Cheap, expensive, and how to tell

The last chapter measured how good our manufacturer is as a business. It said nothing about whether its shares are worth buying, because that depends entirely on the price. A wonderful business at a foolish price is a poor investment, and a mediocre one at a low enough price can be a good one. Valuation ratios are the bridge: they connect the share price to the business behind it, so you can judge cheap from expensive rather than guess.

The price-to-earnings ratio

The most quoted valuation ratio in the market is the price-to-earnings ratio, or P/E: the share price divided by the earnings per share. It tells you how many rupees you are paying for each rupee of the company's annual profit.

Our manufacturer earns an EPS of 12 rupees, from the income-statement chapter. Suppose its shares trade at 240 rupees (illustrative). Its P/E is 240 divided by 12, which is 20. You are paying twenty rupees for each rupee of yearly profit, or, put the other way, the profit is a 5% return on your purchase price, the earnings yield you met in the first chapter, which is simply one divided by the P/E. A high P/E means the market is paying up, usually because it expects strong growth; a low P/E means the market expects little, or is worried. Neither is good or bad until you ask why.

Price-to-book, for what a company owns

The price-to-book ratio, or P/B, compares the share price to the book value per share, the owners' equity divided by the number of shares. Our manufacturer's equity is 400 crore on 10 crore shares, a book value of 40 rupees a share, so at 240 its P/B is 6. You are paying six times the accounting value of the owners' stake.

P/B is most useful for businesses whose worth is largely in their assets, above all banks and other financials, where the book value is a meaningful anchor. It is far less useful for an asset-light business, a software or consumer company whose real value is a brand or its people, which the balance sheet barely captures, so such businesses routinely and rightly trade at high P/B.

EV to EBITDA, valuing the whole business

The P/E looks at the equity alone, which can mislead when companies carry very different debt. The enterprise value to EBITDA ratio fixes that by valuing the whole business. Enterprise value, or EV, is what it would cost to buy the entire company: its market value plus the debt you would take on, less the cash you would get. For our manufacturer, that is a market value of 2,400 crore (240 rupees times 10 crore shares) plus 400 of debt less 100 of cash, an EV of 2,700. Divide by the EBITDA of 250 and you get an EV/EBITDA of about 10.8.

Because EV includes debt, EV/EBITDA lets you compare two companies on the same footing even when one is debt-heavy and the other is not, which the P/E cannot do. It is a favourite for comparing companies within the same industry.

Dividend yield, the cash in hand

The dividend yield is the annual dividend per share divided by the price, the cash return the company pays you directly. Our manufacturer pays 40 crore of its 120 crore profit as dividends, a dividend per share of 4 rupees, which on a 240 price is a yield of about 1.7%. The share of profit paid out, 40 of 120, or about a third, is the payout ratio.

A high dividend yield can attract income-seeking investors, but a low or zero yield is not a fault. A young, high-return company that reinvests its profits instead of paying them out may build far more value than one that pays a fat dividend, because it can compound that money inside the business. What matters is whether the retained profit is being invested at a good return, which brings you back to ROCE.

The rule that makes ratios useful

Here is the discipline without which every ratio above is just a number. A ratio means almost nothing on its own. A P/E of 20 is not "expensive" or "cheap" in the abstract. It is only meaningful compared with two things: the company's own history, and its direct peers. A P/E of 20 may be cheap for a business that has usually traded at 30 and is growing fast, and dangerously expensive for one that has always traded at 10 and is shrinking. Different industries live at different natural multiples, a stable consumer company far higher than a cyclical commodity producer, so comparing across unlike businesses is meaningless. Always ask: high or low compared with what.

What to carry forward

Valuation ratios connect the price you pay to the business you are buying, so you can judge cheap from dear. The P/E prices each rupee of earnings, the P/B each rupee of book value, EV/EBITDA the whole business including its debt, and the dividend yield the cash returned to you. Every one of them is meaningful only against the company's own history and its true peers, never as a bare number, and never across unlike industries.

Ratios like the P/E rest on this year's earnings, but a business is bought for its future, and that turns on growth. The next chapter looks at growth and the per-share numbers, and at why paying up for growth is reasonable only up to a point.