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Narrator: Financial ratios can help investors compare two companies of different sizes and characteristics. Let's practice by looking at the valuation ratios of two hypothetical companies and determine which might be a better value investment.
In this example, we have two companies: Company A and Company B. Let's assume they're in the same industry and selling the same types of products. We'll compare the companies' valuation ratios and other characteristics side-by-side, starting with the most common: price-to-earnings, or P/E, ratio.
Company A has a P/E of 10, which means investors are essentially paying $10 for every $1 of the company's annual earnings. Company B has a P/E of 15, which is more expensive. All else equal, a value investor typically prefers a lower P/E ratio, so Company A appears to be more attractive. Let's look at the next metric, the price-to-sales ratio.
Both Company A and Company B have a price-to-sales of 2, which means an investor is paying a multiple of $2 for every dollar of revenue the company receives through sales. On the surface, they're equal, right? But there's something else we can glean here by comparing the price-to-sales ratios with the P/E ratios.
Company A's investors are paying the same multiple as Company B's for sales but a lower multiple for earnings or profit. Somewhere along the way of collecting "top-line" revenue and generating "bottom-line" earnings, Company A is doing something differently than Company B. This is an indirect way of identifying that Company B might not be quite as efficient at capturing profits from its sales.
To say it another way, every dollar of Company A's sales are currently more valuable because it's shown it can squeeze more profit from those dollars. So even though they appear to be the same, an investor might prefer Company A's price-to-sales to Company B's. Additionally, it might prompt an investor to do further research to understand why the profit margins are so different.
Let's move on to the price-to-book ratio. Recall that the book value of a company is the shareholders' equity or basically the assets minus the liabilities. Company A's share price is a multiple of 2.5 times, while Company B is 3 times.
Value investors typically prefer a lower price-to-book ratio because it indicates they're paying less for equity in the business, so Company A appears to be a better value.
Finally, let's look at book value growth, which can give an investor an idea of how quickly a company is building its assets.
Animation: Chart comparing book value growth for Company A and Company B.
On-screen text: 5% Company A and 9% Company B.
Narrator: Notice how the book value growth rate for Company B is higher than Company A.
One possible explanation is that Company B has been in a more growth-oriented phase as a business. It also provides an explanation for why its valuation multiples are less attractive, which is a common characteristic of a growth stock. Company A, however, has more features that could attract a value investor.
As you can see, you can learn a lot about companies just by comparing a few of their financial ratios. This can be a valuable skill to learn as you begin searching for your own investment candidates.
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