There are a large number of different ratios in use, and this post presents a potpourri of some popular ones. The list is not exhaustive, as indeed only the imagination limits the quantities that can be used in the denominator. Two ratios that are relatively similar to the P/E ratio discussed in the previous post are :
Alternative Price-Earnings or Cash Flow Ratios Earnings can be defined in a variety of ways:
with or without extraordinary items, diluted, etc. There is no right or wrong way: the goal is to find a ratio that makes the comparables firm appear to be as similar as possible. For example, one measure of earnings is EBITDA (earnings before interest and taxes, depreciation, and amortization). The rationale is that accounting depreciation is so fictional that it should not be subtracted out. But EBITDA has problems with leverage (interest expense) and capital expenditures—if you use it, please subtract these. Of course, if you do, you will de-facto use a price over cash flow ratio, which can suffer from the shortcomings that capital expenditures are very “lumpy.” This is why we used earnings rather than cash flows in the first place.
Price/Book-Value-of-Equity Ratios This ratio is commonly used, and often abbreviated as the market/book ratio. It should not be recommended for valuation purposes. The reason is that the book value of equity is often close to meaningless. Accountants use the book value of equity to balance assets and liabilities, in accordance with all sorts of accounting conventions (such as depreciation). As a result, this measure is especially different across firms with different ages of fixed assets (such as buildings).
However, sometimes neither earnings nor the book-value of equity are meaningful. For example, biotech firms may need to be valued even before they have meaningful, positive earnings. The idea is to substitute another, more meaningful quantity for earnings. In biotech firms, a better (but still very bad) measure than earnings may be the number of scientists. An analyst might find that biotech firms are worth $1,000,000 per employed scientist. In principle, the comparables valuation method remains the same as it was when used with price earnings ratios. The alternative ratio typically still has price (either equity value or overall firm value)in the numerator, but a quantity other than earnings (e.g., sales or number of scientists) in the denominator. The analyst chooses comparable firm(s), determines an appropriate typical comparables ratio, and finally multiplies this comparables ratio by the firm’s own quantity to determine its value. This may work well only if firms are comparable enough among the chosen dimensions that application of the ratio of some firms to the ratio of others offers a meaningful price.
Price/Sales Ratios This ratio is especially popular for industries that do not have positive earnings. Therefore, it was commonly used during the Internet bubble, when few Internet firms had positive earnings. Presumably, firms with higher sales should be worth more.
One problem was that firms, such as Amazon during the Internet bubble at the turn of the millennium, were known to sell merchandise at a loss. Naturally, it is relatively easy to sell $100 bills for $99! So, the more Amazon sold, the more money it lost—but the more valuable Amazon appeared to be. After all, with higher sales, the Price/Sales ratio suggested that Amazon would be worth more.
Price/Employees Ratio
This ratio is popular when financials are deemed not trustworthy. Of course, it assumes that the employees at the comparable firm are as productive as the employees in the company to be valued.
Price/Scientists Ratio
This ratio is popular for upstart technology firms, which have neither earnings nor sales. One problem is that it induces firms to hire incompetent scientists on the cheap in order to increase their valuations. After all, firms with more scientists are presumed to be worth more.
Price/Anything Else Your imagination is the limit.
This latter set of ratios only makes sense if you compute them for the enterprise value of the firm (that is, the value of all equity plus the value of all debt). If you want to obtain the value of the equity, you should compute these ratios using the enterprise value, and then subtract off the current value of all debt.