11.1 – The Valuation Ratio
Valuation in general, is the estimate of the ‘worth’ of something. In the context of investments, ‘something’ refers to the price of a stock. When making an investment decision, irrespective of how attractive the business appears, what matters finally is the valuation of the business. Valuations dictate the price you pay to acquire a business. Sometimes, a mediocre business at a ridiculously cheap valuation may be a great investment option as opposed to an exciting business with an extremely high valuation.
The valuation ratios help us develop a sense on how the stock price is valued by the market participants. These ratios help us understand the attractiveness of the stock price from an investment perspective. The point of valuation ratios is to compare the price of a stock viz a viz the benefits of owning it. Like all the other ratios we had looked at, the valuation ratios of a company should be evaluated alongside the company’s competitors.
Valuation ratios are usually computed as a ratio of the company’s share price to an aspect of its financial performance. We will be looking at the following three important valuation ratios:
- Price to Sales (P/S) Ratio
- Price to Book Value (P/BV) Ratio and
- Price to Earnings (P/E) Ratio
Continuing with the Amara Raja Batteries Limited (ARBL) example, let us implement these ratios to see how ARBL fares. The stock price of ARBL is a vital input used to calculate the valuation ratios. As I write this chapter on 28th of Oct 2014, ARBL is trading at Rs.661 per share.
We also need the total number of shares outstanding in ARBL to calculate the above ratios. If you recollect, we have calculated the same in chapter 6. The total number of shares outstanding is 17,08,12,500 or 17.081Crs
Price to Sales (P/S) Ratio
In many cases, investors may use sales instead of earnings to value their investments. The earnings figure may not be true as some companies might be experiencing a cyclical low in their earning cycle. Additionally due to some accounting rules, a profitable company may seem to have no earnings at all, due to the huge write offs applicable to that industry. So, investors would prefer to use this ratio. This ratio compares the stock price of the company with the company’s sales per share. The formula to calculate the P/S ratio is:
Price to sales ratio = Current Share Price / Sales per Share
Let us calculate the same for ARBL. We will take up the denominator first:
Sales per share = Total Revenues / Total number of shares
We know from ARBL’s P&L statement the:
Total Revenue = Rs.3482 Crs
Number of Shares = 17.081 Crs
Sales per share = 3482 / 17.081
Therefore the Sales per share = Rs. 203.86
This means for every share outstanding, ARBL does Rs.203.86 worth of sales.
Price to Sales Ratio = 661 / 203.86
= 3.24x or 3.24 times
A P/S ratio of 3.24 times indicates that, for every Rs.1 of sales, the stock is valued Rs.3.24 times higher. Obviously, higher the P/S ratio, higher is the valuation of the firm. One has to compare the P/S ratio with its competitors in the industry to get a fair sense of how expensive or cheap the stock is.
Here is something that you need to remember while calculating the P/S ratio. Assume there are two companies (Company A and Company B) selling the same product. Both the companies generate a revenue of Rs.1000/-each. However, Company A retains Rs.250 as PAT and Company B retains Rs.150 as PAT. In this case, Company A has a profit margin of 25% versus Company B’s which has a 15% profit margin. Hence the sales of Company A is more valuable than the sales of Company B. Hence if Company A is trading at a higher P/S, then the valuation maybe justified, simply because every rupee of sales Company A generates, a higher profit is retained.
Hence whenever you feel a particular company is trading at a higher valuation from the P/S ratio perspective, do remember to check the profit margin for cues.
Price to Book Value (P/BV) Ratio
Before we understand the Price to Book Value ratio, we need to understand what the term ‘Book Value’ means.
Consider a situation where the company has to close down its business and liquidate all its assets. What is the minimum value the company receives upon liquidation? The answer to this lies in the “Book Value” of the firm.
The “Book Value” of a firm is simply the amount of money left on table after the company pays off its obligations. Consider the book value as the salvage value of the company. Suppose the book value of a company is Rs.200Crs, then this is the amount of money the company can expect to receive after it sells everything and settles its debts. Usually the book value is expressed on a per share basis. For example, if the book value per share is Rs.60, then Rs.60 per share is what the shareholder can expect in case the company decides to liquidate. The ‘Book Value’ (BV) can be calculated as follows:
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
This means if ARBL were to liquidate all its assets and pay off its debt, Rs.79.8 per shares is what the shareholders can expect.
Moving ahead, if we divide the current market price of the stock by the book value per share, we will get the price to the book value of the firm. The P/BV indicates how many times the stock is trading over and above the book value of the firm. Clearly the higher the ratio, the more expensive the stock is.
Let us calculate this for ARBL. We know:
Stock price of ARBL = Rs.661 per share
BV of ARBL = 79.8 per share
P/BV = 661/79.8
= 8.3x or 8.3 times
This means ARBL is trading over 8.3 times its book value.
A high ratio could indicate the firm is overvalued relative to the equity/ book value of the company. A low ratio could indicate the company is undervalued relative to the equity/ book value of the company.
Price to Earning (P/E) Ratio
The Price to Earnings ratio is perhaps the most popular financial ratio. Everybody likes to check the P/E of a stock. Because of the popularity the P/E ratio enjoys, it is often considered the ‘financial ratio superstar’.
The P/E of a stock is calculated by dividing the current stock price by the Earning Per share (EPS). Before we proceed further to understand the PE ratio, let us understand what “Earnings per Share” (EPS) stands for.
EPS measures the profitability of a company on a per share basis. For example assume a certain company with 1000 shares outstanding generates a profit of Rs.200000/-. Then the earnings on a per share basis would be:
=200000 / 1000
= Rs.200 per share.
Hence the EPS gives us a sense of the profits generated on a per share basis. Clearly, higher the EPS, better it is for its shareholders.
If you divide the current market price with EPS we get the Price to Earnings ratio of a firm. The P/E ratio measures the willingness of the market participants to pay for the stock, for every rupee of profit that the company generates. For example if the P/E of a certain firm is 15, then it simply means that for every unit of profit the company earns, the market participants are willing to pay 15 times. Higher the P/E, more expensive is the stock.
Let us calculate the P/E for ARBL. We know from its annual report –
PAT = Rs.367Crs
Total Number of Shares = 17.081 Crs
EPS = PAT / Total Number of shares
= 367 / 17.081
Current Market Price of ARBL = 661
Hence P/E = 661 / 21.49
= 30.76 times
This means for every unit of profit generated by ARBL, the market participants are willing to pay Rs.30.76 to acquire the share.
Now assume, ARBL’s price jumps to Rs.750 while the EPS remains at Rs.21.49, the new P/E would be:
= 34.9 times
While the EPS stayed flat at Rs.21.49 per share, the stock’s P/E jumped. Why do you think this happened?
Clearly, the P/E Ratio jumped because of the increase in the stock price. As we know the stock price of a company increases when the expectations from the company increases.
Remember, P/E Ratio is calculated with ‘earnings’ in its denominator. While looking at the P/E ratio, do remember the following key points:
- P/E indicates how expensive or cheap the stock is trading at. Never buy stocks that are trading at high valuations. I personally do not like to buy stocks that are trading beyond 25 or at the most 30 times its earnings, irrespective of the company and the sector it belongs to
- The denominator in P/E ratio is the ‘Earnings’, and the earnings can be manipulated
- Make sure the company is not changing its accounting policy too often – this is one of the ways the company tries to manipulate its earnings.
- Pay attention to the way depreciation is treated. Provision for lesser depreciation can boost earnings
- If the company’s earnings are increasing but not its cash flows and sales, then clearly something is not right
11.2 – The Index Valuation
Just like a stock, the stock market indices such as the BSE Sensex and the CNX Nifty 50 have their valuations which can be measured by the P/E, P/B and Dividend Yield ratios. The Index valuation is usually published by the stock exchanges on a daily basis. The index valuations give us a sense of how cheap or expensive the market is trading at. To calculate the CNX Nifty 50 P/E ratio, the National Stock Exchange combines the market capitalization for all the 50 stocks and divides that amount by the combined earnings for all the 50 stocks. Tracking the Index P/E ratio, gives a sense of the current state of market as perceived by the market participants. Here is the historical chart of Nifty 50 P/E ratio* –
* Source – Creytheon
From the P/E chart above, we can make a few important observations –
- The peak Index valuation was 28x (early 2008), what followed this was a major crash in the Indian markets
- The corrections drove the valuation down to almost 11x (late 2008, early 2009). This was the lowest valuation the Indian market had witnessed in the recent past
- Usually the Indian Indices P/E ratio ranges between 16x to 20x, with an average of 18x
- As of today (2014) we are trading around 22x, which is above the average P/E ratio
Based on these observations, the following conclusions can be made –
- One has to be cautious while investing in stocks when the market’s P/E valuations is above 22x
- Historically the best time to invest in the markets is when the valuations are around 16x or below.
One can easily find out Index P/E valuation on a daily basis by visiting the National Stock Exchange (NSE) website.
On NSE’s home page click on Products > Indices > Historical Data > P/E, P/B & Div > Search
In the search field enter today’s date and you will get the latest P/E valuation of the market. Do note, the NSE updates this information around 6:00 PM every day.
Here is a snapshot of the search result –
Clearly as of today (13th Nov 2014) the Indian market is trading close to the higher end of the P/E range; history suggests that we need to be cautious while taking investment decisions at this level.
Key takeaways from this chapter
- Valuation in general, is the estimate of the ‘worth’ of something
- Valuation ratios involves inputs from both the P&L statement and the Balance Sheet
- The Price to Sales ratio compares the stock price of the company with the company’s sales per share
- Sales per share is simply the Sales divided by the Number of shares
- Sales of a company with a higher profit margin is more valuable in comparison to the sales of a company with lower profit margins
- If a company is going bankrupt, the ‘Book Value’ of a firm is simply the amount of money left on table after the company pays off its obligations
- Book value is usually expressed on a per share basis
- The Price/BV indicates how many times the stock price is trading over and above the book value of the firm
- EPS measures the profitability of a company on a per share basis
- The P/E ratio indicates the willingness of market participants to pay for a stock, keeping the company’s earnings in perspective
- One has to be cautious about the earning manipulation while evaluating the P/E ratio
- The Indices have a valuation which can be measured by the P/E, P/B or Dividend Yield ratio
- It is advisable to exercise caution when the Index is trading at a valuation of 22x or above
- A valuation gets attractive when the index is trading at 16x or below
- The index valuations are published by NSE on their website on a daily basis