Market value ratios
The market value ratios indicate the current company's value and, for publicly traded companies, its share price. These set of ratios is used commonly by investors to evaluate the attractiveness of a firm from the investment standpoint^{[1]}. The most well know ratios are as following:
1) Price / Earnings ratio (P/E) - shows the market price in relation to companies earnings. Simply saying how many of dollars investor has to pay per each dollar of firms earning.
2) Earnings per Share - Represents what portion of profit the company has generated per each issued share. The ratio does not reflect any current market price, but it is used by investors to measure the profitability of the firm and derive the share price according to what they think the company is worth.
3) Market-book ratio. The market-book ratio shows how a firm is regarded by investors in terms of its stock's market price to its book value ^{[2]}.
Implementation of market value ratios
In financial management, structured and scientific decisions based on analysis of financial statements whereas market value ratios play the critical part^{[3]}. Applying value ratios investors attempts to calculate an accurate estimation of a company's future earnings stream in order to link security value with a current price and decide whether to purchase or liquidate an asset. Usage of ratios, by comparison of the performance of various firms within the same industry help investors to identify companies most suitable for their investment goals and evaluate trends in the firm's financial position over time.
On another hand, a firm's creditors are rarely concerned about the firm's capitalization, but rather care about the ability to cover a firm's debts and payout the debt on time^{[4]}. In this case, market value ratios are hardly applicable and debt or liquidity ratios would be more helpful.
Examples of Market value ratios
- Price-Earnings Ratio (P/E Ratio):
This ratio is calculated by dividing the current price of a share by its earnings per share (EPS). It indicates how much investors are willing to pay for each dollar of a company’s earnings. A higher ratio means investors are willing to pay more for a company’s earnings, which indicates that the company’s stock is expected to grow in the future.
- Price-to-Book Ratio (P/B Ratio):
This ratio is calculated by dividing the current stock price of a company by its shareholders’ equity or book value. It is used to evaluate the relative value of a stock and compare it to the stock prices of other companies in the same industry. A high ratio means investors are willing to pay more for a company’s stock relative to its book value, which indicates that the company’s stock is expected to increase in the future.
- Price-to-Sales Ratio (P/S Ratio):
This ratio is calculated by dividing the current stock price of a company by its total sales. It is used to measure how much investors are willing to pay for each dollar of a company’s sales. A higher ratio indicates that investors are willing to pay more for a company’s stock relative to its sales, which suggests that the company’s stock is expected to increase in the future.
- Price-to-Cash Flow Ratio (P/CF Ratio):
This ratio is calculated by dividing the current stock price of a company by its cash flow per share (CFPS). It is used to measure how much investors are willing to pay for each dollar of a company’s cash flow. A higher ratio indicates that investors are willing to pay more for a company’s stock relative to its cash flow, which suggests that the company’s stock is expected to increase in the future.
Advantages of Market value ratios
Market value ratios offer investors a great way to assess the current financial performance and potential of a firm. These ratios provide a snapshot of the company’s financial health and are useful in comparing the company to its peers. The most well-known market value ratios include:
- Price-Earnings Ratio (P/E Ratio): This ratio is calculated by dividing a company’s stock price by its earnings per share (EPS). A higher P/E ratio indicates that the market is expecting higher future earnings and is willing to pay a higher price for the stock.
- Price-to-Book Ratio (P/B Ratio): This ratio is calculated by dividing the stock price by the company’s book value per share. A higher P/B ratio indicates that investors are expecting the company to generate higher future profits.
- Price-to-Sales Ratio (P/S Ratio): This ratio is calculated by dividing the stock price by the company’s revenue per share. A higher P/S ratio indicates that the market is expecting the company to increase its sales and profits in the future.
- Dividend Yield: This ratio measures the percentage of the company’s stock price that is returned to shareholders in the form of dividends. A higher dividend yield indicates that the company is generating higher returns for its investors.
Overall, these market value ratios can help investors evaluate the potential of a company and make more informed investment decisions.
Limitations of Market value ratios
Market value ratios are useful for investors to evaluate the attractiveness of a company but it is important to note that there are some limitations to their use. The limitations include:
- Market value ratios do not take into account the financial health of the company, so they may not provide an accurate picture of the company’s value.
- Market value ratios are based on historical data and do not consider future prospects.
- Market value ratios may be manipulated by companies to appear more attractive to investors.
- Market value ratios may be affected by market fluctuations, making them unreliable indicators of a company’s true value.
- Market value ratios can be affected by the availability of information, making them an incomplete measure of company performance.
- Price-to-earnings ratio (P/E): It is the ratio of a company’s share price to its earnings per share and is a measure of how much investors are willing to pay for each dollar of a company’s earnings.
- Price-to-book ratio (P/B): It measures the market value of a company relative to its book value, which is the amount of money that shareholders would theoretically receive if a company were liquidated.
- Enterprise value-to-EBITDA ratio (EV/EBITDA): It is a measure of a company's valuation, taking into account its total debt and cash, and is calculated by dividing a company's enterprise value by its earnings before interest, taxes, depreciation, and amortization (EBITDA).
- Price-to-sales ratio (P/S): It is a valuation ratio that compares a company’s stock price to its revenues. It is calculated by dividing the market capitalization of a company by its total sales over a certain period.
- Return on Equity (ROE): It is a measure of a company's profitability that takes into account the company's total equity. It is calculated by dividing a company's net income by its total equity.
In conclusion, there are several market value ratios that investors use to evaluate a firm and its share price from an investment standpoint, such as the price-to-earnings ratio, price-to-book ratio, enterprise value-to-EBITDA ratio, price-to-sales ratio, and return on equity. Each of these ratios provides a different insight into the company's financial health, allowing investors to make informed decisions about their investments.
Footnotes
Market value ratios — recommended articles |
Earnings per share — Book value per share — Return on common equity — Free cash flow yield — Net yield — Earnings Multiplier — Adjusted ebitda — Investment ratio — Book-to-Market Ratio |
References
- Çam, Alper & Tosunoglu, Busra & Gürtay, Enes & Gurtay, Enes. (2015). The Role Of Financial Ratios To Determine The Value Of Stock: A Application In Bist The Role Of Financial Ratios On Evaluation Of Stock Values.
- Brigham, E. and Ehrhardt, M. (2011). Financial management. Mason, OH: South-Western Cengage Learning.
- Frase, L., & Ormiston, A. (2004). Understanding Financial Statements. New Jersey: Pearson Prentice Hall.
- Nissim, D. and Penman, S. (2001). Ratio Analysis and Equity Valuation: From Research to Practice. Review of Accounting Studies, 6.
- Ohlson, J. A. (1995).Earnings, Book Values, and Dividends in Equity Valuation.Contemporary Accounting Research 11, 661-687.
- Tugas, F. (2012). A Comparative Analysis of the Financial Ratios of Listed Firms Belonging to the Education Subsector in the Philippines for the Years 2009-2011. International Journal of Business and Social Science, 3(21), pp.173-190.
Author: Mariia Gordiyenko