Valuation provides an estimate of the ‘worth’ of any item, particularly in the sphere of investments, where it refers to stocks. When contemplating an investment decision, the business’s valuation carries the most weight, even if that business seems especially attractive. It is important to identify a good value when selecting a company – a mediocre business at an economical price may be preferable to one that carries a sky-high valuation.
Valuation ratios provide insight into how the stock market evaluates a particular stock’s worth. These ratios help evaluate the company’s attractiveness as an investment opportunity, comparing its price to associated benefits. As with all ratios, it is important to compare the company in question to its competition too.
Valuation ratios are typically determined by comparing the firm’s share price with an element of its financial results. We will explore three significant valuation ratios:
Continuing the example of ARBL, let us apply these ratios to evaluate its performance. The stock price, being an integral element in calculating the valuation ratios, is Rs.661 per share as of October 28th 2014.
In order to calculate the above ratios, we need to recall the total number of shares outstanding in ARBL. In Chapter 6, we calculated it to be 17,08,12,500 or 17.081Crs.
Price to Sales (P/S) Ratio
In many instances, investors may prefer to utilise sales rather than earnings when assessing the value of their investments. This is often due to the fact that cyclical patterns or accounting regulations can result in a profitable company appearing to have no earnings at all.
To counteract this, investors look at the Price/Sales Ratio (P/S Ratio), which evaluates the stock price compared to the company’s sales per share. The formula for calculating this is:
The price-to-sales ratio is determined by dividing the current share price by the sales per share. Let’s compute this for ARBL, starting with the denominator:
Sales per share can be calculated by dividing the total revenues by the total number of shares. Based on ARBL’s income statement:
Total Revenue = Rs. 3482 Cr
Number of Shares = 17.081 Cr
Thus, the sales per share is obtained by dividing 3482 by 17.081, resulting in:
Sales per share = Rs. 203.86
This means that for each outstanding share, ARBL generates sales worth Rs. 203.86.
Price to Sales Ratio = 661 / 203.86
= 3.24x or 3.24 times
A P/S ratio of 3.24 times shows that for each Rs.1 in sales, the stock is worth Rs.3.24. It is evident that a higher P/S ratio translates to a higher valuation of the firm, so it’s important to compare this ratio with that of its rivals to estimate if the stock is overpriced or undervalued.
When comparing the P/S ratio of two companies (Company A and Company B) that are selling the same product and both generating a revenue of Rs.1000, there may be cause for one to trade at a higher value.
In this example, Company A retains Rs.250 in PAT compared to Company B, which only holds Rs.150 in PAT; therefore, Company A’s profit margin is 25%, significantly more than Company B’s 15%. Thus, it is reasonable that Company A would trade at a premium P/S ratio as each rupee earned has higher retention of profit.
If the P/S ratio of a firm seems to be high, you must check the profit margin as well. This will enable your decision-making skills.
Price to Book Value (P/BV) Ratio
To comprehend the Price to Book Value ratio, it is essential to have an understanding of the term ‘Book Value’.
In a scenario where a company is required to cease operations and sell off its assets, the minimum amount it can expect to receive is determined by what is known as the “Book Value” of the company.
The book value of a firm is the amount remaining after all liabilities have been settled. It is akin to the salvage value of the company and is usually expressed on a per-share basis. For example, if a company has a book value per share of Rs.60, each shareholder can expect to receive Rs.60 when the firm decides to liquidate. To calculate the BV, one should subtract all liabilities from total assets held by the company.
BV = [Share Capital + Reserves (excluding revaluation reserves) / Total Number of shares]
Let us calculate the same for ARBL:
From ARBL’s balance sheet, we know:
Share Capital = Rs.17.1 Crs
Reserves = Rs.1345.6 Crs
Revaluation Reserves = 0
Number of shares: 17.081
Hence the Book Value per share = [17.1+1345.6 – 0] / 17.081
= Rs.79.8 per share
If ARBL were to liquidate assets and settle debts, shareholders could receive Rs.79.8 per share.
If we divide the stock’s current market price by its book value per share, the result will be the Price to Book Value (P/BV). This ratio illustrates how much more expensive the stock is compared to its book value. Generally, the higher this figure, the pricier the stock.
Let us calculate this for ARBL. We know:
The stock price of ARBL is Rs.661 per share
BV of ARBL = 79.8 per share
P/BV = 661/79.8
= 8.3x or 8.3 times
This indicates that ARBL is trading above 8.3 times its book value.
A high ratio could point to the company being overvalued in comparison with its equity/ book value, whereas an opposite effect may be seen if the ratio is low.