Valuation Ratios

A great company isn’t automatically a great stock. Price is what matters. Pay a hundred times annual earnings for a wonderful business and you can still lose money for years. Valuation ratios help put that price in context: they relate market value to what a company earns or owns.

The price-to-earnings ratio (P/E)#

The P/E ratio is the most famous valuation measure:

A P/E of 20 means you pay 20 times annual earnings. If earnings stayed flat and were paid out in full, you’d get your money back in 20 years.

The inverse is the earnings yield: at a P/E of 20 it’s 5%. It compares nicely with bond yields. If 10-year Treasuries yield 4.5% and the stock market has an earnings yield of 4.5%, the extra reward for owning stocks rather than bonds is thin.

Trailing or forward?#

• Trailing P/E uses the last twelve months’ earnings – facts, but history.
• Forward P/E uses analysts’ estimates for the next year – forward-looking but uncertain. Analysts tend to be optimistic on average.

The Shiller P/E#

Earnings swing with the economy. In a recession they collapse and the P/E shoots up, even if the stock isn’t expensive. Nobel laureate Robert Shiller popularised the cyclically adjusted P/E (CAPE): price divided by the average inflation-adjusted earnings of the past ten years. It’s used mainly for whole markets. Historically, high CAPE readings were followed by lower returns over the next decade – but it’s useless for timing next month.

Other important ratios#

Enterprise value: the price of the whole business#

Market cap is only the price of the equity. Anyone buying the entire company also takes on its debt – but gets its cash. Enterprise value (EV) accounts for that:

Comparing ratios properly#

A ratio on its own says little. It becomes meaningful in comparison:

1. With the industry: software companies with high margins and fast growth almost always carry higher P/Es than carmakers or banks. A P/E of 25 is cheap for one and expensive for the other.
2. With the company’s own history: how was it valued on average over the past ten years? A big deviation may be an opportunity or a sign that the outlook has changed.
3. With growth and quality: a company that reliably grows earnings 15% a year with little debt deserves a higher P/E than one that stagnates.
4. With interest rates: when bonds yield 5%, investors are less willing to pay high P/Es than when bonds yield nothing.

Summary#

Valuation ratios relate a stock’s price to earnings, sales, book value or cash flow. P/E is the best known, EV/EBITDA also accounts for debt, and free cash flow yield shows how much cash is actually generated. Ratios only make sense compared with the industry, history, growth and interest rates – and a low valuation can be a trap as easily as an opportunity.