Current Valuation Ranges for Stocks

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Academic studies on the value premium—the additional return for investing in portfolios of stocks with low valuations—use percentile rankings. Stocks are ranked based on whether they are cheap or expensive relative to all other stocks based on a given ratio such as the price-earnings (P/E) ratio or the price-to-book-value (P/B) ratio.

The Value Grades and Scores used in A+ Investor and VMQ Stocks are based on a similar ranking process. Stocks with comparatively lower valuations are assigned better grades and scores. Stocks with comparatively higher valuations are assigned worse grades and scores.

An advantage to using relative valuations is that they will always identify stocks. The downside is that they shift with market conditions. When the overall market gets more expensive, so will the absolute range of what counts as a cheap valuation.

With this in mind, here are the current ranges for the valuation ratios included in our Value Grade and Score. Value investors will want to stay below the median and preferably closer to or below the cheapest 20% (lowest quintile). The most expensive 20% (highest quintile) should be viewed as a valuation danger zone.

Price to Sales

The price-to-sales (P/S) ratio is determined by dividing market price per share by the sales per share for the most recent 12 months. Seeking undervalued stocks based upon the price-to-sales ratio was first popularized by Kenneth Fisher in his 1984 book “Super Stocks.”

Proponents of the price-to-sales ratio argue that earnings-based approaches to selecting stocks are inferior because earnings are influenced by many management assumptions trickling through the accounting books. The price-to-sales ratio can provide a meaningful valuation tool when negative earnings render earnings-based models useless.

Price to Earnings

The price-earnings (P/E) ratio, or earnings multiple, is one of the most popular measures of company value. It is computed by dividing the current stock price by earnings per share for the most recent four quarters.

The price-earnings ratio is followed by so many because it relates the market’s expectation of future company performance—embedded in the price component of the equation—to the company’s actual recent earnings performance. The greater the expectation, the higher the multiple of current earnings investors are willing to pay for the promise of future profits. However, there is no guarantee that these expectations will be met, making high price-earnings stocks riskier.

Enterprise Value to EBITDA

The ratio of enterprise value to earnings before interest, taxes, depreciation and amortization (EBITDA) is determined by dividing enterprise value for the most recent quarter by EBITDA for the most recent 12 months. Enterprise value is equal to the market value of equity (including preferred stock) plus interest-bearing debt minus excess cash.

Many investors feel that a company’s enterprise value relative to its EBITDA is a better way to measure company value than the price-earnings ratio alone. The ratio is neutral to the company’s capital structure and capital expenditures (capex).

Shareholder Yield

A stock’s shareholder yield—the sum of its buyback yield and dividend yield—shows the percentage of total cash that the company is paying out to its shareholders, either in the form of a cash dividend or as expended cash to repurchase its shares in the open market. Thus, if a company is paying a 5% dividend yield and has a buyback yield of 10%, its shareholder yield would be 15%.

Unlike other valuation measures, shareholder yield is inversely related to value, with higher shareholder yields implying lower valuations. A negative shareholder yield occurs when the percentage increase in the number of shares outstanding is greater than the stock’s dividend yield.

Price to Book Value

The price-to-book-value ratio is calculated by dividing the share price by book value per share. Book value is generally determined by subtracting total liabilities from total assets and then dividing by the number of shares outstanding. It represents the value of the shareholder’s equity based upon historical accounting decisions.

The price-to-book ratio was a favorite measure of Benjamin Graham and his disciples who sought companies with a share price below the book value per share.

Price to Free Cash Flow

The price-to-free-cash-flow (P/FCF) ratio is calculated by dividing the share price by free cash flow per share for the most recent 12 months. Cash flow is reported on the cash flow statement. It is the sum of cash from operations, cash from investing and cash from financing adjusted for exchange rate effects. Free cash flow is calculated by subtracting capex and dividend payments from cash flow from operations.

The cash flow statement is harder to manipulate through accounting techniques than earnings. Unlike earnings, which are an accounting figure, cash flow represents the net total of cash flowing into and out of the company over a given period.