Valuation ratios

A valuation ratio is a measure of how cheap or expensive a security (or business) is, compared to some measure of profit or value. A valuation ratio is calculated by dividing a measure of price by a measure of value, or vice-versa.

The point of a valuation ratio is to compare the cost of a security (or a company, or a business) to the benefits of owning it.

The most widely used valuation ratio is the PE ratio which compares the cost of a share to the profits made for shareholders per share.

The PE ratio has many variants. It may use adjusted or diluted earnings, it may be historical or forward looking, it may be an absolute or relative number, and it may be calculated over a single year or the long term.

EV/EBITDA also compares price to profits, but in a somewhat more complex manner. It compares the cost of buying the businesses of a company free of debt, to profits. Because someone buying a company free of debt would no longer have to pay interest, the profit measure used changes to profit before interest. It is also adjusted for non-cash items.

Price/book value compares a share price to the value of a company's assets. This ratio is generally only important for certain sectors, such as property holding companies and investment trusts. This is because investors buy shares for the cash flows they will generate, and because asset values shown in the accounts usually reflect the accrual principle rather than real economic value.

The most theoretically correct way in which to value securities is to use a discounted cash flow. So why do investors rely so much on valuation ratios? One advantage of valuation ratios is that they are a lot simpler. The uncertainties around the numbers used for a discounted cash flow means that it may not be any better in practice.

It is also possible to regard valuation ratios as a quick equivalent to a discounted cash flow. Suppose one is comparing companies in the same sector, and they are broadly similar businesses with very similar risks and the same expected rates of cash flow growth. In that case a price/FCF will show the same same companies as being relatively cheap and expensive as a free cash flow DCF valuation will.

Tobin's Q is usually used rather differently. By comparing market cap to the value of assets it provides a useful indicator of value, but is generally more useful for assessing whether the market is over-valued or under-valued, than for valuing individual securities.

The PE ratio is also used in a similar manner (to look at the valuation of the market). This implicitly assumes mean reversion. The cyclically adjusted PE is often used this way.