How to Compare Stocks Using Valuation Ratios

Summary

The script discusses using financial ratios to evaluate investment potential, comparing hypothetical Company A and Company B. It highlights the importance of the price-to-earnings (P/E) ratio, with Company A's lower P/E suggesting better value. The price-to-sales ratio reveals Company A's efficiency in converting sales to profits. The price-to-book ratio also favors Company A, indicating investors pay less for equity. Lastly, Company B's higher book value growth hints at a growth-oriented phase, justifying its higher valuation. The video encourages investors to delve into financial ratios for informed investment decisions.

Takeaways

• 🔍 Financial ratios are essential tools for investors to compare companies of varying sizes and characteristics.
• 💹 A lower price-to-earnings (P/E) ratio, like Company A's P/E of 10, is generally preferred by value investors as it indicates a cheaper stock.
• 📊 Despite having the same price-to-sales ratio of 2, Company A is more attractive due to its potential higher efficiency in converting sales into earnings.
• 📈 The price-to-book ratio, which compares a firm's market value to its book value, suggests that Company A is a better value with a ratio of 2.5 compared to Company B's 3.
• 📚 The book value growth rate can indicate a company's expansion; Company B's higher rate suggests a more growth-oriented approach.
• 🤔 The discrepancy in profit margins between the two companies might warrant further investigation into their operational efficiencies.
• 💼 Value investors typically seek companies with lower valuation multiples, which makes Company A more appealing based on its financial ratios.
• 🌱 The higher valuation multiples of Company B could be attributed to its growth phase, a common trait of growth stocks.
• 📉 Company A's financial ratios collectively make it a more attractive option for value investors looking for undervalued stocks.
• 🔎 Analyzing financial ratios can reveal insights into a company's financial health and investment potential.

Q & A

What is the primary purpose of financial ratios in investment analysis?

Financial ratios help investors compare companies of different sizes and characteristics to determine which might be a better value investment.

What does a P/E ratio of 10 for Company A indicate?

A P/E ratio of 10 for Company A indicates that investors are paying $10 for every $1 of the company's annual earnings, suggesting it might be a more attractive investment for value investors.

Why might a value investor prefer a lower P/E ratio?

A value investor typically prefers a lower P/E ratio because it implies they are paying less for each dollar of earnings, which can indicate better value.

What does the price-to-sales ratio of 2 for both Company A and Company B signify?

A price-to-sales ratio of 2 for both companies means an investor is paying $2 for every dollar of revenue the company receives through sales.

How does comparing the price-to-sales ratio with the P/E ratio provide insight into a company's efficiency?

Comparing the price-to-sales ratio with the P/E ratio can reveal a company's efficiency in converting sales into earnings, with Company A being more efficient in this case.

What does the price-to-book ratio indicate about the value of a company's equity?

The price-to-book ratio indicates how much an investor is paying for the equity in a business, with a lower ratio suggesting they are paying less for the equity.

Why might Company A be considered a better value based on the price-to-book ratio?

Company A might be considered a better value because its price-to-book ratio is 2.5 times, compared to 3 times for Company B, suggesting investors are paying less for its equity.

What does book value growth rate signify for an investor?

Book value growth rate gives an investor an idea of how quickly a company is building its assets, with a higher rate often associated with a growth-oriented business.

Why might Company B's higher book value growth rate be associated with less attractive valuation multiples?

Company B's higher book value growth rate might be associated with less attractive valuation multiples because it could be in a more growth-oriented phase, which is typical for growth stocks that often trade at higher multiples.

What additional research might an investor conduct after comparing the financial ratios of Company A and Company B?

An investor might conduct further research to understand the differences in profit margins and the reasons behind the efficiency in converting sales into earnings between Company A and Company B.

How can comparing financial ratios help in identifying investment candidates?

Comparing financial ratios can help identify investment candidates by revealing a company's financial health, efficiency, and growth potential, which are crucial factors for investors.

Outlines

00:00

💹 Valuation Ratios for Investment Comparison

This paragraph introduces the concept of using financial ratios to compare companies for investment purposes. It discusses the valuation ratios of two hypothetical companies, Company A and Company B, within the same industry. The focus is on the price-to-earnings (P/E) ratio, where Company A has a P/E of 10 and Company B has a P/E of 15, suggesting that Company A might be a better value investment for value investors. The paragraph also touches on the price-to-sales ratio, showing both companies have a ratio of 2, but implies that Company A might be more efficient in converting sales into profits.

Keywords

💡Financial Ratios

Financial ratios are quantitative measures used by investors and analysts to evaluate a company's financial performance and position. They are derived from the company's financial statements and are used to assess various aspects such as profitability, liquidity, and solvency. In the video script, financial ratios are the central tool for comparing two hypothetical companies, Company A and Company B, to determine which might be a better value investment.

💡Price-to-Earnings (P/E) Ratio

The price-to-earnings (P/E) ratio is a valuation ratio of a company's current share price compared to its per-share earnings. It is used to determine if a company's stock is overvalued or undervalued. In the script, Company A has a P/E ratio of 10, suggesting that investors are paying $10 for every $1 of earnings, making it potentially more attractive to value investors compared to Company B's P/E ratio of 15.

💡Price-to-Sales Ratio

The price-to-sales ratio is a valuation ratio that compares a company's stock price to its revenue per share. It is used to evaluate how much investors are willing to pay for each dollar of a company's sales. In the transcript, both Company A and Company B have a price-to-sales ratio of 2, but the comparison with the P/E ratios suggests that Company A might be more efficient at converting sales into profits.

💡Profit Margins

Profit margins measure how much out of each dollar of sales a company retains as net income. They are a key indicator of a company's profitability and efficiency. The script implies that Company A has higher profit margins than Company B, as it can 'squeeze more profit from those dollars,' indicating better operational efficiency.

💡Price-to-Book Ratio

The price-to-book ratio is a valuation ratio calculated as a company's current market price per share divided by the book value per share. It indicates the premium that investors are willing to pay over the book value of the company. The script mentions that Company A has a price-to-book ratio of 2.5 times, which is lower than Company B's 3 times, suggesting that Company A might be a better value for investors.

💡Book Value

Book value refers to the net value of a company's assets as recorded on its balance sheet, calculated as total assets minus total liabilities. It represents the theoretical amount that would be returned to shareholders if the company were to be liquidated. In the video, the book value is used to calculate the price-to-book ratio, with Company A having a lower multiple, indicating a potentially better value.

💡Book Value Growth

Book value growth is the rate at which a company's book value increases over time. It is an indicator of a company's ability to grow its assets and is often associated with growth-oriented companies. The script notes that Company B has a higher book value growth rate than Company A, suggesting that it is in a more growth-oriented phase and may justify its higher valuation multiples.

💡Value Investor

A value investor is an investor who looks for undervalued companies with strong fundamentals and potential for growth at a price that is lower than the company's intrinsic value. In the context of the video, value investors are shown to prefer lower P/E, price-to-sales, and price-to-book ratios, as seen with their preference for Company A over Company B.

💡Growth Stock

A growth stock is the stock of a company that is expected to grow at an above-average rate compared to the market. These stocks often come with higher valuation multiples due to their potential for rapid growth. The script suggests that Company B might be a growth stock due to its higher valuation multiples and higher book value growth rate.

💡Top-line Revenue

Top-line revenue, or total revenue, refers to the gross income generated by a company's main operations and is the starting point for financial reporting. It is often contrasted with bottom-line earnings, which account for all expenses. The script uses the terms 'top-line' and 'bottom-line' to highlight the difference in efficiency between Company A and Company B in converting sales into profits.

💡Bottom-line Earnings

Bottom-line earnings, or net income, is the company's profit after accounting for all expenses, including cost of goods sold, operating expenses, taxes, and interest. It represents the final income of a company after all costs have been deducted. The video script discusses how Company A is more efficient at generating bottom-line earnings from its top-line revenue compared to Company B.

Highlights

Financial ratios are essential for comparing companies of different sizes and characteristics.

Company A and Company B are in the same industry selling similar products.

Company A has a P/E ratio of 10, suggesting investors pay $10 for every $1 of earnings.

Company B has a P/E ratio of 15, indicating it is more expensive than Company A.

Value investors typically prefer a lower P/E ratio, making Company A more attractive.

Both companies have a price-to-sales ratio of 2, meaning investors pay $2 for every $1 of revenue.

Company A's price-to-sales ratio is preferred due to its higher efficiency in converting sales to profits.

Company A's lower multiple for earnings suggests better profit generation from sales.

Company A's price-to-book ratio of 2.5 times is lower than Company B's 3 times, indicating better value.

Lower price-to-book ratio is preferred as it means paying less for equity in the business.

Company B's higher book value growth rate suggests a more growth-oriented business phase.

Company B's less attractive valuation multiples are typical for growth stocks.

Company A exhibits more characteristics that attract value investors.

Comparing financial ratios provides insights into a company's financial health and investment potential.

Understanding financial ratios is a valuable skill for investors searching for investment opportunities.

Transcripts

Financial ratios can help investors compare two companies of different sizes and characteristics.

Let’s practice by looking at the valuation ratios of two hypothetical companies and determine

which might be a better value investment.

In this example, we have two companies: Company A and Company B. Let’s assume they’re

in the same industry and selling the same types of products.

We’ll compare the companies’ valuation ratios and other characteristics side-by-side,

starting with the most common: price-to-earnings, or P/E, ratio.

Company A has a P/E of 10, which means investors are essentially paying $10 for every $1 of

the company’s annual earnings.

Company B has a P/E of 15, which is more expensive.

All else equal, a value investor typically prefers a lower P/E ratio, so Company A appears

to be more attractive.

Let’s look at the next metric, the price-to-sales ratio.

Both Company A and Company B have a price-to-sales of 2, which means an investor is paying a

multiple of $2 for every dollar of revenue the company receives through sales.

On the surface, they’re equal, right?

But there’s something else we can glean here by comparing the price-to-sales ratios

with the P/E ratios.

Company A’s investors are paying the same multiple as Company B’s for sales but a

lower multiple for earnings or profit.

Somewhere along the way of collecting “top-line” revenue and generating “bottom-line” earnings,

Company A is doing something differently than Company B.

This is an indirect way of identifying that Company B might not be quite as efficient

at capturing profits from its sales.

To say it another way, every dollar of Company A’s sales are currently more valuable because

it’s shown it can squeeze more profit from those dollars.

So even though they appear to be the same, an investor might prefer Company A’s price-to-sales

to Company B’s.

Additionally, it might prompt an investor to do further research to understand why the

profit margins are so different.

Let’s move on to the price-to-book ratio.

Recall that the book value of a company is the shareholders’ equity or basically the

assets minus the liabilities.

Company A’s share price is a multiple of 2.5 times, while Company B is 3 times.

Value investors typically prefer a lower price-to-book ratio because it indicates they’re paying

less for equity in the business, so Company A appears to be a better value.

Finally, let’s look at book value growth, which can give an investor an idea of how

quickly a company is building its assets.

Notice how the book value growth rate for Company B is higher than Company A.

One possible explanation is that Company B has been in a more growth-oriented phase as

a business.

It also provides an explanation for why its valuation multiples are less attractive, which

is a common characteristic of a growth stock.

Company A, however, has more features that could attract a value investor.

As you can see, you can learn a lot about companies just by comparing a few of their

financial ratios.

This can be a valuable skill to learn as you begin searching for your own investment candidates.