The valuation ratios give the measure of relative price of a security or a business in comparison to the measure of value or profit. The worth of valuation ratio is obtained by dividing the price measure of the security by the value measure of the security or vice-versa.
The main use of calculating the valuation ratio is to compare the price of a security with the benefits provided by the asset. The same concept may be applicable for business or company in case of security.
Some of the widely used valuation ratios are:
PE ratio is defined as the price/earning ratio. PE ratio is the most popular valuation ratio and is obtained by comparing the share price with EPS (Earnings per share) of a company.
This ratio compares the price of the share with the profit that is earned by the shareholders per share. The reason behind the popularity of PE ratio is its simple equation that is given by
PE = Share Price/EPS
The EV/EBITDA is another very popular valuation ratio that is used to compare the price with profits. The EV/EBITDA is advantageous over the PE ratio because it is not affected by the capital structure of the company. But computing the EV/EBITDA ratio is a bit complex than that of PE ratio. It is calculated by dividing purchasing cost of a business free of debt by the profits.
Price/book value gives the value by comparing the price of share price with the asset value of the company. This ratio is primarily used for the investment trusts and property holding sectors. This is calculated by
Price/book value = Share Price/NAV
Where, NAV stands for net asset value .
Another important valuation ratio is Tobin’s Q. The value of Tobin’s Q is obtained by comparing the market value of the tangible assets of a company to the replacement value of the same tangible assets of the company. Mathematically, Tobin Q is given by the following formula:
Q = market value / replacement value .
The Tobin’s Q ratio is useful to indicate whether the market is undervalued or over valued.
Last Updated on : 27th June 2013