Business valuation metrics reveal the market's consensus view on the company's financial health and prospects for future earnings.
What are Valuation Metrics?
Valuation metrics are comprehensive measures of a company's performance, financial health and prospects for future earnings. EPS, the P/E ratio, and other metrics generally compare the market's opinion (share price) to actual reported earnings or to company book value. In this way, valuation metrics reflect the collective opinions of market analysts and investors about the company's future prospects.
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. This article defines, explains, and calculates four of the most frequently used valuation metrics:
The Role of Financial Statement Metrics (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 in the four primary financial accounting statements in Exhibit 1:
Some businesspeople refer to financial 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 for …
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 (the subject of this article).
Valuation metricsask: What are the firm's prospects for future earnings?
Activity and efficiency metrics. Activity metrics ask: Does the firm use resources efficiently?
Leverage metrics. Leverage metrics ask: How do owners and creditors share risks and rewards?
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:
Earnings per share (EPS)
Price to earnings ratio (P/E ratio)
Book value per share
Market to book ratio.
Find input data for Valuation Metrics in three financial reports:
Valuation Metric 1
Earnings Per Share EPS
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)
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
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
Thirdly, Total equity allocated to preferred stock = Liquidation value allocated to preferred shares
+ Cumulative dividend allocated to preferred shares
= $986,000 + $379,900
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
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. Detailed example Income statement providing input data for Valuation metrics examples. The Income statement show how Revenue and Expense account items represent the Income statement equation:
Income = Revenues – Expenses.
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.
Grande Corporation Figures in $1,000's Retained Earnings Statement for the year ending 31 Dec 20YY
Retained Earnings 1 Jan 20YY
Add net income for FY 20YY
"Less" div dec & paid FY 20YY
Dividends pd on pref stock
Dividends pd on com stock
Total dividends deducted
Retained Earnings balance 31 Dec 20YY
Exhibit 1. Example Retained Earnings statement with data for the Earnings per share (EPS) metric..