New investors are often bewildered and confused by the financial jargon of business valuation. Confusing, strangely named ratios can simply be Greek to a newcomer to the market. Here are three of the most basic business valuation metrics used by investors that you should know.
Market capitalization is the value of a publicly traded company based on current market prices. It is calculated by multiplying all outstanding shares by the share price. For example, you start up a company called XYZ, and you divide your company into 100 publicly traded shares. One share of XYZ costs $5 per share.
Therefore, your market capitalization would be $500.
- There are four categories for market capitalization:
- Large Cap companies have a market cap of over $10 billion.
- Mid Cap companies have one between $2 to $10 billion.
- Small Cap companies have one between $300 million to $2 billion.
- Micro Cap companies have one under $300 million.
Market capitalization can be deceiving and must be measured in correlation to other important business metrics. Just because a company’s market cap is soaring doesn’t necessarily mean that it is justified – it just means that the stock price is increasing at a rapid pace, thus increasing the company’s weight.
Let’s say your company, XYZ, has $500 in available cash. Remember that you issued 100 shares at $5 each.
In this situation, the price-to-book ratio is now 1. That means that for each outstanding share, there is $5 in cash to back it up. It is calculated by dividing the share price by the cash (book) value per share.
Let’s say your company’s shares increase in value to $10, but you still only have $500 in cash. Dividing $10 by $5 would now give the company a price-to-book ratio of 2.
Legendary investors such as Benjamin Graham and Warren Buffett have been followers of the book value principle. Graham famously taught that if a company is fundamentally sound and its price-to-book ratio falls below 1.0, then it is a good value investment, since logically, barring other capital losses, a company’s stock price should be worth at least its book value, if not higher.
Price-to-Earnings, or P/E ratio, is the most frequently used valuation technique for businesses. It is calculated by dividing the share price by its annual earnings (profit) per share.
Let’s pretend your XYZ company, which now trades at $10, survived for a year, and at the end of the year you earned profits (revenue – expenses) of $50. Remember that you still have 100 total outstanding shares, currently worth $10 each. Divide $50 by 100 and you have an EPS (earnings per share) of $0.50.
Now let’s divide the share price of $10 by $0.50 = 20. 20 is now your current P/E ratio, which from now on will be referred to as a trailing P/E ratio. Now your company will provide the public with a forecast, or guidance, of what your next 12 months are going to look like.
You declare with certainty that your company will earn $100 next year and double your profits from this year. Divide that $100 by 100 and now you have an estimated EPS of $1. Dividing the share price of $10 by $1 now gives you a new P/E ratio – 10.
This is now regarded as your forward P/E, or a forecast of how your stock will perform, based on your current promises. Now, investors get really excited about the prospects of your business, so they bid your shares up to $20 per share.
Your trailing P/E has now increased to 40, while your forward P/E has now risen to 20 – a fairly top-heavy situation.
This is the reason stock prices increase and are ultimately throttled by P/E multiples.
Value investors will seek out stocks with low P/Es – usually under 20, but it can be higher in a high-growth industry such as tech – and declare that they are “cheap”.
These stocks will tend to move slowly or not at all, but with limited downside risk.
Meanwhile, growth investors will search for stocks with high P/Es – some higher than 50, depending on the sector – in an effort to find stocks with the most momentum and driven by the most hype. These stocks can move very fast – see any Chinese Internet stock – but can also crash the fastest, due to the lack of fundamental scaffolding.
Other Valuation Metrics
These three are but the tip of a very big iceberg, but understanding these three valuation metrics will make it far easier to understand other important metrics, such as P/S (price-to-sales) and RoE (return-on-equity), and make it far easier to gauge the value and profitability of a business.