When can you trust a ratio?

Deciding which ratios to use on different sectors can look daunting. Don't be put off. Here's our guide to the most widely quoted ratios.

The price/earnings ratio

Investors usually start with the price/earnings ratio, a measure of the current share price, say £2.50, compared to one year's earnings per share, say 50p, to give a ratio of five. It is a useful measure of whether a share is cheap (a low p/e) or expensive (a high p/e). But watch out for the traps.

Earnings per share often includes non-cash items such as paper gains from the sale of property or stocks. So by relying on a high p/e in isolation you may be overpaying for non-recurring earnings. Also beware volatile profits. If you are analysing cyclicals, such as chemicals or mining, you need to think about where we are in the cycle.

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A miner may look cheap on a p/e of ten, but the earnings used may be the peak earnings which are set to slump. Equally, a high p/e of say 50 may not always be expensive because earnings are depressed now but will rebound. Sectors such as consumer staples have fairly steady earnings, so p/es will vary much less.

A handy ratio to look at alongside the p/e, especially for growth stocks, is the PEG ratio the p/e ratio divided by the forecast yearly earnings growth, typically over the next five years. A firm with a PEG of one is often said to be fairly valued. While extremely crude, this is a reasonable rule of thumb for stocks expecting double-digit growth. For low-growth stocks, however, the PEG is largely meaningless.

Investing by the book

Another widely quoted ratio is the price/book (p/b) ratio. Book value (also known as net asset value or shareholders' equity) means the value of the company's balance-sheet assets less its liabilities. In theory, a firm with a p/b of less than one is a bargain; it's selling for less than the net value of its assets.

Unfortunately, reality is a bit more complex. First, there's the question of what the firm's assets are really worth. For example, p/b is often used on property companies where a p/b of, say, 0.5 might look like a bargain. But if the book value relates to property prices at the top of a bubble, the stock may be one to avoid. The ratio also falls down when firms carry high levels of intangible assets such as brands, so the p/b is generally useless for firms that lack physical assets.

What's more, unless you're concerned with the break-up value of a firm, p/b alone doesn't tell you much. Since earnings come from the return a firm earns on its assets, return on equity (ROE, net income divided by shareholders' equity) is a useful addition. High ROE firms should trade on higher p/bs than low ROE firms, because they eke out more profits for shareholders from the same amount of shareholder capital.

So ROE is a useful way to compare how efficient businesses are. However, ROE can only be compared between firms in the same sector. And cyclical firms will have a much higher ROE at share price peaks than troughs. And since ROE focuses on net assets, a firm that piles on debt while interest rates are low will boost its ROE. As a result, it may look better than a less-indebted peer, but be less well placed to survive when times get tough.

So, whether looking at p/e, ROE or any other ratio, you should also take the strength of a firm's balance sheet into account. One way of doing this is the Altman Z score, which assesses the risk of a firm going bankrupt within two years(See: How Z scores can help you beat the slumpfor more). A Z score of above three is considered safe.

Investing for income

The third way to think about valuation is focusing on the income the stock will pay. Dividend yield is the favoured way of valuing utilities and other low-growth stocks. But it is also an important complement to the p/e when assessing any industry with fairly stable cash flows, such as telecoms or healthcare.

Again, sustainability is key; check how many times one year's earnings covers the dividend (you usually want at least two times, but utilities can get away with much less). And note that the yield is of little use for small growth firms, which often don't pay a dividend.

Beware of banks

Provided you take account of where a firm is in the economic cycle, the ratios considered so far work for most sectors. The exception is financials. Bank earnings, for example, regularly include large non-cash items, such as revaluation gains or losses on assets, provisions for bad debts or higher payouts on policies.

Many investors use p/b for financials, but to be thorough you also need to consider a number of industry-specific measures such as combined ratios (policy payouts plus expenses divided by premiums earned). In short, valuing financials is difficult; a simpler approach is to treat them as income plays and value them on the dividend yield, being careful to avoid any firms lending or expanding recklessly.

Ratios that deserve a health warning

Valuing companies that have little or nothing in the way of earnings or assets is most difficult of all. But that does not stop creative analysts having a go. So you will sometimes see ratios such as the share price to one year's sales (price/sales) quoted. This can be used to put a high valuation on exceptionally low-margin or unprofitable businesses.

You should also avoid even woollier ratios such as the dotcom era favorites price to eyeballs', or price per click'. These can support lofty share valuations for firms that have no earnings, cash flows or assets. A high number is a red flag, not a reason to buy.