Evaluating stocks - Valuation

PE Ratio

PE ratio is calculated as close price of the stock divided by the earnings per share excluding extraordinary items for the most recent financial year. The ratio indicates the number of units of stock price it takes to purchase a single unit of the company’s earnings per share (EPS). If the company is currently trading at Rs.300/share and EPS of the company is Rs.30, then the PE ratio is 300/30 = 10x. So it costs Rs.10 to be eligible to purchase Re.1 of the company’s earnings

PE ratio is the most important valuation ratio and helps understand whether a company is undervalued or overvalued. The best way to use a PE ratio is by comparing the ratio of different companies operating in the same sector

Suppose company A is trading  at a PE ratio of 12 and B is trading at a PE of 17. Obviously A is undervalued when compared to B as it costs only Rs.12 to purchase 1 units of A’s EPS, whereas B’s costs Rs.17. However it is important to understand the reason behind the undervaluation. If the market is expecting B to grow at a faster rate, demand for shares of B will increase leading to higher share price and consequently higher PE ratio. So in this case the higher PE for B is justified. However suppose market has not correctly understood A’s earning potential and hence has ignored the stock leading to low PE. Such a situation might present a genuine buying opportunity of the stock, however it is important to ensure that the market has not correctly understood A’s earning potential. If market has ignored A because of poor earnings or bad management practice, it is better to ignore the same in spite of relative cheapness

Forward PE Ratio

Forward PE ratio is calculated as close price of the stock divided by estimated earnings per share of the company for the current financial year. If the current stock price is Rs.300 and estimated EPS of the company for the current financial year is Rs.8, then forward PE ratio is 300/8 = 37.5
Forward PE ratio can be used to compare it with the current PE ratio of the company. Suppose current PE ratio of company A is 15 and the forward PE ratio is 12, it indicates that EPS of the company is expected to grow over the next year. The deeper the discount between current PE ratio and the forward PE ratio, the higher the potential for the stock price to increase

PE Premium vs Sector

This data item is calculated as the percentage difference between the stock PE ratio and the sector PE ratio

	PE ratio	Premium / Discount
Stock A	22.0	25.0%
Stock B	12.3	-30.1%
Sector average	17.6	—

As can be seen from the table above, stock A has a higher PE ratio than the sector average which results in a positive output. When the output is positive it is said that the stock is trading at a premium to the sector. In stock B’s case the output is negative, indicating that the stock’s PE ratio is lower than the sector’s PE ratio. In such a scenario it is said that stock is trading at a discount to the sector

A company might be trading at discount to the sector either because the stock’s future earnings potential are low or because market has not noticed its earnings potential and hence there is a temporary pricing mismatch

Such a situation might present a genuine buying opportunity of the stock, however it is important to ensure that the market has not correctly understood B’s earning potential. If market has ignored B because of poor earnings or bad management practice, it is better to ignore the same in spite of relative cheapness

PB Ratio

This ratio is calculated as recent close price of the stock divided by book value per share of the company for the most recent financial year. Book value per share refers to the total shareholders investment in the company divided by shares outstanding

The ratio helps understand the unit price to be paid for the assets leftover after paying all liabilities of the company. Suppose the company has total assets of Rs.250. These assets have been purchased using Rs.180 of debt and Rs.70 shareholders equity. Hence if all liabilities of the company are to be paid off, Rs.180 worth of assets will have to be sold and Rs.70 will remain on the books of the company. If the share price of the company is Rs.300, PB ratio will be calculated as 300 / 70 = 4.3x

Just as in PE ratio, PB ratio is used for valuation purposes, specially in case of banks and financial companies. Non banking companies do carry large amount of assets on their books, however these assets are not valued on a regular basis, hence there is usually a huge divergence between book value and market value of the assets. On the contrary banks and financial companies regularly value the assets they carry on their books. Hence using PB ratio to value such companies is more appropriate and relevant
A low PB stock is considered to be undervalued compared to a higher PB one. However it is important to further analyse the reasons behind undervaluation before deciding to buy the stock

PB Premium vs Sector

This data item is calculated as the percentage difference between the stock PB ratio and the sector PB ratio

	PB ratio	Premium / Discount
Stock A	3.8	40.7%
Stock B	1.3	-51.9%
Sector average	2.7	—

As can be seen from the table above, stock A has a higher PB ratio than the sector average which results in a positive output. When the output is positive it is said that the stock is trading at a premium to the sector. In stock B’s case the output is negative, indicating that the stock’s PB ratio is lower than the sector’s PB ratio. In such a scenario it is said that stock is trading at a discount to the sector
A company’s PB ratio might be at a discount to the sector because the earnings potential of the company is considered to be low or the assets of the company are under stress. It is also possible that PB is at a discount as the market has mispriced the stock. Prudent analysis is necessary before making a purchase decision

Dividend Yield

The ratio is calculated as dividend per share (DPS) for the most recent financial year divided by the close price of the stock. Dividend is the portion of company’s profit that is paid out to shareholders. Dividend per share (DPS) refers to the total dividend paid out divided by the common stock of the company

Suppose DPS is Rs.16 and stock price is Rs.250, dividend yield is calculated as (16/250)*100 = 6.4%
The ratio is used to calculate the earning on investment considering only dividends declared. Higher the dividend yield the better. One should always consider dividend yield when investing in a company’s stock, as it can be significant part of the return that might be generated. High dividend yield stocks could be a good investment avenue to supplement any income needs

Dividend Yield vs Sector

The data item is defined as the difference between the dividend yield of company and the yield of the corresponding sector. A positive number indicates that the dividend yield of the company is higher than average payout of the sector and vice versa

It is important to note that lot of fast growing companies do not pay dividends and prefer to retain money for future investment purposes. Alternatively a company might also not be paying dividends because of poor profitability. So one has to investigate the company to understand the reason behind deep discount or high premium

PS Ratio

The item is defined as close price of the stock divided by the revenue per share of the company for the most recent financial year. The ratio indicates the number of number of units of stock price to be expended to purchase 1 unit of revenue per share. Suppose revenue of the company is Rs.100,000, shares outstanding is 500 and stock price is Rs.100. PS ratio is calculated as (100,000/500) / 100 = 2x. So it costs Rs.2 to purchase every Rupee of the company’s revenue
PS ratio is a valuation ratio and is used in lieu of PE ratio. When a company is loss making, EPS becomes negative and calculating PE ratio is not possible. In such a scenario PS ratio can be used. Just as in PE ratio, PS ratio is used by comparing the ratio of 2 or more companies operating in the same sector. The lower the ratio, the more undervalued the company. However one has to understand the reasons behind undervaluation before deciding whether the stock has investment potential

Forward PS Ratio

Forward PS ratio is calculated as close price of the stock divided by estimated revenue per share of the company for the current financial year. If the current stock price is Rs.300 and estimated revenue per share of the company for the current financial year is Rs.80, then forward PS ratio is 300/80 = 3.75
Forward PS ratio can be used by comparing it with the current PS ratio of the company. Suppose current PS ratio of company A is 3x and the forward PS ratio is 1.8x, it indicates that the revenue of the company is expected to grow over the next year. The deeper the discount between current PS ratio and the forward PS ratio, the higher the potential for the stock price to increase

PS Premium vs Sector

This data item is calculated as the percentage difference between the stock PS ratio and the sector PS ratio

	PS ratio	Premium / Discount
Stock A	4.7	51.6%
Stock B	1.9	-38.7%
Sector average	3.1	—

As can be seen from the table above, stock A has a higher PS ratio than the sector average which results in a positive output. When the output is positive it is said that the stock is trading at a premium to the sector. In stock B’s case the output is negative, indicating that the stock’s PS ratio is lower than the sector’s PS ratio. In such a scenario it is said that stock is trading at a discount to the sector
A company’s PS ratio might be at a discount to the sector because the growth potential of the company is considered to be low or the business of the company is under stress. It is also possible that PS is at a discount as the market has mispriced the stock. Prudent analysis is necessary before making a stock purchase decision