Business Valuation – Ratio Analysis

In the prior examples, we focused on the cash inflows (i.e., the dividends of the investment). Now we look at the ratios that define the financial health of a company.

Let’s first look at the price-to-earnings ratio. This ratio compares the share price to the earnings per share. 

Price-to-Earnings = Stock Price / Earnings Per Share 

Earnings per share is net income minus preferred dividends divided by the average number of common outstanding shares. 

Imagine the following scenario: 

“Tony’s Ribs has net income (earnings) of $100,000; 10,000 shares outstanding; and its price per share is $85.”

 In this example, we have net income of $100,000 and 10,000 shares. Therefore, every shareholder is entitled to $10 of income (i.e., earnings per share). In other words, if we were to give 100% of our earnings as dividends, then each shareholder would get $10. 

We compare the company’s stock price to its earnings per share. We divide the stock price of $85 by the $10 earnings per share, resulting in a price-to-earnings ratio of 8.5. This means that if we receive 100% of earnings as dividends, it will take us 8.5 years to recover our initial investment in the company. The lower the price-to-earnings ratio, the better. 

Now let’s look at the price-to-earnings-to-growth (PEG) ratio, which factor in the growth rate of a company into its valuation. The price-to-earnings-to-growth ratio builds on the price-to-earnings ratio. 

Price-to-Earnings-to-Growth = Price-to-Earnings / Growth Rate

We simply take the company’s price-to-earnings ratio and then divide it by the growth rate of the company. If the price-to-earnings ratio is 8.5, and let’s say our growth rate is 5%, we divide 8.5 by 5, resulting in a price-to-earning-to-growth of 1.7.

Now this 1.7 doesn’t tell us anything specific about the company unless we compare it to another company’s PEG ratio. The lower the price-to-earnings-to-growth ratio, the better the investment option, because it signifies a higher growth rate.

In the price-to-earnings ratio and the price-to-earnings-to-growth ratio, we were using the company’s net income to value the company. But what happens if a company has a net loss instead of net income? Newer companies often experience losses for several years before becoming profitable. One option to value a company that has a net loss is the price to-sales ratio. 

Price-to-Sales = Market Capitalization / Annual Sales

We divide the company’s market capitalization by the company’s annual sales. Let’s say that Tony’s Ribs has a price per share of $85 and 200,000 shares outstanding. Therefore, its market capitalization is $17 million ($85 X 200,000).

If annual sales are $1 million, then the price-to-sales ratio would be 17 ($17 million / $1million). This means it would take 17 years to generate enough sales to equal the company’s worth today.

The next ratio is the price-to-book ratio. This ratio attempts to answer, “How does the company’s value compare to the company’s equity on its balance sheet?” 

Price-to-Book Ratio = Market Capitalization / Total Equity

Based on the balance sheet formula, we know that equity is simply assets minus liabilities. Let’s imagine that Tony’s Ribs has assets of $8,500,000 and liabilities of $6,800,000. Therefore, its equity is $1,700,000 ($8,500,000 assets – $6,800,000 liabilities). The company’s market capitalization is $17 million, making the price-to-book ratio 10 ($17 million / $1.7 million). In other words, the stock market values the company at 10 times what its equity on its balance sheet says that its worth.