Everyone Wants a Value. Here's How Investors Can Find One
In this Action Alerts PLUS tip sheet, we discuss valuation metrics and how to use them.
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Let's wrap up this week'scollection of investor tip sheets by turning to valuation metrics that we use to evaluate positions either in the AAP portfolio or ones we are considering in the Action Alerts PLUSBullpen.
We use these formulas and numbers to determine if a stock is undervalued, fairly valued, or overvalued, relative to its historical multiples, as well as those for its industry and peer groups and the S&P 500. Because there is no "silver bullet" when it comes to valuing a stock, something that is a balance between mathematics and art, we prefer to triangulate a stock's potential upside as well as the downside risk using at least two and preferably three valuation metrics.
Before we get to these metrics, let's review some key terms that play a role in calculating these figures:
EPS = earnings per share
EBITDA = earnings before interest, tax, depreciation, and amortization. EBITDA is widely used as a proxy for a company's core operating cash flows.
Current Market Price: The share price of a company's stock at the present time.
Market Cap
Formula: Current Market Price Per Share x Number of Shares Outstanding
The total dollar value of all outstanding shares. Market Capitalization is a measure of company size.
P/E Ratio
Formula: Current Market Price of a company's stock/ EPS
This ratio is used to determine the relative value of a company's shares in an apples-to-apples comparison to others in the same sector. It can also be compared against a company's historical P/E multiples or compared to current and historic market P/E multiples -- against one another or over time. Companies that have no earnings or that are losing money do not have a P/E ratio because there is nothing to put in the denominator.
Trailing P/E Ratio
Formula: Current Market Price / Trailing EPS
This valuation ratio is calculated by dividing the current market price by trailing 12-month (TTM) Earnings Per Share.
Forward P/E Ratio
Formula: Current Market Price / Estimated EPS
A valuation ratio calculated by dividing the current market price by projected 12-month Earnings Per Share. This is the metric that we tend to favor over the Trailing P/E ratio as it incorporates EPS growth expectations.
PEG Ratio
Formula: P/E Ratio / 5-Yr Expected EPS Growth
A forward-looking measure rather than typical earnings growth measures, which look back in time (historical). It's used to measure a stock's valuation against its projected 5-year growth rate.
Price/Sales Ratio
Formula: Current Market Price / Total Revenues Per Share
A valuation ratio calculated by dividing the current market price by trailing 12-month (TTM) Total Revenues. Often used to value unprofitable companies.
Price/Book Ratio
Formula: Current Market Price / Book Value Per Share
A valuation ratio calculated by dividing the current market price by the most recent quarter's (MRQ) Book Value Per Share.
Enterprise Value
Formula: Market Cap + Total Debt - Total Cash & Short-Term Investments
EV is a measure of theoretical takeover price and is useful in comparisons against income statement line items above the interest expense/income lines such as revenue and earnings before interest, taxes, depreciation, and amortization.
Enterprise Value/Revenue
Formula: Enterprise Value / Total Revenues
Generally, the EV/Revenue multiple is used for companies with negative or limited profitability, but we can use it as part of our valuation triangulation process.
The EV to revenue multiple is commonly used for early-stage or high-growth businesses that don't have positive earnings yet
Enterprise Value/EBITDA
Formula: Enterprise Value / EBITDA
The EV/EBITDA multiple answers the question, "For each dollar of EBITDA generated by a company, how much are investors currently willing to pay?"
Dividend Yield
Formula: Dividend Per Share/ Current Share Price of a company's stock
The Dividend Yield is a financial ratio that measures the annual value of dividends received relative to the market value per share of a security. Because dividend yields vary significantly between industries, the comparison of this ratio should only be done for companies operating in the same industry.
At the time of publication, AAP had no position in any security mentioned.