Know Your Valuation Multiples

Valuation multiples are formulas that can be used in order to try to determine the value of a company and its stock. There are many different valuation multiples out there that you could potentially use. Here are the basics of some of the most popular valuation multiples that are available.

P/E Ratio

The most popular valuation multiple available today is the P/E ratio. This is short for price/earnings ratio. With this ratio, you are going to take the current price of one share of a company's stock and divide that by the earnings per share for a specific amount of time. This tells you how much money people will pay earnings. Many times, investors will compare the price/earnings ratio of one company to another within the same industry. Many people believe that this valuation multiple is not very effective because it takes a limited view of company valuation.

PEG Ratio

The PEG ratio is a similar valuation multiple and it is also used to determine the value of a stock. The difference between the price/earnings ratio and the PEG ratio is that the PEG ratio takes into consideration the growth of the company as well. In order to calculate in the PEG ratio, you take the price/earnings ratio and divide that by the annual earnings per share growth. Many people prefer of this valuation multiple over the price/earnings ratio.

Enterprise Multiple

Another commonly used valuation multiple is referred to as the enterprise multiple. With this multiple, you are essentially looking at a company as if you were planning on buying it. If you come up with a low ratio, this means that the company could be undervalued. With this calculation, you are going to take the enterprise value and divide it by the EBITDA. EBITDA stands for earnings before interest, taxes, depreciation & amortization.

Return on Equity

Return on equity is another valuation multiple that you may want to consider using. This measurement is used in order to determine how much money can be generated from the available assets of the company. When you calculate this, you are basically seeing how efficient a company is with the money that they have. If you find a company that is efficient, this could be a worthy investment for you. In order to calculate this, you are going to take the net income of the company and divide that by the shareholders equity. The big downside to this valuation multiple is that it does not take into consideration how much debt a company has. 

Dividend Discount Model

The dividend discount model is a popular valuation model that involves using the dividends that are paid by the company in order to evaluate the value of the stock. People that use this method put an emphasis on the importance of cash flow when it comes to investing. In order to calculate this valuation multiple, you are going to take the amount of dividends that was paid per share and divide that by the difference between a discount rate and the dividend growth rate.

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