Valuation is both an art and a science. I’ve heard that phrase a lot throughout the years. And the more I think about it, the more it is true.
Stock valuation is incredibly important. Valuation just refers to how expense (or cheap) a stock is based on earnings, cash flow, or some other kind of metric.
As DGI investors, we should always strive to get the best deal on our stocks.
Here are five important valuation techniques dividend investors need to know.
1. Price-to-earnings (P/E) ratio
The P/E ratio is calculated as the stock price divided by earning per share.
Price-to-earnings ratio = Stock price / earnings-per-share (EPS)
Earnings per share is calculated as net income dividend by the diluted share count.
Diluted share count represents all shares outstanding plus any securities that can be converted into common shares.
P/E measures how expensive (or cheap) a stock is relative to its earnings. For instance, a P/E ratio of 15x means that investors are paying 15 dollars for every dollar of profit the business generates.
P/E ratio is typically the most commonly cited metric in the financial media. Currently, the S&P 500 trades at a P/E ratio of ~24x earnings.
While the P/E ratio is a great valuation tool to use, there are a few things to consider.
First, the P/E ratio doesn’t consider the capital structure of the business. In other words, it doesn’t account for the level of debt a business has.
Would you want to invest in a stock that trades at a P/E ratio of 5x, but has debt worth 10x earnings?
One quick way to adjust for this is to modify the P/E ratio numerator to include debt (on a per-share basis).
Second, sometimes it may be useful to compare the current stock price relative to future profits. This is called the forward P/E ratio because we’re comparing the current stock price to future (or “forward”) earnings.
Typically, the stock price is compared to earnings 12 months into the future. So, a stock with a forward P/E ratio of 20x means investors are paying 20 bucks for every dollar of future expected profit.
2. Price-to-book (P/B) ratio
Price-to-book (P/B) is a very popular metric among value investors (especially Warren Buffett supporters).
Let’s first define a few terms. Book value is a very important tool in financial analysis.
It represents the net assets of a business (total assets minus total liabilities). In essence, it is the theoretical value of a business if it were liquidated.
Book value per share represents the book value of the company divided by the diluted share count.
One metric investors utilize in certain industries is the price-to-book (P/B) ratio.
Price-to-book = Share price / Book value-per-share
P/B measures how much investors are paying for the net assets of a business. By net assets, I mean total assets minus total liabilities–this is basically a stock’s “tangible” net worth.
For instance, a price-to-book ratio of 1.5x means investors are paying 1.5 times the net assets of the company.
Price-to-book is a useful metric for businesses with primarily tangible assets such as a manufacturing business or a bank or even an insurance company.
It is less useful to evaluate companies that rely heavily on intangible assets (like patents, brands, or trademarks) such as technology companies or pharmaceuticals.
Let’s define a few terms first before talking about this metric.
Enterprise value is another way to measure a company’s value other than using market capitalization.
Remember, market capitalization is calculated as the stock price multiplied against shares outstanding.
Enterprise value is calculated as market capitalization plus debt and preferred shares less cash.
The reason why enterprise value is sometimes used is because it takes into account the capital structure of the business (i.e. the mix of debt and equity).
EBITDA represents earnings before interest, taxes, depreciation, and amortization. EBITDA is used as an alternative to net income because it strips out the impact:
- Differences in debt
- Different tax rates
- And differences in accounting
EV/EBITDA = Enterprise value / Earnings before interest, taxes, depreciation, and amortization
EV/EBITDA measures how much a business is trading for relative to profits.
Price to sales (or P/S) is a very popular valuation metric for fast growing companies.
The reason some stocks are valued based on sales is because they don’t generate any profits! As a result, the ONLY way investors can evaluate them is by sales!
All DGI investors should run away (and run fast) from stocks that trade at high price-to-sales multiples. High P/S stocks rarely pay a dividend.
Second, high P/S stocks likely don’t have a history of generating consistent profits. Dividends are ultimately driven by earnings growth.
Accordingly, these stocks should be avoided.
Dividend aristocrats typically don’t trade at a very high price-to-sales ratio.
5. Price-to-cash flow
Some DGI investors don’t like net income because it’s based on “accounting” numbers which can be fudged. As a result, they like to rely on cash flow instead.
Price to cash flow measures how much investors are paying for a business relative to the cash it generates.
Price-to-cash flow = Market capitalization / Cash flow from operations
For example, a price-to-cash flow ratio of 16x means investors are paying 16 bucks for every dollar of cash flow generated.
To be a successful dividend investor, you need to be able to carefully evaluate how expensive or cheap stocks are.
Now you know how to value dividend stocks like a pro!
With that in mind, don’t spend hours and hours and lose sleep over valuation.
As Warren Buffett once said, it is better to pay a fair price for a wonderful company than it is to pay a great price for a fair company!