As mentioned, for any decision as to whether any particular investment should be made or not, or whether credit should be granted to a firm; it is extremely important to look into the valuation of such firm. The valuation ratios come in handy in such cases.
1. Valuation Ratios for Equity Analysis
There are four important valuation ratios that should be considered in equity analysis in order to identify if the price of the shares is justified. They are:
Ratio |
Formula |
Description |
Price Earnings Ratio |
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This ratio helps in identifying if the market price of the shares is justified by its earnings if compared to its historical performance and others in the industry. |
Price to Cash Flow |
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This ratio helps in identifying if the cash flows are sufficient to justify the market price of the shares. |
Price to Sales Ratio |
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This ratio helps in identifying if the sales of the company justify its market price or not. |
Price to Book Value |
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This ratio helps in identifying if the market price of the share is in sync with its book value. |
Some other important valuation ratios are:
Ratio |
Formula |
Description |
EBITDA Per Share |
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This ratio calculated the gross earnings attributable to each share. |
Dividend per share |
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This ratio gives details about the dividend earnings per share held |
Dividend Payout ratio |
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This ratio gives information about the retention of earnings as well. |
Retention Rate |
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This ratio gives details about the amount of profits reinvested in the business. |
Sustainable Growth Rate |
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This represents the growth rate that can be sustained for a longer period. |
2. Valuation Ratios for Credit Analysis
a. The main purpose of credit analysis is the evaluation of credit risk. The credit evaluation process is similar to the credit rating process; it involves the evaluation of business risk, financial risk, and management evaluation.
b. The business risk profile helps in determining the appropriate levels of financial risk.
c. In calculating any ratios that involve the debt (some of them are discussed above) should be adjusted for the relevant off-balance sheet items. There should be special emphasis on the earnings from continuing operations.
d. For the purpose of credit risk analysis, we can calculate the coverage ratios. Some of them are:
Ratio |
Formula |
EBIT Coverage |
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EBITDA Coverage |
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Funds From Operations Coverage |
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e. Other ratios that can be calculated are:
Ratio |
Formula |
Return on capital |
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Funds to Debt |
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Free operating cash flow to debt |
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Discretionary cash flow to debt |
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Net Cash Flow to CAPEX |
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Debt to EBITDA |
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Debt-to-Total Capital |
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