All share market-investing strategies have one thing in common – “target” shares.  Technical analysts apply their charts, graphs, and price patterns to specific shares in which they are considering an investment.  The same can be said of fundamental analysts of all stripes – both growth investors and value investors.  Of the many tools available to spot attractive targets, valuation ratios have something to say to all investors.

Value investors look for shares whose fundamentals indicate the market “does not get it,” and is unwilling to pay what the shares are worth, representing a potential bargain to the investor.

Growth investors look for shares with high growth potential, regardless of the current price of the shares.

Both types of investors get signals from valuation ratios because all valuation ratios are derived with Price per Share as the numerator in the formula.  Price per share is a hard number representing what investors in the marketplace are willing to pay for the shares.  

Unlike earnings per share, assets and liabilities, and other financial metrics that can be expertly massaged and manipulated to appear better than they truly are, the share price is the share price.  It goes up when there are more investors trying to buy the shares than are willing to sell, and it goes down when there are more investors trying to sell than there are investors willing to buy.  It is really all that simple.

Growth investors look at high valuation ratios as a potential sign even better days lie ahead while Value investors see the same ratio as a sign to stay away, since the shares are overpriced.

The drawback to Valuation ratios always lies in the reliability of the denominator.  The most popular Valuation ratio is the P/E or Price to Earnings Ratio and many view it with healthy skepticism, since earnings numbers can be manipulated.

Some investors prefer another ratio – the P/B or Price to Book ratio – since it uses the supposed dollar value of the company as the denominator.  Book value is what would remain of a company’s assets after its liabilities were paid should the company be liquidated in bankruptcy.  Book value represents a dollar amount that would go back to the shareholders.  Here is the formula for calculating the P/B ratio:

P/B Ratio = Price per Share/Book Value (Total Assets –Intangible Assets and Liabilities) per Share

Although these numbers are readily available from a company’s financial statements, the P/B is included on most financial websites.  There are actually two ways to calculate this ratio, and the formula above is the more conservative measure, since it excludes intangible assets from the calculation.  The idea is you cannot sell an intangible, while tangible assets have market value.  A P/B less than 1.0 means the shares are trading for less than they are worth – an obvious target for any Value investor.  A P/B ratio of 3 means an investor is paying $3 dollars for every dollar of company assets.

However, the market value of tangible assets point out a major drawback of this ratio – asset depreciation.  Although accounting conventions call for hard assets to be depreciated over time, the problem is who would be willing to buy 5 or 10 year old equipment and what would they be willing to pay?   

There is a Valuation ratio that uses hard numbers in both numerator and denominator called the Price to Sales (P/S) ratio.  Here is the formula for this ratio:

Price to Sales Ratio = Price per Share/Net Sales (Revenue) per Share

The denominator represents net sales or revenue as reported in a company’s financial statements divided by the total number of common shares outstanding.  The P/S is readily available on most financial websites.  Proponents argue this ratio is almost foolproof, since accountants cannot manipulate either the share price or the company’s sales.

While this ratio certainly has value for all investors, it is not as “foolproof” as its advocates claim.  First, there is the issue of revenue recognition – when is a sale recorded – and the issue of accounts receivables.  Nevertheless, a P/S of 5 tells an investor the market is currently willing to pay $5 for every $1 in sales the company generates.

Ratios in isolation make little sense since there are significant variations that have to do with the nature of the business in which the share you are targeting operates.  Investors are always warned to compare the valuation ratios of a target share against the values for its industry sector or better yet, for a direct competitor.

Investors who look for macroeconomic events as clues to find attractive target shares see possibilities stemming from the recent flooding in Australia.  Over the coming months and even years, much infrastructure in the area will need to be repaired or rebuilt.  Shares of building materials therefore are worth a look.  The following chart shows the P/B and the P/S ratio for two such companies, along with sector values for comparison:

Brickworks Ltd is Australia’s largest manufacturer of brick while Boral provides a wider variety of building materials ranging from concrete products to plasterboard.  On each of these valuation ratios, both would appear attractive to any investor shopping for shares undervalued by the market.  Both are extremely cheap when you look at how much you would pay for company assets and Boral’s P/S suggests the company generates more in sales than the current price of the shares.  Should you buy?

Definitely not without a little more homework.  First, newer investors might be troubled by the huge gap between these companies and sector performance on the P/S ratio.  In truth, sector comparisons can often be misleading because of the companies included within the sector.  Boral and Brickworks are both in the Industrial Goods Sector/General Building Materials Inventory.

Second, regardless of whether you are new to the wonderful world of share market investing or an investor looking to improve your returns, if you want to get good at this game, eventually you are going to have to get into reviewing actual financial statements and reading annual reports.  In the case of these two companies – especially Boral with a P/S under 1.0 – you want to look into when they recognise revenue.  

Next week we will use both those companies for a walk through of what to look for in a company’s financials.