Valuation Ratio and Growth Ratios

A valuation ratio shows the relationship between the market value of a company or its equity and some fundamental financial metric (e.g., earnings). The point of a valuation ratio is to show the price you are paying for some stream of earnings, revenue, or cash flow (or other financial metric).

Earnings per Share = ( Net Income – Preferred Dividends ) ÷ Average Common Shares Outstanding

EPS shows the rate of earnings per share of common stock. Preferred dividends is deducted from net income to get the earnings available to common stockholders.

Price-Earnings Ratio = Market Price per Share ÷ Earnings per Share

Used to evaluate if a stock is over- or under-priced. A relatively low P/E ratio could indicate that the company is under-priced. Conversely, investors expect high growth rate from companies with high P/E ratio.

Dividend Pay-out Ratio = Dividend per Share ÷ Earnings per Share

Determines the portion of net income that is distributed to owners. Not all income is distributed since a significant portion is retained for the next year’s operations.

Dividend Yield Ratio = Dividend per Share ÷ Market Price per Share

Measures the percentage of return through dividends when compared to the price paid for the stock. A high yield is attractive to investors who are after dividends rather than long-term capital appreciation.

Book Value per Share = Common SHE ÷ Average Common Shares

Indicates the value of stock based on historical cost. The value of common shareholders’ equity in the books of the company is divided by the average common shares outstanding.

Examples, Questions, Answers of Valuation Ratio

1. For the period ended 31 December 2020, company ABC has made a profit before tax $9,000,000. Income tax for the years amount $2,000,000.

The company share capital structure are as follow:

Ordinary share (1,000,000 @$1) = $ 1,000,000
8% preference share                 = $ 200,000
Total                                        = $ 1,200,000

Earnings Per Share for December 2020

Solution:

Profit before tax for the years                 = $9,000,000
Less income tax                                         = ($2,000,000)
Profit after tax                                            = $7,000,000

Less preference share dividend

( 200,000 @ %8)                                           = ($ 16,000)
Earnings attribute to ordinary shares     = $6,984,000
Number of ordinary shares                      = 1,000,000
Earning per share                                       = $6.984

2. Donald Corporation had 3 million shares of common stock outstanding throughout the year in 2015. During the year, it issued five thousand, $1,000 convertible bonds with an interest rate of 8%. These bonds were issued at par on 1/1/2015. Each bond is convertible into 10 shares of common stock. Assuming Donald Corporation had a net income of 2.4 million for 2015 and has an effective tax rate of 40%, what is its diluted EPS (rounded)? 

A. $0.87
B. $0.80
C. $0.88
Correct Answer: B

This is based on the following calculation:

$2,400,000+ [400,000 x (1-.40)] = $ 2,640,000
3,000,000 shares + (5,000 x 10 shares) = 3,050,000

where 400,000 represents the interest expense on the convertible debt which would be avoided if converted.

Diluted EPS = 2,640,000/3,050,000 = 0.87. Basic EPS = 2.4/3 = 0.80. So, the diluted EPS should actually be 0.80.

Sources: PinterPandai, Corporate Finance Institute

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