The ease of access to multiple stock markets through CFD platforms like City Index allows us to pick the best stocks from a large universe of over 6,000 stocks, including IPO markets. However, we are still limited by the size of our trading capital. This makes it important for us to understand how to determine the value of a business so that we can allocate our capital to the best opportunities.
By taking the time to value a business or stock before investing, it provides us with a reference as to whether the stock is undervalued or is fair valued. Furthermore, it can also be used as an indicator to exit when the stock is overvalued or when its fundamentals start to deteriorate.
While there are many financial ratios that provide different insights into the fundamentals of a business, here are four key ratios that can be applied to most stocks, including dividend-paying stocks.
#1 Price To Book (P/B) Ratio
The price-to-book ratio is a simple and popular way to value a company (market capitalisation) relative to its book value or net assets on its balance sheet. A P/B ratio of 1 means that the stock is trading at fair value. If the stock price is trading above the book value of 1, it is considered to be overvalued. On the other hand, if the stock price is trading below the book value or under 1, it is considered to be undervalued. Therefore, value investors would always prefer stocks that have a P/B under 1.
Formula:
Where:
- Stock Price = current trading price
- Book Value Per Share = (Total assets – intangible assets – total liabilities) ÷ number of outstanding shares
We can use this ratio to value companies that have either positive or negative earnings or that are asset-heavy, like banks and Real Estate Investment Trusts (REITs). To use it effectively, compare the P/B ratio of the selected stock to the average P/B ratio within its respective industry for a better benchmark.
One downside to this metric is the differences in accounting standards practiced by companies, which can lead to a variation in the classification and valuation of assets and liabilities, affecting the book value.
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#2 Price/Earnings To Growth (PEG) Ratio
For companies that are fast-growing and asset-light, it would be more beneficial to value them based on the price/earnings-to-growth (PEG) ratio. Unlike the traditional price-to-earnings (P/E) ratio, which is another popular metric used by investors to determine the valuation of a company based on its past earnings, the PEG ratio addresses a major weakness by also accounting for the future growth of the company.
As a general rule of thumb, if the stock has a PEG ratio of under 1, it is considered to be undervalued, while a ratio above 1 is considered to be overvalued.
Formula:
Where:
- PE Ratio = (Price Per Share) ÷ Earnings Per Share
We can use this ratio to value companies that have positive earnings and also those that are growing fast at the different lifecycle stages. However, it should be noted that for the PEG we are making an assumption of the future earnings growth rate of the company, which may not be an accurate forecast.
#3 Dividend Yield Ratio
Another simple way that investors can determine the value of a stock is by the dividend yield ratio. As the name suggests, the dividend yield ratio measures the annual value of dividends received relative to the stock price.
This is useful for income investors to determine whether a stock is undervalued or overvalued by comparing the dividend yield to its share price over a period of time. Assuming there is no change in the fundamentals of a company or the dividend payout, a higher dividend yield indicates the stock is undervalued due to the decline in price. Similarly, the reverse is true, where a lower yield is indicative of the stock being overvalued as the price has appreciated, causing the yield to fall.
Formula:
Where:
- Dividend per share = (Total annual dividend payment) ÷ (Total number of outstanding shares)
Income investors can use this ratio among others, for REITS and regular dividend-paying stocks like banks to determine the value of a stock. The downside to this ratio is that the stock needs to be paying regular dividends in order to track its performance over time.
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#4 Debt-to-Equity Ratio
As we are investing our hard-earned money, it’s important to understand the financial risk of a company before investing in it. Naturally, the more debt a company has, the higher its risk of default or bankruptcy under unforeseen circumstances.
Using the debt-to-equity (D/E) ratio, we can calculate the level of debt the company has taken relative to the value of its shareholders’ equity net of liabilities. The higher the D/E ratio suggests, the more risk the company is taking by using leverage to finance its operations rather than its equity. Similarly, a low D/E ratio suggests the company is financing its operations with its own equity rather than using financial leverage or debt. As investors, we may prefer companies with a lower D/E ratio than their industry average to lower our investment risk.
Formula:
Where:
- Assets = Liabilities + Shareholder Equity
To effectively use the D/E ratio to gauge the risk of the company, we must compare the D/E ratio of the company with its industry average. Given that the D/E ratio depends on the nature of the business and its industry, the ratio may vary widely from one industry to another.
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Using these or other financial ratios can help eliminate blind entry into any stock based simply on our emotions. Instead, by knowing the valuation of a stock, we would have a more objective price point to determine whether the stock that we wish to invest in is currently undervalued, fair valued, or overvalued. This would give us an edge in our investing, as we can select the best opportunities to go long or short on a stock using a CFD platform like City Index.
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