![](https://pbs.twimg.com/media/E93Fd0jVkAM9MIo.jpg)
It's the weekend!
Grab a cup of coffee, in this thread I will explain
1. What are Valuation Ratios?
2. What ratio should be used when?
3. Why one standard ratio like a PE doesn't work all the time?
Lets dive right in.
![](https://pbs.twimg.com/media/E93FdkZUYAMctkH.png)
You have to consider multiple characteristics and factors together while valuing a company.
![](https://pbs.twimg.com/media/E93FedQUYAAab1v.png)
A Price to Book (PB) ratio doesn't work for companies with low assets and book values while it works perfectly for companies that are asset heavy.
![](https://pbs.twimg.com/media/E93FfKDVkAchhK8.jpg)
Assuming the company passes on entire earnings as dividends, this ratio will also denote the number of years it takes for you to recoup your investment at the current share price.
1⃣ Easy to understand
2⃣ Quick tool to compare across peers
3⃣ Widely used
Cons
1⃣ Earnings per share is a highly managed accounting number
2⃣ Doesn't work for companies that have zero or negative earnings
3⃣ Doesn't reflect components of Balance Sheet like Debt
If you flip the ratio of P/E to Earnings/Price, you get something known as an Earnings Yield.
![](https://pbs.twimg.com/media/E93FfhwUcAg-4ak.jpg)
If a fixed deposit gives you 6% return, then its yield is said to be 6%.
Similarly a
PE ratio of 25 means an Earnings Yield of 4%
(1/25 = 0.04)
PE ratio of 100 means an Earnings Yield of 1%
(1/100 = 0.01)
PE is good ratio to use when
1⃣ A company has earnings
2⃣ The company isn't cyclical, financial or in an asset heavy industry
3⃣ When you want to do a quick compare of peers in the industry
1⃣ Profit Margins
2⃣ Growth in Earnings
3⃣ Industry Structure
4⃣ Company Structure
5⃣ Cash Flows
Never invest just based on a single ratio.
This is a good ratio to use esp for fast growing companies, provided the growth in earnings is sustainable.
![](https://pbs.twimg.com/media/E93FgM8UcAYEkhq.png)
PEG Ratio of < 1 implies the company is undervalued
Price to Sales is just what the name suggests.
Current Share Price / Most recent 12 month Sales per Share
![](https://pbs.twimg.com/media/E93Fg6QVgAQI4dj.png)
This is mostly used for companies that aren't earning any revenue yet and do not have a positive net income.
![](https://pbs.twimg.com/media/E93FhLPVIAIiMPD.jpg)
1⃣ Less susceptible to accounting shenanigans: Sales of a company cannot be altered easily
2⃣ Sales unlike earnings for most part are not as volatile and relatively stable for company
1⃣ Does not take into account profitability
A company may be doing 100cr in sales every year but if its profit margin is 1% on that 100cr, its Price to Sales ratio will be very less but that alone doesn't make it a good investment
1⃣ To compare companies across the industry and establish a benchmark ratio
2⃣ When a company isn't reporting any or low earnings and is in its growth phase
In this instead of taking Current Share Price / Sales per Share
we take the total
Enterprise Value = (Value of Debt + Value of Equity - Net Cash)
and divide it with the actual yearly sales number.
![](https://pbs.twimg.com/media/E93Fh1AVEAYRGSy.png)
EV to Sales gives a more comprehensive picture by incorporating the leverage (debt) of the company.
Price to Cash Flow is a measure of current market value relative to the cash generated by a business.
It is measured as
Current Share Price / Cash Flow per Share
![](https://pbs.twimg.com/media/E93FiHhVkAASU82.png)
1⃣ Unlike earnings, cash flow is very hard to manipulate
2⃣ Companies that do not have net earnings yet, can easily be compared on the basis of cash flow
Cons
1⃣ Doesn't incorporate Balance Sheet Leverage (Debt)
2⃣ Doesn't incorporate Growth in Cash Flow
Price to Cash Flow is most suitable to be used when evaluating Technology Product companies or companies who have reoccurring revenues with a limited asset base.
As such, these companies either do not have positive net earnings or if they do then these earnings are miniscule compared to cash flow.
![](https://pbs.twimg.com/media/E93FimBVEAIZC11.png)
Here, in the denominator instead of Cash Flow from Operations, we use Free Cash Flow.
Price to FCF, incorporates the effects of cash used by the companies for investing and financing purposes.
![](https://pbs.twimg.com/media/E93Fi4kVUAcWel-.jpg)
As the name suggests,
Price to Book is ratio of current share price / most recent per share book value of the firm.
![](https://pbs.twimg.com/media/E93FjHVVIAEoHGC.png)
In case a company is liquidated this is the expected value each shareholder can expect to receive (at least theoretically).
![](https://pbs.twimg.com/media/E93FjVNVUAAOkD-.png)
Financial and asset heavy cyclical companies are best evaluated
using a Price to Book ratio.
The firms have a high asset base and due to the cyclical nature of their business peak earnings from these assets are achieved only in certain years.
![](https://pbs.twimg.com/media/E93FjktVcAYcMXY.png)
Why?
Cause technology companies do not need significant assets to conduct their business.
A true tech company will have a very small asset base and really high cash flow from that asset base.
1⃣ Stable metric, the book value of a company doesn't fluctuate as much as earnings would
2⃣ Can be used to evaluate financial and cyclical companies
Cons
1⃣ Doesn't tell you anything about profitability of a company
Enterprise Value = (Value of Debt + Value of Equity - Net Cash)
and divides that with
Earnings Before Interest, Tax, Depreciation and Amortization (also known as a proxy for cash flow)
![](https://pbs.twimg.com/media/E93FkRsUYAEi1JD.png)
1⃣ Incorporates Balance Sheet elements like Debt
2⃣ Links Balance Sheet to Cash Flows
Cons
1⃣ Doesn't tell you anything about growth in earnings or cash flows
Every company is different and all ratios taken together can help you decipher an investment from all angles.
![](https://pbs.twimg.com/media/E93Fk86VIAgICf_.png)
Learn all about them in this thread below.
https://t.co/XFxH7hyhHu
It's the weekend!
— Tar \u26a1 (@itsTarH) July 10, 2021
Grab a cup of coffee, in this thread I will explain
1. What is Dupont Method for ROE?
2. What is the difference between ROE, ROCE and ROIC?
3. How to identify companies that will improve their ROCE in future?
Lets dive right in. pic.twitter.com/Co7LFFYto9
Here is a link to my last weekend's thread
https://t.co/w2jT7WVYt7
It's the weekend!
— Tar \u26a1 (@itsTarH) August 21, 2021
Grab a cup of coffee, in this thread I will explain
1. How to do Industry Research?
2. How to research a Company from scratch?
3. How to determine Margin of Safety and build an Investment Case?
Lets dive right in. pic.twitter.com/cijy1ilYZR
Teach a Free class on Data Visualizing using a tool called Tableau over @skillshare
Get access to the class by using the below link
https://t.co/VyPiV7u7pp
https://t.co/UhAgK7aMlU
Here is a link to that class
(gives you Free access to all other classes on Skillshare for 30 days)
https://t.co/NWZOPx8dvW
https://t.co/r7uNYuqjsn
Subscribe for free, if you're interested.
Thank you to the 2500+ of you who already have!