A rising chart can tempt anyone to buy, but price alone says nothing about value. A stock at fifty rupees can be expensive, while one at five thousand can be reasonable. When investors review the BSE Share Price of a company, the natural next question is whether it is justified by earnings and assets. The NSE Share Price of a rival firm raises the same question, along with how the two compare. Valuation ratios provide structured answers. This article introduces the most useful ones and explains how to apply them without falling into common traps.
Table of Contents
Price to Earnings Ratio
The price-to-earnings ratio calculates the share price divided by earnings per share. It expresses how many rupees investors are prepared to fork out for every rupee earned by the company. If the ratio is twenty, the stock is priced at twenty times the company’s annual earnings. Expansive multiples are often explained by optimistic prospects, whereas dour figures suggest mature companies or troubled businesses. Always interpret the statistic in context. View it relative to the company’s own history or a similar group of stocks, as banks, software concerns and power utilities have varying typical multiples.
Price to Book and Return on Equity
While the price-to-book ratio is a useful metric, it is best applied to the banking sector and other financial institutions, where the value of the balance sheet drives profits. A low price-to-book may be justified if the company makes good returns on its capital. Take it in conjunction with the return on equity, which indicates the profit made on shareholder funds. If a firm consistently delivers superior returns, it should command a premium on the stock market, conversely, one that makes inadequate use of capital may be fairly priced despite a low ratio.
Enterprise Value and Cash Flow
For capital intensive companies, enter prise value is a more meaningful measure than simple price to earnings, because it takes into account the impact of debt and cash. Consider the free cash flow yield as well, as it indicates the cash profits after spending on capital equipments. Profits are subject to window dressing but cash generation can be taken as a reliable indicator of performance. Companies that have plenty of spare cash can be good investments, as they are able to pay dividends, make share buybacks or invest in new projects that will make the company more valuable over time.
Avoiding Valuation Pitfalls
A low ratio might be a good value play, but inexpensive stocks can become cheaper still if problems emerge for the business, a situation sometimes called a “value trap”. Expensive growth stocks can work out well, if they continue to grow rapidly for a prolonged period. Examine the quality of the earnings, levels of debt, standing of promoters, and the competitive position before buying a stock simply for its ratio. It is safer to examine a set of figures, rather than concentrating on one metric.
Also consider the state of the economy. For cyclical industries, ranging from steel to cement, profits are swollen near the peak and can give misleadingly low price to earnings multiples, which reflect the expectations of future profits. Take the average for the whole cycle before arriving at a conclusion.
Finally, a rule of thumb is to provide a margin of safety by estimating an appropriate range. Buy stock when it is considerably cheaper than its intrinsic value and take several steps towards your target price, rather than risking big profits by rushing in at the last moment. The value investor is not always right, but a systematic approach reduces downside risk, while helping investors to keep emotions in check. Constant analysis of these ratios makes investors more sceptical about expensive stock and less prone to panic selling, while still leaving scope for bargain hunting and speculation.
