In our previous topics, we covered both Quantitative fundamental analysis and Qualitative fundamental analysis. Now, introducing advanced ratio analysis one by one.
Most of the fundamental investors, only rely on the few ratios to determine the valuation of stocks. Let us start with alternative methods of analyzing by using ratios.
In this topic, we covered a few alternative methods to analyze non-public companies.
Retail investors are crazy about investing in IPO (Initial Public Offering) but they don’t know how to analyze private companies before listed on the stock exchange.
Just look into the private company’s balance sheet, we don’t get it operating income, net income, or free cash flow statements. In this situation, we use some alternative methods to calculate the valuation of the company.
Alternative Financial Analysis Ratio of Shares:
- Price-to-sales-ratio ( P/S) ratio
- Enterprise value-to-Sales (EV/S)
- EV-to-EBITDA
Price to Sales Ratio:
P/S Ratio = Current stock price / 12-month sales per share
The sales per share are calculated by dividing the twelve-month sales number by the number of outstanding shares.
A low P/S ratio suggests the company is undervaluated and a high P/S ratio suggests overvaluation of the company. Here we can verify with competitor’s performance.
Enterprise Value to Sale (EV/S):
For the buyer of the entire business, what matters is the value of the entire firm or what he would have to pay to take over the entire business including the value of equity and value of debt, this is called the enterprise value of the company.
EV considers the value of equity and value of debt and including the interest payment. Debt becomes the liability of the acquirer on the acquisition of 100% equity. It is calculated as
Enterprise value = Market value of equity (market capitalization) + Market value of debt – cash and cash equivalents
Why should we calculate this ratio? With this ratio, we can get an overview of how much it costs to investors relative to per unit sale
- If the EV/S ratio is higher, then it’s considered that the company has a higher valuation and it’s not a good bet for investments because investors won’t be getting any immediate benefit out of this investment.
- If the EV/S ratio is lower, then it’s considered that the company is undervalued and investors consider the buyer at a fair price of the stock.
When considering sales, it is net sales, not gross sales. A gross sale is a figure which is inclusive of the sales discount and sales returns. Here we take the net sales for this calculation.
EV-to-EBITDA:
Before going to the concept, let’s understand the terminology EBITDA which is Earnings before interests, taxes, depreciation, and amortization. Many of us are familiar with earnings interests and taxes but are somehow confused with depreciation and amortization.
Let’s try to simplify the terms, depreciation is the expensing of a fixed asset over some time. The monetary value of an asset decreases over time due to its usage. Depreciation is calculated by subtracting the asset’s salvage value or resale value from its original cost.
For example, a machine can be used for a fixed period of the business, and depreciation of the asset value is expensed in the early years of the asset’s life.
Amortization is the process of incrementally charging the cost of an intangible asset to expense over its life period. Intangible assets are not physical assets, such as patents, trademarks, and copyrights.
EV-to-EBITDA also known as Enterprise multiple, is used to determine the value of the company. For example higher enterprise multiples in high-growth industries (Biotech) and lower multiples in Industries with slower growth (Railways).
Enterprise is multiple determines the economic value of the company because it takes debt into account. It is frequently used to determine the value of the business if it’s acquired.
Chief investment officers evaluate the company based on the enterprise multiple not the Price to earnings multiple. EV multiples take into account both the cash in the hand and the debt the company is to pay for it.
Advanced Fundamental Analysis of Shared – Takeaways
- Whenever we apply for an IPO, we need to check these fundamental ratios to understand the business of the company.
- Don’t get it into the value traps. For example, investors see the lower EV/ EBITDA values and jump to buy the stocks. It might be the case that stock never recovered at all.
- We need to forecast the future potential growth of the company, stock prices may affect the systematic risk varying from country to country.
- Generally, EV/EBITDA values below 10 are seen as a good signal to buy the stocks.
- Just like the price-to-earnings ratio, the lower the EV/EBITDA, the cheaper the valuation for the company.
- I hope here onwards, fundamental investors analyze the above-discussed ratios before investing in any stocks.