Ratios and Relative Value Analysis Technique for Valuing Firms Key Terms

Understand fundamental valuation ratio key terms when appraising the value of company shares

By John Williams, Business Writing and Research

Whether you trade stocks online, manage a personal retirement account including stock-based mutual funds, or have a company and you want to determine its market value for sale or stock offering, use relative valuation techniques to quickly approximate the value of a company based on the value of similar companies. You still have to do some homework to see how the market is performing overall, decide which ratios are most relevant to your situation and ensure apples-to-apples comparison between organizations you’re studying to make these ratios provide accurate feedback. Review these relative value analysis key terms before you begin your due diligence on valuing firms.

EBITDA

Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is a lengthy acronym for cash flow--what a company earns before doling out money to cover payments to debtors and Uncle Sam, plus charging off property losing value due to wear and tear or spreading out expenditures to cover more intangible assets they hold.
Try: The Motley Fool wraps up what they refer to as “every money-losing company’s favorite acronym.”

P/E or P/S

The most commonly reported fundamental ratios in business media simply compares a company's stock price to its earnings per share (price-to-earnings or P/E) or to its total sales per share (price-to-sales or P/S), helpful for a new company with no earnings history. While these ratios give you an easy number to compare against other companies or the overall industry, they provide a rudimentary starting point for valuing a firm.
Try: Investopedia explains P/E ratios, their calculations, limitations and possible replacement ratios such as Price/Earnings to Growth (PEG), which incorporates earnings growth per share. Morningstar shows several price-based ratios such as P/E and P/S plus price/cash flow and price/estimated growth.

Price-to-book

Use price-to-book (P/B) to compare the share price to the company's book value, which considers the company's balance sheet: total tangible assets (like capital equipment and property) minus debts and obligations, preferred stock, and intangible assets (like intellectual property or brand reputation). What could a company generate in a fire sale, if it went under?
Try: Use the Path to Investing guide for examples of using P/B ratios in evaluating various industries, including more difficult industries like software providers (heavy on intellectual property).

Profitability ratios

Profitability ratios are ratios that calculate how much money a company has left over after covering business costs, and usually begin with "return on" like return on investment, equity or assets. You can calculate these returns before or after taxes.
Try: CreditGuru.com provides simple definitions plus formulas for the most common profitability ratios.

Activity ratios

Activity ratios answer how much time does a company need to earn money. Common terms include "turnover," the average amount of activity occurring in a set length of time, like how many times a company sells inventory (inventory turnover), or how much time it takes to collect money or pay suppliers (accounts payable or receivable turnover).
Try: Financial Education provides a basic activity ratios definition and ratio-specific links to help you evaluate a company based on how well it runs its operations.

Leverage ratios

A leverage ratio calculates the proportions between a company's loans and the assets it owns (debt ratio) or how much capital the company operates from creditors versus stockholders (debt to equity).
Try: MYSMP covers the various debt ratios to explore how to value a company based on its ability to cover obligations.