Investment valuation ratios compare current share price to various per-share performance indicators such as earnings, dividends, sales, and operating cash flow to help investors evaluate whether the stock is overvalued, fairly, or undervalued as an investment opportunity. Income, value and growth investors have different investment objectives and thus may have different views on a stock’s value relative to its price.
The relationship between a company's stock price and its per-share metrics is also referred to as a multiple. A multiple can be examined on an absolute basis and used highlight historical trends, but it is more meaningful when compared to competitors and the overall market. As with most ratios, investment value ratios can have many variations and an investment decision should not be made based on a single ratio.
[sidebar] Per Share Data. Any item in a company’s financial statements can be calculated on a per-share basis. For balance sheet items (such as debt or book value per share), the denominator is the period end shares outstanding. For income, expense, and cash flow items, the denominator is the weighted average number of shares outstanding during the period.
Basic and Diluted. Companies with outstanding stock options and other convertible securities report diluted earnings per share in addition to basic earnings per share. This treatment recognizes the potential dilution (an increase in the number of shares outstanding) that would occur if all convertible securities were immediately converted to common shares.
Discontinued Operations. When companies sell off or shut down a component of their operations, earnings per share (both basic and diluted) will be reported with an additional qualification – earnings from continuing operations.
The price-to-earnings (P/E) ratio [market price per share divided by earnings per share] compares the current share price to the amount of earnings the company generates. Expressed as a multiple, it indicates how much shareholders are paying for each dollar of earnings. For example, if a company were currently trading at a P/E multiple of 15, an investor is willing to pay $15 for $1 of current earnings per share (EPS).
The denominator can be trailing EPS, forward EPS, or a combination of the two. Trailing P/E uses earnings from the past, generally basic EPS for the last four quarters of reported earnings. Forward P/E uses a 12-month projection of earnings based on the most recent quarter.
The P/E ratio reflects the market's view of a firm's growth prospects – in other words, future growth is already accounted for in the stock price. Investor sentiment about a stock's pricing and earnings prospects is usually more optimistic in a bull market and more pessimistic in a bear market.
The P/E ratio of one company is easily compared to another; all else being equal, a $10 stock with a P/E of 75 is more expensive than a $100 stock with a P/E of 20. However, high growth stocks (for example...