Valuation metrics help company owners and potential investors evaluate the company's prospects for future earnings, dividend payments, and share price growth.
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
- What are valuation metrics?
- Four popular valuation metrics.
- Income statement example.
- Balance sheet example.
- Statement of retained earnings example.
- 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.
- 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.
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.
- Valuation metrics.
Valuation metrics ask: What are the firm's prospects for future earnings?
- Activity and efficiency metrics (the subject of this article).
Activity metrics ask: Does the firm use resources efficiently?
- Liquidity metrics.
Liquidity metrics ask: Can the firm meet immediate spending needs?
- Profitability metrics.
Profitability metrics ask: is the firm earning acceptable margins?
- Leverage metrics.
Leverage metrics ask: How do owners and creditors share risks and rewards?
- Growth metrics.
Growth metrics ask: Are revenues, profits, and market share growing?
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.
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
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.
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.
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.
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.
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.