 7 Valuation Metrics to Use as a Value Investor - No BS Investing
Posted July 15, 2022, 10:00 - in Investing

# 7 Valuation Metrics to Use as a Value Investor

Calculating valuation metrics is a big part of researching and buying stocks that are undervalued in the market. These metrics help you analyze company fundamentals to determine if the company is a strong one and if its stock is overvalued or undervalued.

Here are seven popular valuation metrics used by value investors that you can calculate before you invest in a specific company.

Key Takeaways:

• Working Capital Ratio = Current Assets / Current Liabilities
• Quick Ratio = Cash + Cash Equivalents + Current Equivalents + Short-Term Investments / Current Liabilities
• Earnings per Share = Net Profit / Total Number of Shares
• Price to Earnings Ratio = Current Stock Price / Earnings per Share
• Debt-to-Equity Ratio = Total Liabilities / Total Shareholders’ Equity
• Return on Equity = Net Income / Shareholder’s Equity
• Price-to-Book = Market Capitalization / Book Value of Equity

## 1. Working capital ratio

Also known as the current ratio, the working capital ratio shows you the company’s ability to pay for current liabilities (e.g., rent payments) with its current assets (e.g., cash and cash equivalents). Here’s the formula:

Working Capital Ratio = Current Assets / Current Liabilities

Find current assets and liabilities on the company’s balance sheet (use a free tool like last10k.com to access these statements). A good working capital ratio is typically between 1.5 and 2. Lower than 1.0 could mean liquidity problems in the future (aka not being able to quickly generate enough cash to pay off debt if needed).

Say that XYZ Company has \$900,000 of current assets and \$1,000,000 of current liabilities. Its working capital ratio is 0.90. Now say that XYZ Company has \$900,000 of current assets and \$800,000 of current liabilities. Its working capital ratio is exactly 1.1.

Compare a company’s working capital ratio with other companies in the same industry. For example, Target has a working capital ratio of .99 (a bit low but you also have to look at other metrics). This number is on track with other general merchandise retailers including Walmart (.95 working capital ratio) and Costco (1.03 working capital ratio).

## 2. Quick ratio

Similar to the working capital ratio, the quick ratio measures how well a company’s current assets could cover its current liabilities.

But instead of looking at all assets like the working capital ratio, this ratio only looks at assets that can be converted to cash within 90 days or less. Here’s the formula:

Quick Ratio = Cash + Cash Equivalents + Current Equivalents + Short-Term Investments / Current Liabilities

A quick ratio of more than 1.0 is considered less risky than a company with a quick ratio of less than 1.0.

You can find quick cash information on your selected company’s balance sheet, and the current liabilities. Say that XYZ Company has quick assets of \$20,000 (in millions) and current liabilities of \$30,000 (in millions). The quick ratio would be .67, which suggests the company might have trouble paying off debts using only quick assets.

However, if XYZ Company has quick assets of \$20,000 (in millions) and current liabilities of \$21,000 (in millions), the company has a quick ratio of .95. This means it’s in a better position to cover current liabilities with its liquid assets.

## 3. Earnings per share (EPS)

Earnings per share (EPS) is a calculation that shows how profitable a company is on a per-share basis.

EPS = Net Profit / Total Number of Shares

A company is more likely to be profitable if it has a higher EPS. Compare the company’s EPS with the industry’s EPS (aka the peers) to determine if it’s good. Say that XYZ Company’s net income from 2021 is \$10M dollars. They had 2M shares outstanding.

EPS = (\$10 million / 2 million) = \$5. If XYZ Company produces medical devices, pharmaceuticals, and consumer packaged goods, its EPS is comparable with similar companies like Johnson & Johnson which had an annual EPS of \$5.63 in 2019.

Hint: Simplify this process. Instead of calculating these valuation metrics manually, use a tool like Investing Pro Plus to automatically view key financial ratios.

## 4. Price-to-earnings ratio (P/E)

This ratio shows if a stock is cheap (low P/E), fairly priced, or expensive (high P/E):

P/E Ratio = Current Stock Price / Earnings per Share

Here’s what it means: if a company has a P/E ratio of 10, investors are willing to pay \$10 for every dollar it earns in profit.

Compare your company’s P/E ratio to the market average P/E ratio which currently ranges from 20-25. A P/E ratio higher than that could be considered bad. A lower PE ratio could be considered safer. You normally look for a low P/E, but you need to take other ratios into consideration rather than using this ratio as your main investment factor.

## 5. Debt-to-equity ratio

Debt-to-equity shows how much debt the company uses to run the business. Running off too much debt or borrowed money means that the company could go under if hard times hit.

Debt-to-Equity Ratio = Total Liabilities / Total Shareholders’ Equity

A good debt-to-equity ratio depends on the industry, but between 1.0-1.5 is preferable. Over 2.0 shows that the company gets two-thirds of its capital financing from debt which can be considered risky.

As an example of this ratio, say that XYZ Company’s total liabilities are \$5,000 and its shareholders’ equity is \$3,500. The debt-to-equity ratio is 1.4.

## 6. Return on equity (ROE)

The return on equity (ROE) measures the profitability of a company. It shows how effectively a company uses its equity (aka the value of the shares issued by a company).

ROE = Net Income / Shareholder’s Equity

Although a healthy ROE depends on the company’s industry, an ROE above 15% is considered good. However, a healthy ROE can vary depending on the business’s industry.

Let’s say that XYZ Company has a net income of \$2,000,000 and \$10,000,000 in shareholders’ equity. \$1M / \$10M = .20. The company has a solid ROE of 20%.

## 7. Price-to-book ratio

Price-to-book ratio tells you if a stock’s price is over or undervalued. You compare the company’s net value to its market value:

Price-to-book = Market capitalization / Book value of equity

Market capitalization or market cap is the total value of all a company’s shares of stock. To get this number, multiply the price of a stock by its total number of outstanding shares. Book value of equity is how much cash a company would have after its assets were sold and liabilities were paid off with the money.

A good P/B value is considered to be any value under 1.0, but a stock with a P/B value under 3.0 is still considered good by some value investors.

Let’s look at this ratio in practice. Say that XYZ Company’s latest closing share price is \$25.00. Its outstanding shares equals \$100M. Market cap = \$250M.

Now say that the company has \$200 million in assets and \$100 million in liabilities. \$500M-\$400M = \$100M. \$100M is the company’s book value. \$250M / \$100M = 2.5. The company has a P/B value of 2.5x. This means that the market price is valued at over twice its book value.

A low P/B ratio should be accompanied by a high return on equity (ROE) to determine if the company is undervalued.

## Calculate these valuation metrics

Manually calculating valuation metrics can be very time-consuming. You can use a fundamental analysis tool to simplify the process. We recommend Investing Pro Plus. This tool helps you easily evaluate stock fundamentals. Sign up for a free trial for Investing Pro Plus here