Fundamental Valuation Ratios

# Valuation

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This metric looks at the relationship between the market value of a company and a financial metric like earnings.

The aim is to show you the price you are paying for some future stream of revenue/cash flow. For example, if you pay \$100 for a company that expects to generate \$200 a year, then the company is cheap because the P/E ratio is 0.5x (the S&P 500’s P/E ~18x). On the other hand, if you pay \$100 for a company that expects to generate only \$10 a year, the company is expensive because its P/E will be 10x. P/E values can also be negative if a company is generating negative earnings or making a loss.

Essentially, valuation ratios are based on estimates of future streams of cash flows/earnings.

Since these ratios are forward looking, you will have to make an estimate about what you and the rest of the market believe this company could potentially generate. Analyst expectations about future earnings can easily be found online and play a role in the movement of an asset’s price.

The most commonly used measure is the Price - Earnings ratio (also known as P/E or PE ratio) which looks at how much an investor pays for a single dollar of earnings. This ratio is also beneficial to compare competitors within the same industry.

Another major valuation ratio is a company’s enterprise value to its earnings before interest, tax, depreciation and amortization (EV/EBITDA). A company’s enterprise value measures the total value of a company and is calculated by adding debt and subtracting cash from a company’s market value. This ratio analyzes a company's financial health and propsect for future growth. Overall, the ratio tells you how many times a company’s EBITDA covers the value of the business and a lower ratio indicates that a company is undervalued.

What is Value Investing?

Value investing is the style of buying into companies that have low valuation metrics (and possibly selling short companies that have high valuation metrics)

The style was formalised in the late 40’s by Benjamin Graham, author of the book “The Intelligent Investor” and subsequently popularised by famed investor Warren Buffet.

Value investors believe that whilst it’s hard to time the market, it’s possible to price it and they seek to buy companies that offer compelling entry points.

Valuation