Financial Metrics 101
Market capitalisation, often referred to as ‘market cap’, is a metric detailing the monetary value of a company. It is calculated by multiplying the number of the company’s outstanding shares with the current market value of an individual share. Typically quoted in US Dollars, market cap is a quick and commonly used valuation technique when investors are trying to ascertain a company’s monetary worth.
Market Capitalisation = Number of Outstanding Shares × Current Share Price
Because the formula for determining a company’s market cap requires knowing the number of outstanding shares and their values, only publicly traded companies on stock exchanges can have a market capitalisation. Privately-held companies use alternative metrics and valuation methods, such as comparable company analysis (CCA) and discounted cash flows (DCFs).
Public companies can then be categorised by size according to their market capitalisation: large-cap ($10 billion+), mid-cap ($2 billion - $10 billion), and small-cap ($300 million - $2 billion). Typically, large-cap companies tend to be more established firms with lower risk but also lower growth potential for investors relative to small-cap companies.
Enterprise Value (EV)
EV is an alternative and more comprehensive valuation method compared to market capitalisation, capturing a company’s total market value as opposed to its equity market value. EV does this by including the company’s market value of debt and cash on the balance sheet (i.e. liquid assets owned by the company) as well as its market capitalisation:
EV = Market Capitalisation + Total Debt – Cash & Cash Equivalents
EV possesses several advantages over market capitalisation within a valuation context. Firstly, by incorporating total debt, EV provides a much more representative valuation profile of a company relative to market capitalisation since this would need to be paid off in a potential takeover. EV additionally facilitates a direct comparison between companies with different capital structures, which is overlooked when only referring to market capitalisation. EV also features in many valuation multiples that form the basis for financial ratios that are often cited when assessing the performance of a company, such as EV/EBITDA and EV/Revenue.
EBITDA is an acronym for ‘earnings before interest, taxes, depreciation, and amortisation’. Appearing on the income statement, it describes a company’s profitability inclusive of interest, taxes, depreciation, and amortisation expenses. EBITDA’s popularity as a valuation metric stems from the fact its both easily calculated and provides instant insight into the value of a company.
Despite this, EBITDA is not formally recognised by the International Financial Reporting Standards (IRFC) or the US Generally Accepted Accounting Principles (GAAP) as a financial metric. This drawback implies a lack of standardisation when calculating EBITDA and so limits its comparability between companies.
The price-to-earnings (PE) ratio is another commonly used alternative method for valuing a company. Generally, the PE ratio is by investors to assess a company’s current performance against its own past performance or aggregate market performance. Defined as the market value per share divided by earnings per share (EPS), it captures two main performance indicators.
Firstly, it can be used to determine whether a company’s share prices are under or overvalued relative to their EPS. Secondly, a PE ratio can also indicate the future growth expectations of a company, where the higher the PE ratio, the higher the growth expectations.
PE Ratio = (Market Value per Share) / EPS
Subsequently, a high PE ratio may signal that a company’s share prices are overvalued, but also of high expected earnings growth. Investors must therefore discern which component is driving the PE ratio. Understanding this is crucial to establishing whether investing in a company is good value for money.
Normal PE ratios typically range from 10 – 30, with the FTSE All-Share index daily average currently hovering around the 15.5 mark. This is by no means a ceiling, as witnessed when the PE ratio of Tesla, the electric carmaker, hit highs of over 1300 in late December 2020.
The price-to-earnings to growth (PEG) ratio acts a complementary measure to the PE ratio and is simply the PE ratio divided by the earnings growth rate per share over a specified time period. As with the PE ratio, a low PEG ratio indicates that a stock may be undervalued and vice-versa. As a rule of thumb, PEG ratios less than 1 imply a company is undervalued.
PEG Ratio = ((Market Value per Share / EPS) ) / (EPS Growth )
Taking the earnings growth rate into account enables the PEG ratio to factor in the growth potential of a company and so provides a more complete valuation method. The reliability of the PEG ratio hinges upon the relevance of its data inputs and any discrepancies could lead to misleading interpretations. To avoid this, it is common to specify whether the PEG ratios are ‘trailing’ or ‘forward’ when growth rates used in the calculations are historical or predictive, respectively.
The price-to-book (PB) ratio is yet another approach taken by investors to value a company. It takes a company’s market price per share and divides it by its book value per share, where book value is the value of total assets minus intangible assets (such as patents, software and goodwill) and total liabilities. Essentially, book value captures how much a company would be worth if it sold all of its assets and repaid all of its debts.
PB Ratio = (Market Price per Share) / (Book Value per Share)
Similarly to the PE and PEG ratios, a low PB ratio could imply a company is undervalued, relative to its competitors in the same industry. However, differences in accounting practices (specifically asset valuation) across industries may not always facilitate a direct comparison of PB ratios.
The debt-to-equity ratio is a leverage ratio that highlights a company’s debt relative to total assets. In doing so, the debt/equity ratio tells you whether a company’s capital structure is comprised of either more debt or equity financing since it is simply calculated by dividing total liabilities by total shareholder equity:
Debt/Equity Ratio = (Total Liabilities) / (Total Shareholdes' Equity)
A higher debt/equity ratio is usually associated with higher risk profiles as it implies financing a larger degree of potential growth through borrowing. This can be problematic when the cost of debt financing (i.e. the interest) outweighs additional income generated. What is considered an excessive debt/equity ratio depends on market conditions and varies from industry to industry. For instance, companies in capital-intensive industries such as energy and transportation will often have acceptably higher debt/equity ratios in order to finance large capital investments.
Subsequently, the debt/equity ratio is best utilised as a financial metric when comparing companies within the same industry, although the typical debt/equity ratio generally ranges from 1-1.5.
Return on Equity (ROE)
ROE is a simple financial metric used to evaluate investment returns, calculated by dividing net income by shareholders’ equity. Expressed as a percentage, it represents a company’s total return on equity capital or, in other words, the profits generated from each pound of shareholders’ equity.
Return on Equity = (Net Income) / (Shareholders' Equity)
ROE is particularly insightful for investors when comparing a company to its competitors. This is because ROE acts as a proxy for how efficient a management team is at converting equity finance into profits, although this is limited if a company primarily relies on debt. ROE can also be used to estimate a company’s future growth by multiplying the ROE value by the retention ratio, the percentage of net income that is reinvested by the company to fund future growth.
Standard ROE rates range from 5-15%, though these can be negative if the firm is lossmaking. The S&P 500’s long-term average annualised ROE stands at around 14.7%.
N.B. These metrics should not be used in isolation from one-another. Instead, their effectiveness is optimised when used together. Painting a more complete picture of a company’s financial performance enables more thorough and reliable valuation analysis.