2017-12-18Valuation Metrics PE Ratio Market Book Explain Balance Sheeet
 
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Valuation and Valuation Metrics
Definitions, Meaning Explained, Example Calculations

 

Valuation metrics help company owners and potential investors evaluate the company's prospects for future earnings, dividend payments, and share price growth.

The best known valuation metric—Earnings Per Share—is also a measure of the firm's profitability.

What are Valuation Metrics?

Valuation metrics are comprehensive measures of a company's performance, financial health and prospects for future earnings. All reflect the collective opinions of market analysts and investors about the future prospects for the company. Not surprisingly, these metrics are of keen interest to shareholders and investors.

Valuation Metrics: One Family of Financial Statement Metrics

Valuation Metrics belong to the larger family of financial statement metrics. These use data from a company's Income statement, Balance sheet, and other financial accounting sources, to measure the strength of the company's financial performance and financial position. Note especially that the general approach with valuation metrics is to compare the market's opinion (measured in market price of the company's shares) to actual reported earnings or to book value of the company.

This article defines, explains, and calculates four of the most frequently used valuation metrics:

  • Earnings per share
  • Price to earnings ratio P/E
  • Book value per share
  • Market to book ratio
 

Contents

Related Topics

  • For an overview of cash flow and financial statement financial metrics: Financial Metrics.
  • For an introduction to investor leverage and financial metrics with a leverage focus, see Leverage Metrics.
  • The article Profitability Metrics describes and explains measures of profitability.

Metrics Resources

  • For in-depth coverage of financial metrics, including a working set of related financial statements and financial metrics, see the Excel-based ebook Financial Metrics Pro.
 

Financial Statement Metrics Role (Business Ratios)

Valuation metrics belong to one of six financial metrics families that analysts call financial statement metrics. Financial statement metrics use date from company financial statements to measure …

  • Company financial performance across a time period.
  • The firm's financial position at one point in time.

These metrics derive primarily from figures from the four primary financial accounting statements in Exhibit 1: 

 

Exhibit 1. Valuation metrics and other financial statement metrics (ratios) use figures from the Balance sheet, Income Statement, Retained Earnings statement, and Statement of Changes in Financial Position.

Note that some businesspeople refer to all statement metrics as business ratios. This is because almost all of these metrics do in fact calculate as ratios, made of two or more financial statement figures. The four valuation metrics appearing below are result from ratio calculations. However, Note especially, however, a few financial statement metrics in other families are not ratios. The Working capital activity metric, for instance, is the difference between two Balance sheet figures, not a ratio.

What is the Purpose of Financial Statement Metrics? Who Uses These Metrics?

Financial statement metrics are generally useful to … 

  • Investors considering buying or selling stock or bonds in a company.
  • Shareholders and boards of directors, for evaluating management performance.
  • Company officers and senior managers, for identifying strengths, weaknesses, and target levels for business objectives.

Six Families of Financial Statement Metrics (Business Ratios)

Each of the six financial statement metrics families addresses a different kind of question about the company. The six families and the general question each addresses are as follows.

Sections below define, explain, and calculate metrics in the Valuation family. Links above for other metrics families lead to similar coverage on other pages for Activity, Liquidity, Profitability, Leverage, and growth metrics.

Four Popular Valuation Metrics

Sections below define, explain, and illustrate four frequently used valuation metrics: (1) Earnings per share (EPS), (2) Price to earnings ratio (P/E ratio), (3) Book value per share, and (4) Market to book ratio.

Valuation Metric 1
Earnings Per Share

As its name suggests, Earnings per share (EPS) simply shows company earnings per outstanding share of common stock. As a result, EPS serves as both a valuation metric and as a profitability metric. Some firms in fact highlight the profitability role by presenting an EPS figure at the bottom of the Income statement.

EPS Considers Common Shares Only

Earnings per share always refers to outstanding shares of common stock. Preferred shares are excluded from the EPS calculation for the same reason that preferred shareholder equity is sometimes excluded from the another profitability metric, Return on equity (ROE). This is because: 

  • Owners of preferred shares have precedence over owners of common shares, both in the payment of dividends and in payouts in the event of liquidation.
  • As a result, preferred ownership represents funds that are not and would not be available to common stock owners.

To exclude preferred share impact on the EPS, the earnings figure in the EPS calculation is net profits less preferred share dividends.

Calculating EPS from Financial Statement Data

Data for calculating EPS come from several sources:

  • Firstly, from the sample Income statement in Exhibit 2, below.

         Net profit on sales: $2,126,000
  • Secondly, from the sample Statement of retained earnings in Exhibit 4, below:

         Preferred share dividends: $33,000
  • Thirdly, from information usually in the company's Annual report.

         Average common shares outstanding for the year:  800,050 shares

Earnings per share
             = (Net profit – Preferred share dividends) / Average common shares outstanding
             = ($2,126,000 – $33,000) / 800,050
             = $2.62 / share

Using the EPS Metric

The EPS example above shows a typical EPS calculation for end-of-year reporting purposes. Note especially that input data include annual earnings and yearly average shares outstanding. As a result, the EPS figure for the Annual Report represents the full reporting year just ended. Company EPS, however, can change from quarter to quarter. Changes are possible and likely, of course, because both earnings and shares outstanding can change from quarter to quarter.

In some cases, investors deciding whether or not to buy shares, will want to know the most recent quarter's EPS as well as the annual figure. The quarterly EPS figures can be important when:

  • The company is growing rapidly.
  • The company is restoring profitability after several unprofitable periods. In other words, when the company is having a successful turnaround.
  • The company is in decline. It is losing sales, market share, and profits.

Valuation Metric 2
Price to Earnings Ratio (P/E Ratio)

Investors buy stock in a company expecting dividends and/or appreciation in share price. The extent to which they expect growth in these areas impacts the price they are willing to pay for the stock. Investor confidence in future growth is measured in the price to earnings ratio (or P/E ratio).

The P/E ratio is defined as: Common stock market price, divided by earnings per common share. Note that P/E ratios can change continuously because stock prices change continuously.

Calculating the P/E Ratio

The P/E ratio definition above describes its calculation:

Price / earnings ratio =
     Common stock market price / Earnings per common share (EPS)

Note that this P/E example uses the EPS figure results in the section immediately above (Valuation Metric 20. And, the common stock share price is the current market price.

     Earnings per share of common stock EPS:  $2.62
     Share price, common stock:  $50.00

P/E ratio = Common stock market price / Earnings per common share (EPS)
     = $50.00  /  2.62
      = 19.08

Using the P/E Ratio Metric

Companies publish price to earnings values at the end of each reporting period. For some purposes, analysts consider these figures to be constant until the end of the next reporting period.

However, because stock prices vary continuously, industry analysts and individual investors may calculate the P/E ratio differently.

  • The analyst comparing stock P/E ratios for different companies will probably use an average stock price for the reporting period.
  •  An individual investor, however, deciding whether or not to buy shares, will want to know the up to the minute P/E ratio, using the current stock price.

P/E Rule of Thumb    

Analysts compare P/E ratios for individual companies to industry standards or to the P/E ratios of competing companies.  A higher P/E ratio means it will take longer for the company to recover investment cost for owners (it will take longer if the P/E ratio remains at its present level, that is). A higher P/E ratio, therefore, indicates investor confidence in the future growth of earnings. 

Valuation Metric 3
Book Value Per Share

In principle, book value per share is the value that would be distributed to owners (stockholders) if the company is liquidated and the equity turned into cash at its book value (Balance sheet value). Note, this assumes that dividend payments are up to date and the company does not have massive outstanding debt.

Note especially that the book value per share can bear little or no relation to the stock's market price.

The book value per share contributes to a more commonly used valuation metric, however, the market to book ratio (Valuation metric 4 in section below).   

Preferred and Common Book Value Per Share         

A company's preferred shares and common shares each have their own book value per share:

Book value per share, preferred stock 
     = Equity allocated to preferred stock / Preferred shares outstanding

Book value per share, common stock
     = (Owner's equity − Equity allocated to preferred stock)
                / Common shares outstanding 

To further complicate the analysis, note that equity allocated to preferred stocks has two components: a liquidation value preference per share, and a cumulative dividend.

Calculating Book Value Per Share

Input Data for Book Value Per Share

Data for calculating book value per share come from several sources.

  • Firstly, from the example Balance sheet in Exhibit 3, below:
         Total stockholder's equity: $13,137,000 (from Balance sheet):
  • Secondly, from company's annual or quarterly report:
         Common shares outstanding:  800,050
         Preferred shares outstanding : 29,000
  • Thirdly, specified by the company issuing preferred shares:
         Liquidation value preference per preferred share: $34.0
              Note that the liquidation preference may be set equal
              to the preferred share purchase price or, sometimes,
              a multiple of that price.

         Par value per share, preferred stock: $131.00
         Cumulative dividend allocated to preferred shares (as percentage of par): 10.0%      

Intermediate Calculations for Book Value Per Share

Before calculating book value per share, itself, three intermediate calculations are necessary.

  • Firstly, Liquidation value allocated to preferred shares
         = Liquidation value preference per preferred share * preferred shares outstanding
         = $34.00 * 29,000
         =  $986,000      
  • Secondly, Cumulative dividend allocated to preferred shares         
        = Par value per share preferred stock 
                 * Preferred share cumulative dividend percentage
                      * Number of Preferred shares outstanding   
        = $131.00 * 10.0% * 29,000
        = $379,900
  • Thirdly, Total equity allocated to preferred stock
         = Liquidation value allocated to preferred shares 
                + Cumulative dividend allocated to preferred shares
     = $986,000 + $379,900
     = $1,365,900

Calculating Book Value per Share

Using the above input data and intermediate results, the two book value per share figures calculate as follows:

Book value per share, preferred stock 
     = Equity allocated to preferred stock / Preferred shares outstanding
     = $1,365,900 / 29,000
     = $164.57 

Book value per share, common stock
     = (Owner's equity − Equity allocated to preferred stock) / Common shares outstanding
     = ( $13,137,000  −  $1,365,900 ) / 800,050
     = $11,770,300 / 800,050
     = $14.71

Book Value Per Share Rule of Thumb

Astock's book value per share is typically below the current market price per share. The book value per share is sometimes considered the minimum, or "price floor" for the stock. 

The next valuation metric below, Market to book ratio, examines the relationship between market value and book value per share

Valuation Metric 4
Market To Book Ratio

The market-to-book ratio compares the market's valuation of the company's stock to the book value per share (the subject of the previous section, Valuation metric 3). Analysts and Investors view the Market to book ratio as a measure of investor confidence in the stock's future price.

Calculating Market to Book Ratio

The market to book example for a company's common stock shares calculates from data and results from the previous section above:

     Common stock market price per share:  $50.00
     Book value per common share:  $14.71

Market-to-book ratio = Market value per share / Book value per share
     = $50.00 / $14.71

     Market to Book Rule of Thumb

Market to book ratios greater than 1.0 indicate the market has confidence in this stock's future. A market-to-book ratio less than one is evidence that the market has low confidence in this stock's future price.

Income Statement Example

The example Income statement in Exhibit 2, below, contributes input data for some of the valuation metrics calculations above.

Exhibit 2. This example Income statement contributes input data for some of the valuation metrics calculations above.

Balance Sheet Example

The example Balance sheet in Exhibit 3 below contributes input data for some of the valuation metrics calculations above.

Exhibit 3. Example valuation metrics calculations above draw date from this sample Blance sheet.

Statement of Retained Earnings Example

The example Statement of Retained Earnings in Exhibit 4 below contributes input data for some of the valuation metrics calculations above.

Exhibit 4. This example Statement of retained earnings contributes input data for some of the valuation metrics calculations above.

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