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.
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Value-Based Ratios
Land Contract (Purchase Contract)
The land contract, purchase contract, or contract for deed is recommended as a method of sale when the buyer does not have a sufficient down payment. It is an agreement whereby one party agrees to convey land to another party for a certain price, with the seller retaining legal title and the deed until some specified future date (for example, until all payments are made). Although legal title stays with the seller during the contract, equitable title passes immediately to the buyer. The land contract is becoming popular in several states among unrelated parties.
There are several variations in methods of payment under the land contract. Some are as follows:
• Fixed money price and fixed annual payments.
• Payment based on fixed amount of commodities each year. For example, the contract could specify so many bush- els of wheat each year. The value of the payment would then be determined by the price of wheat for that year.
• Fixed purchase price with yearly payment based on percentage of gross receipts. This method is sometimes used on dairy farms.
• Variable purchase price with variable payments. The payments could consist of a certain percentage of the gross income during the parents’ lifetime.
• Combinations and variations of the above may be worked out.
Advantages
• The purchase contract facilitates the purchase of a farm by a young buyer with limited funds. It is one of the few ways this can be done.
• The repayment schedule encourages a young farmer to build up equity during the early years.
• Some sellers like the purchase contract because of income tax savings due to use of the installment plan. Install- ment payments allow the gain from the sale to be spread over several years.
• An element of control is left in the hands of the seller.
• Ejection of a defaulting buyer under a contract for deed may be easier than a mortgage foreclosure. However, courts often tend to require similar procedures in each case.
Disadvantages
• The buyer has less secure title to the property, since it is an equitable title, but not the legal title.
• It may be more difficult for the buyer to sell his equity if, for health reasons, he wants to quit farming.
• If the down payment is small, the seller takes more credit risk in the early years of the contract than is taken by regular lending agencies that require a larger buyer equity.
Outright Sale, with Mortgage
Use of a deed and a mortgage in combination is a common method of transferring the ownership of real estate between unrelated persons. The seller deeds title to the property to the buyer. The buyer makes a down payment and gives the seller a mortgage on the property to ensure payment of the balance of the purchase price.
Where this method is used in estate planning, the parents may for example deed title of the farm to the child and the child could encumber title by giving a mortgage back to the parents. This method should be encouraged, provided the child can make sufficient down payment. Often the child cannot; and, from the parents’ viewpoint, there are serious disadvantages when little or no down payment is required. Passing the title to a person who might have little incentive to increase equity involves some risk. In this type of situation, some authorities believe the child should pay at least one- fourth of the purchase price before the parents pass title. This amount could reasonably vary due to a number of factors.
Advantages
• Outright sale permits the purchasers to make permanent improvements on the land.
• A sale with a mortgage is a businesslike way of making the transfer. It is usually best to have the farm appraised to prevent family misunderstanding as to its value, especially if there is more than one heir.
• Equitable treatment of all the heirs can be separated from the problem of transferring the farm.
• The transfer may prevent the farm from becoming run down when owners become too old to maintain it properly.
• In instances where an estate tax problem exists, sale of the farm will set the value to be included in the estate for estate tax purposes.
• A sale to children makes it possible for the buying children to operate the farm during their most productive years.
Disadvantages
• The parents lose control over the property.
• The capital gains tax may be greater than the estate taxes would be. Selling by the installment sales method can be used to reduce the taxes. Installment sales must conform to certain restrictions.
• The parents may not receive enough for the farm. The parents often are tempted to sell for less than the market price; and, if their wealth is limited, this may later cause them hardships.
• If parents sell to one child for less than market price, conflicts may result with their other children.
• The estate cannot take advantage of current use valuation.
The Title Company at Work
The title company is an integral part of the mortgage loan process. The title search and title insurance commitment certify that the borrower or buyer will truly own the subject property clearly and cleanly. To accomplish this certification, the title company will examine the ownership and lien records about the property:
1. Analyze the description. The title company will analyze the legal description to the property to ensure that the property actually does exist where it claims to exist. More to the point, the title will serve to assure the buyer or lender by confirming the subject property.
2. Trace the succession of ownership. The title company will also examine how ownership of the land has been transferred from the first legally recorded owner of the property down to the current owner. This is often called the chain of title. The title company will ensure that there were no questionable breaks or interruptions in the succession of ownership—which may jeopardize the real ownership status of the current owner.
3. Review the restrictions against the property. The title company will then review and report all unreleased restrictions against the property, such as recorded encumbrances, easements and liens. Once the title company has completed its search and examination of public records, it will describe its findings to the person or company who ordered the title search. The title company will then issue a commitment to insure its discoveries. The title insurance does not go into effect until the title insurance premium is paid, which usually occurs during the loan closing. In most mortgage transactions, the title insurance company usually issues two separate types of insurance coverage:
- Owners policy. With most purchases, the seller will pay for this portion. With refinances, it is normally the buyer’s responsibility.
- Lenders policy. With both purchases and refinances, the borrower will normally be responsible for the cost of the lender’s title insurance coverage.
The title insurance premium is a one-time charge and varies according to the title company. The title insurance protects the owner and lender against possible losses from title-related problems. For example, consider the hypothetical situation of a Native American tribe winning a claim in court that a person’s house is on top of their ancestral burial grounds and the court orders the homeowner to surrender the property. The title insurance would protect the homeowner by either (1) paying the tribe for the land or (2) paying the original mortgage amount plus down payment and losses to the current owner.