Valuation Ratios For Value Investors
Value investors focus on valuation ratios in hopes of purchasing stocks on sale, then patiently wait for the market to realize its fair value. The price-earnings ratio, which divides a company’s earnings per share into its current share price, is a popular valuation ratio used. Value investors may also use earnings before interest, taxes and depreciation (EBITD) as the divisor, or free cash flow which subtracts capital investment cash requirements from normal operating cash flow.
While these are suitable ratios to use for many companies, they are not always appropriate, particularly if the company (or its competitors) have negative earnings, EBITD, or free cash. For example, if you are comparing two companies both trading at $10 per share, but the first company has earnings per share of $-1 and the second company has earnings per share of $1, the first company would technically have a lower price-earnings ratio (-10 vs. 10) and be viewed more attractively even though it has negative earnings. Similarly, a company may appear to have a very high price-earnings ratio due to miniscule earnings, but it still may be more attractive if all of their competitors have “negative” price-earnings ratios due to negative earnings.
To combat this, value investors can turn to the price-book ratio and the price-sales ratio when searching for deeply discounted stocks. For the 230+ companies trading on the S&P/TSX Composite Index, only three have a negative book value (tangible assets less liabilities) and naturally, all of them have positive sales. This approach levels the playing field and allows investors to make better comparisons due to an increase in sample size.
The table below summarizes the median valuation ratios by sector and for a select few key industries where the sample size was large enough to make a proper calculation. I chose median instead of mean because the distributions can be highly skewed in certain sectors and industries and would be misleading. Using the median, I believe, is more representative. The ratios were calculated using Friday’s closing prices.
As you can see, ratios can vary widely between sectors and within industries. When examining stocks in your portfolio, or ones you are considering acquiring, take a quick look at how they compare with similar companies in their sector and industry. You may find you’re willing to pay no more than 2 times book value for grocery store stocks, and no more than 6 times for software companies. Make sure you are comparing apples to apples.
Value investors also must realize that it can often take significant time for the market to come to realize what you, the investor, have already. This can make value investing frustrating to many investors, especially those with short time horizons or those looking to make a quick score. The Oil & Gas, Exploration & Production Industry appears extremely cheap right now, for example, but it has been that way for years now. The opportunity cost of an investor having their cash tied up in these stocks for years is significant, and should be a key consideration when making a value investment decision.
Finally, I want to note that many financial websites have these ratios widely available, but may differ due to slight differences in their calculations. For example, one website may include extraordinary items in their earnings per share calculation while another may exclude it. Free cash flow can also differ by what a company classifies as regular capital investments. Finally, calculations may be done on a forward basis, a trailing twelve month basis, or on the most recent completed annual financial statements. Whatever your data source, just ensure you are using the same one for all your calculations.
If interested, you can always subscribe to our free weekly newsletter and get instant access to these five ratios for all S&P/TSX Composite companies. Just visit the Subscribers Area, enter the site password (which you will receive after confirming your email), and download the latest Value Investors Report in PDF or Excel format.
I hope this information helps you and as always, if you have any questions please feel free to send me an email or leave a comment below. Happy Investing!