A lot of investors seek stocks they believe the market has undervalued. They believe the market reacts to good and bad news, resulting in price movements giving the opportunity to turn in a profit.

Although there is no right way to analyse a stock, some investors use financial rations to help analyse a company’s fundamentals.

1.     Price to Earnings Ratio (P/E | PtE)

The price to earning ratio helps determine the market value of the stock compared to the company’s earnings. It shows what the market is willing to pay today for a stock based on its past or future earnings.

*A high P/E could mean the stock’s price is high relative to earnings and possibly overvalued.

*A low P/E might indicate that the current stock price is low compared to earnings and possibly undervalued.

The P/E ratio is important as it provides a measuring stick for comparing whether a stock is over valued or undervalued. However it is important to company a companies P/E to companies within the same industry.

Since the ratio determines how much you would have to pay for each dollar in return, a stock with a lower P/E ratio relative to the companies in it’s industry costs less per share for the same level of one with a higher P/E. This helps to determine undervalued stocks in an industry.

You must also keep in mind that the P/E ratio has limitations are based historical earnings and on analysts. Historic earnings do not guarantee future earnings and analysts’ expectations can prove to be wrong. Also the P/E does not factor in earnings growth (PEG) which we discuss in point 5.

2.     Price to Book Ratio (P/B | PtB)

The P/B ratio helps to determine whether a stock is overvalued or undervalued by comparing the net assets of a company to the price of all the outstanding shares. The P/B is a good indicator of what people are willing to pay for each dollar of a company’s assets. The P/B ratio divides a stock’s share price by it’s net assets (total assets – total liabilities).

The ratio shows the difference between the market value of a company’s stock and it’s book value. The market value is the price an investor is willing to pay for the stock based on expected future earnings.

A P/B ratio of 0.95, 1 or 1.1 means the stock is trading at nearly book value. In other words the P/B ratio is more useful the greater the number differs from 1. A company trading with a P/B ratio of 0.5 is attractive because it implies that the market value is ½ of the company’s stated book value. This would indicate the company is undervalued.

3.     Debt to Equity (DoE | DE)

The debt to equity ratio helps to determine how a company finances its assets. The ratio shows the proportion of equity to debt a company is using to finance its assets.

A low debt to equity ratio means the company uses a lower amount of debt to finance rather than it’s shareholders. Too much debt can pose a risk to a company if they don’t have the earnings or cash flow to meet its debt obligations.

The debt to equity ratio can vary from industry to industry. A high debt to equity ratio doesn’t always mean the company is run poorly. Often, debt is used to expand operations and generate additional steams of income. Some industries with a lot of fixed assets such as the auto and construction industries, typically have higher ratios than companies in other industries.

4.     Free Cash Flow (FCF)

Free cash flow is the cash produced by a company through it’s operations, minus cost of expenditures. (The cash left over after the company pays all it’s operating & capital expenses [CAPEX]).

Free cash flow shows how efficient the company is at generating cash and is an important metric in determining whether a company has sufficient cash after funding operations and expenditures.

Free cash flow can be an early indicator that earnings may increase in the future, since increasing free cash flow typically means increased earnings. Rising free cash flow could mean it may push the stock price up in the future. When a company’s share price is low and free cash flow is on the rise, the odds are good that the earnings and value of the shares could soon be heading up.

5.     Price to Earnings to Growth (PEG)

The PEG ratio is a modified version of the P/E that also takes into account the earnings growth. The P/E doesn’t always tell you whether or not the ratio is appropriate for the company’s forecasted growth rate.

The PEG ratio measures the relationship between the Price/Earnings ratio and earnings growth. And so providing a more complete picture of whether a stock’s price is over or undervalued by analysing both today’s earnings and the expected growth rate.

Typically a stock with a PEG < 1 is considered undervalued since it’s price is low compared to the company’s expected earnings growth. A PEG > 1 might be considered as overvalued since it might indicate the stock price is too high compared to the company’s expected earnings growth.

6.     Dividend Yield (Yield)

The Dividend Yield indicates how much a company pays out in dividends each year relative to its share price. It is represented as a percentages and is calculated by dividing the dollar value of dividends paid in a given year per share of stock held by the price per share.

The yield is a way to measure how much cash flow you are getting for each dollar invested. I.e. how much “Bang for your buck” you are getting from dividends.

E.g. Suppose company ABC’s stock is trading at $20 and pays annual dividends of $1 per share to it’s shareholders. Also, suppose that company XYZ’s stock is trading at $40 and also pays $1 per share. This would mean that company ABC’s yield is 5% (1/20=0.05), while XYZ’s yield is 2.5% (1/40 = 0.025). Therefore company ABC with double the yield is more attractive to invest in.

The Yield should be looked at compared to other companies in the same industry. Usually stocks with yield of at least 50% higher than the market indicate a good investment. Obviously a high yield is more attractive however you must take into account other factors as this is not always the case.

Average Yields tend to be between 2 to 5 %.

Remember, a dividend is a percentage of a businesses profits that it is paying to its owners (shareholders) in the form of cash. Any money that is paid out in a dividend is not reinvested in the business. If a business is paying shareholders too high a percentage of its profits, it may be a sign that it has little room to grow by reinvesting in its business, and the company may not have much upside. Therefore, the dividend payout ratio, which measures the percentage of profits a company pays out to shareholders, is a key metric to watch because it is a sign that a dividend payer still has flexibility to reinvest and grow its business.

Generally speaking, double-digit dividend yields (10%+) are too good to be true. They often are either being paid by unstable companies or simply represent too much of a company's earnings to be sustainable.

7.     Price to Sales (P/S | PtS)

The P/S Ratio is a valuation ratio that compares a company’s stock price to it’s revenues. It is an indicator of the value place on each dollar of a company’s sales or revenues. It can be calculated by dividing the company’s market cap by it’s total sales over the last 12 months.

The P/S Ratio is most relevant when used to compare companies in the same industry. A low ratio may indicate undervalued, while high ratio significantly above the average may suggest it is overvalued.

Consider the quarterly sales for ABC Co. shown in the table below. The sales for fiscal year 1 (FY1) are actual sales, while sales for FY2 are analysts’ average forecasts (assume that we are currently in Q1 of FY2). ABC has 100 million shares outstanding, with the shares presently trading at $10.

ABC’s P/S ratio on a trailing 12-month basis would be calculated as follows –

·       Sales for past 12 months (ttm) = $455 million (sum of all FY1 values)

·       Sales per share (ttm) = $4.55

·       P/S ratio = $10 / $4.55 = 2.20

ABC’s P/S ratio for the current fiscal year would be calculated as follows –

·       Sales for current fiscal year (FY2) = $520 million

·       Sales per share = $5.20

·       P/S ratio = $10 / $5.20 = 1.92

If ABC’s peers – which we assume are based in the same sector and are of similar size in terms of market capitalization – are trading at an average P/S ratio (ttm) of 1.5, compared with ABC’s 2.2, it suggests a premium valuation for the company. One reason for this could be the 14.2% revenue growth that ABC is expected to post in the current fiscal year ($520 million vs. $455 million), which may be better than what's expected for its peers.

This ratio is particularly useful for comparing the valuation of early-stage companies that have revenues but are not yet profitable.

None of these indicators should be viewed in isolation, since it only presents a very narrow view of a company or stock. You should use all these indicators and review the company as a whole to make an informed decision on whether the company is right for you or not.