The 5 most important stock market ratios that every investor should know

The 5 most important stock market ratios that every investor should knowStock market ratios are the main tool of any stock investor who uses the valuation method of relativa valoración, which I already told you about on this blog recently. The objective of this article is to serve as a brief introduction to the analysis using stock market ratios to begin to get used to its use. To do this, in this article we will see what stock market ratios are, how to use them and the 5 most important stock market ratios that every investor should know with their respective formulas and examples.

What are stock market ratios?

Stock market ratios are tools used to determine the financial or business situation or the valuation of a listed company. This kind of financial ratios are often used to determine if a company is trading at a good price, although it can also be used for other purposes, such as determining a company's indebtedness, its liquidity or the average time it takes to collect from its creditors.

Precautions when using stock market ratios

It is important to bear in mind that stock market ratios are only tools, so they are not everything in the valuation of companies and should be handled with caution. Ratios can be a good indicator that we are facing a great investment opportunity, but a further in-depth analysis will always be necessary.

The followers of value investing we must be able to go beyond these indicators and delve into the underlying businesses. This implies understanding the business behind each action, its strengths, weaknesses, competitive advantages, etc. In other words, we must reconcile financial analysis with competitive analysis in order to have a solid valuation of the company and be able to obtain the most accurate intrinsic value possible.

The PER: Uniting price and benefits

The PER (“Price to Earnings Ratio” or Ratio Price Benefit) is without a doubt the most popular stock market ratio due to its simplicity and ease of use. This market ratio relates the capitalization bursátilof a company with its net profit or, what is equivalent, its earnings per share with its price per share. Therefore, your formula will be as follows:

PER = Market capitalization / Net profit = Price per share / Earnings per share

To give an example, a company that trades at a price of 40 euros per share and has a profit per share of 2 euros, its PER will be 20 times (40/2).

The historical average PER of the stock markets is around 15, so "in principle" if a share is listed with a PER well below these levels it will be cheap and if it is listed with a higher ratio it will be expensive. Of course, I say "in principle" because it will depend on each company and its future prospects, so we must use this stock market ratio with great caution.

Price / Book Value: A classic of stock market ratios

The Price / Book Value ratio (also known as PVC, “Price / Book Value” or P / BV) is the classic ratio to value stocks from a theoretical point of view. It is obtained by dividing the price of a share by its theoretical book value, or what is equivalent, dividing the market capitalization by the equity. Here is the formula:

PVC = Market capitalization / Equity = Price per share / Notional value per share

Its calculation is simple. Suppose a company is listed with a market capitalization of € 100 million, with the book value of its equity being € 50 million. So your PVC ratio will be 2 times (100/50).

Normally, the PVC ratio is quoted in a range between 1,5 and 2,5. A company with a PVC lower than 1 is usually from companies with high possibilities of bankruptcy, although it may also be that we are before cases of good investment opportunities.

P / FCF: Beyond the benefits

The P / FCF ratio (“Price to Free Cash Flow” or Price-Free Cash Flow Ratio) is the ratio that relates the market capitalization of a company with its free cash flows. While the net profit figure of a company is somewhat "artificial", since it can be made up with different accounting tricks, free cash flow is an objective value. Therefore, this ratio can be considered more objective than the PER, although it requires a more complex calculation.

Its formula is the following:

P / FCF = Market capitation / Free cash flow = Price per share / Free cash flow per share

Suppose a company has a free cash flow of € 100 million, while it is trading with a market capitalization of € 1.200 billion. Your P / FCF ratio will be 12 times (1.200 / 100).

EV / EBITDA: Beyond the price

The EV / EBITDA ratio is possibly the most complete ratio of the 5 stock market ratios that we are analyzing. This ratio relates the company value (“Enterprise value” in English) of a company with its EBITDA ("Earnings Before Interests, Taxes, Depreciation and Amortization" or "Profit Before Interest, Taxes, Depreciation and Amortization"). Its formula is simple:

EV / EBITDA = Company value / EBITDA

Suppose a listed company has an enterprise value of € 1500 billion and an EBITDA of € 300 million. Your EV / EBITDA ratio will be 5 times (1500/300).

This stock market ratio is usually the ratio most used by venture capital companies to decide whether to invest in a company or not, since it reflects the value of a company in a more complex way than the rest of the stock market ratios.

Dividend Yield: From the company to the shareholder

It is useless for a company to earn a lot of money if this money is not distributed sooner or later to its shareholders. Dividend Yield measures the percentage of a share price that goes to shareholders as a dividend each year. It is calculated as follows:

Yield per Dividend = (Dividend per share / Price per share) * 100

As an example, suppose that a company that trades at 10 euros per share pays out a dividend of 40 cents per share each year. Your dividend yield would be 4% ((0,4 / 10) * 100).

The Dividend Yield is expressed as a percentage, which usually ranges in figures between 2% and 5%, although it will depend, as with other ratios, on the type of company and its future prospects. It is common that high-growth companies do not distribute dividends among their shareholders because instead of distributing the benefits among the shareholders, what they do is reinvest them in the company to grow in the future.