In the past post we covered the DuPont analysis of ROE. In this post we move on to covering the different types of equity valuation ratios ,that are ratios used in equity analysis.
Equity Valuation ratios used in Equity analysis
The most commonly used equity valuation ratio in equity analysis by investors and analysts alike is the P/E ratio i.e. the price to earnings ratio. It is the ratio of the current market price of a share of the company’s stock divided by the company’s earnings per share.
P/E ratio or the price to earnings ratio is calculated with net income. Therefore the P/E ratio is sensitive to non recurring earnings or one time earnings. (Click here to read about non recurring items on the income statement and the layout of the income statement). That is one time earnings could artificially inflate the P/E ratio than what it should actually be. As net income is considered more susceptible to manipulation, other related measures such as price to cash flow (Click here to see the post on cash flow statement), price to sales and price to book value ratios may be used.
The other equity valuation ratios are ‘per share’ equities measures such as EPS i.e. earnings per share, EBIT per share and EBITDA per share are also used.
‘Per share’ equity valuation ratios do not allow for comparison across companies or peers, as the number of shares outstanding for each company could be different therefore rendering comparison impossible. For example, if companies A and B both have $100 worth of earnings but the shares outstanding for company A is 100 and company B is 50. In that case, the earnings per share of Company A will be $1 and that of company B will be $2. The higher EPS of B does not make it a better or bigger company than A.
Dividends related equity valuation ratios
Dividends to common shareholders are paid from the net income. So neither the EPS nor net income figure is affected by the payment of common dividend. The net income that is not paid out as dividend is retained by the company as retained earnings. These retained earnings are ploughed back into the company to fund its further growth. Retained earnings play an important role in determining a firm’s sustainable growth rate.
The formula for sustainable growth rate is given as;
g = RR × ROE
where, RR = retention rate
ROE = return on equity
This formula can be understood intuitively. The sustainable growth of a company is a function of its profitability. Here ROE is used as measure of profitability instead of net income. ROE here signifies the returns (profits) earned on the equity invested in the company. That part of the returns that is not distributed to the owners is what is retained by the company to fund sustainable growth.
Retention rate, RR is calculated as;
RR = (Net income available to common shareholders – dividends declared) / Net income available to common shareholders
RR = (Net income to common / net income to common) – (dividends / net income to common)
RR – 1 – dividend payout ratio
As we can see from the formula, the retention rate is a complement of the dividend payout ratio. If the dividend payout is large, the retention will be lower and vice versa. Dividends paid per share tend to be largely fixed year after year. Therefore, the dividends payout ratio will fluctuate with the earnings of the company.
That’s all folks…this brings us to the end of Financial Analysis Techniques…from the next post we start a new topic – Inventories …..stay posted until then….
For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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