Wednesday, July 29

Valuation Ratios

Valuation Ratios help us value a company in the simplest manner. This method of valuing companies is also called Relative Valuation. 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 EV/EBITDA 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.

Similarly there are various other valuation ratios that have evolved over time.

The most theoretically correct way in which to value securities is to use a discounted cash flow. So why do investors and valuers 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 companies as being relatively cheap and expensive as a free cash flow DCF valuation will. 

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