businesses with diversified revenues and profits. Smaller capitalisation firms tend to be more domestic focussed with less diversified revenues and profits.   

What to watch out for

Market capitalisation is a measure of a firm’s size in value terms, but this doesn’t always correlate directly with the size of its sales or profits. 

Investors might place a lower valuation on a mature firm with large but slowly-growing sales, for example, and a high valuation on a company with fewer but more rapidly-growing sales. In this case, a firm with very large sales and profits could have a lower market capitalisation than a firm with relatively small sales and profits.

Dividend yield

Dividend yield measures the dividend per share (DPS) investors are entitled to, relative to the stock price. DPS is calculated by dividing the total amount of dividends paid by a firm by the number of shares outstanding. 

How is dividend yield used?

Dividend yield is a basic valuation metric used to assess the actual cash dividend payment investors receive for their shares relative to the price they pay.

Dividend yields are usually used as a means of valuing mature companies that pay out a sizable portion of their profits in dividends.

Dividend yields are less useful for growing companies that retain most of their profits to reinvest in their businesses.

What to watch out for 

Yields, like dividend yields, are calculated by dividing the measure (dividend) by the stock price. It is usually the price part of the calculation that causes dividend yield to change in the short term. 

For example, if a price falls but the dividend stays the same, the yield will increase. 

High dividend yields, say 10% or more, could indicate a stock is undervalued relative to its prospects. But, it might be the stock price has fallen to reflect a poor outlook for the business, and a dividend cut could be on the cards.

The profits and dividends for some companies, those that are mature, operate in a cyclical industry, and have limited structural growth for example, tend to be tied to economic activity.

These firms might be able to pay high cash dividends during periods of strong economic growth, but may not be able to sustain those payouts if the economy were to suffer a downturn. 

Investors should question the sustainability and variability of a firm’s dividend payout when using dividend yield as a valuation tool.

Price earnings to growth ratio (PEG)

The price earnings to growth ratio (PEG ratio) is a stock's price to earnings (P/E) ratio divided by the growth rate of its earnings, usually calculated over three or five years. 

The P/E ratio is calculated by dividing price by earnings per share (EPS). P/E is then divided by either an average growth or compound annual growth rate (CAGR) of EPS to calculate the PEG ratio.

PEG ratios can either be on an historical basis, using a reported earnings per share (EPS) and historical growth in EPS, or on a forward basis using forecasts for EPS and growth rates.

How are PEGs used?

PEG ratios are commonly used to assess a firm’s P/E ratio alongside its growth in EPS. 

Companies whose stock prices trade on high P/E ratios, say more than 30x, tend to be experiencing rapid growth in EPS, either historically or forecast. On the other hand, the stock prices of companies experiencing slower growth in EPS might trade on a lower P/E ratio.

Dividing P/E ratios by growth rates allows a valuation comparison between companies with different growth profiles. 

For example, Company A’s stock trades on a P/E of 40x and the firm has produced 20% average growth in EPS over the past five years. That would give it a PEG ratio of 2. Company B’s stock trades on a P/E ratio of 20x but its EPS has grown on average by a more pedestrian 10% a year.

Although Company B, with a P/E ratio of 20x might appear cheaper than Company A’s P/E of 40x, after dividing by their respective growth rates, both have a PEG ratio of 2. 

On a PEG basis they would be valued equally.

What to watch out for 

PEG ratios can be helpful when comparing companies with different growth profiles, but growth is not the only factor that influences P/E ratios. A high P/E might be the result of fast growth but it could also be because of lower risk, and more stable and predictable earnings growth.

The stock prices of very stable and predictable businesses tend to trade on high P/E ratios, for example, even without superhuman growth rates.

One size never fits all

The important point with ratios, and investing as a whole, is there are no shortcuts. By understanding the logic behind ratios and why they are used, as well as knowing some of the pitfalls to keep an eye out for, investors can build a tool kit to help them make good decisions.

Context is key. It’s never a good idea to use one ratio or investment metric in isolation and jump to conclusions. Everything should be assessed relative to something else and keeping this in mind will help better decision making.

Let’s finish with a final cliché. Valuation is an art not a science, it’s about predicting the future, something we think we are better at than we actually are. That means questioning assumptions, and maintaining a healthy dose of common sense are probably the most useful tools any investor should have in their kit. 

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