What Does Valuation Ratio Mean?
A valuation ratio is any one of several calculations that determines whether a particular security is cheap or expensive when compared to a certain measure, such as profits or enterprise value. In other words, valuation ratio helps an investor to determine the cost of an investment with respect to the value or benefits of owning that investment.
Divestopedia Explains Valuation Ratio
Valuation ratios are commonly used because they are simple to calculate. Also, it gives a clear idea of the relationship between cost of an investment and the benefit of owning it.
There are many valuation ratios used to determine the worth of investments, with the price earnings (PE) ratio being one of the most popular for public companies. The PE ratio compares the cost of a share to the profits earned by shareholders per share. The comparison between cost and return is direct, so it gives the investor an idea of the worth of his/her investment. There are many variations to the PE ratio where the adjusted earnings, or the diluted earnings, of a company is used to calculate whether the cost and return are commensurate. It can be calculated for a single year or for a period of several years.
Another commonly used valuation ratio is EBITDA, which compares the price of the share with respect to its profits. This EBITDA is adjusted for non-cash items such as interest, tax, depreciation and amortization to arrive at the actual profits earned by the company.
The third type of valuation ratio is the price/book value. This ratio compares the share price to the assets of the company. However, this ratio is applicable only to certain sectors, such as investment trusts, because the assets are calculated based on the accrual principle rather than its real economic worth. The idea behind this price/book ratio is to give investors a sense of the cash flow that their investment is likely to generate.
Despite the popularity of valuation ratios, many experts prefer to use the discounted cash flow model for the purpose of evaluating an investment.