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Market value ratios are a financial term used to calculate share price of a company’s stock. They are controlled by investors who can decide whether shares are under- or over-priced.
These calculations are not under the manager’s supervision, since investor relations offices have more knowledge and control on them. Their main target is to analyze the company’s performance from an investing point of view and understanding the fluctuations of share prices closely.
Privately-held entities are not subject to this type of ratios, since it is very difficult to assign a market value of their shares.
Formula For Market Value Ratios
There are several ways to calculate the market value ratios. This is a method used by investors to calculate the value of a business. It involves taking the stock’s price per share (also known as market value) and comparing it to the book value (also known as the shareholder’s equity).
The price to book value ratio, made simple would be: the number of time a businesses’ stock is trading for each share to the businesses’ book value per share. This helps investors to get an idea of the amount that shareholders are investing towards the business assets.
Market value = Number of outstanding shares * Market price per share
Interpretation Of Market Value Ratios
Market value mainly refers to trading and competition, since it assigns a price to company shares. This is the quoted price at the point of auctioning, showing the price for a company’s shares at the current market value. It may seem a bit complex, but it is a very common method to calculate the value of a business.
Many investors use it when deciding whether to buy or sell shares, since the market value can fluctuate. First the total number of shares outstanding must be estimated for the company.
This information is usually provided in the financial report, which should be available on their website. Then, the current price of the stock must be found, which is quite easy when looking up stock quotes.
Once these two values are determined, the stock price is multiplied with the number of shares outstanding, leading to the market value of equity.
If this seems a bit overwhelming, let’s take an example to make it simpler and clearer.
Imagine that you started investing in various companies that just entered the IT market. We already know that IT is a developing industry and they may become successful on a long term. The current share price is of $100 and they recently announced that they will launch a wireless printer. After analyzing the ratios the forecast says that their device will be very successful after launch, even though it is still in development process.
In six months the share price will increase to $2,000, which means that investors buying shares will be in profit. However, the business still needs to develop new devices to increase its value, which can be challenging due to competition. This is why these ratios offer temporary prices, depending on the fluctuation of the market prices and the company’s success.
Effects Of Market Value Ratios
Even though business owners and managers are not directly involved in this process, this ratio is very important to investors. They can decide upon purchasing shares or not, taking into consideration the company’s value on a long term.
Imagine that you heard a rumor about Pepsi launching a new product and you think this would be a good investment. You can easily use these ratios in deciding if purchasing a share will be profitable on the long run. Let’s say that the current share price now is of $50 and the forecast states that on the long term the new drink will be a hit.
In one week the price would rise up to $500 and you can sell this share, having a $450 profit. That sounds cool, right? Well, if you know how the market value fluctuates, you can even withdraw more money on the long run, as long as you are familiar to the company’s value.
Types of Market value ratios
There are several types of market value ratios, among which the most common are: price/earnings ratio, dividend yield, market value per share, book value per share and earnings per share.
Book value per share
Used as a benchmark to identify if the market value is lower or higher, used as a decision factor for selling or buying shares. This can be calculated as the stockholders’ equity aggregate amount, divided by outstanding shares quantity.
Book to Market = Book Value of Firm/Market Value of firm
This type of ratio is commonly used to understand if the shares are under- or over-priced compared to competitors’ ratios. To calculate this, the market price is divided by earnings per share.
Price/Earnings Ratio = Price per share/Earnings per share
This is one of the most important ratios for potential investors, since it shows the return on investment if they purchase the company’s shares at the current price. The dividend yield is shown as the total dividends that are paid during a full year, divided by the stock market value.
Dividend yield = Annual dividends per share/(Price per share
Market value per share
Even though it may seem a bit complicated, it is not. The market value per share divides the business market value to the total number of shares. Basically, this shows the market value assigned on each of the company’s stock shares.
Market value per share = Business market value/Total number of shares
Earnings per share
This ratio does not provide valid or meaningful information on the market price, but it can be used by investors when deriving a price for potential worthy shares. The earnings per share can be calculated as business reported earnings divided by total outstanding amount of shares.
Earnings per share = Total reported earnings/Number of shares outstanding
Advantages Of Market Value Ratios
Investors can receive many benefits if they are aware of how market value ratios are calculated. Here’s a list with most common advantages:
- Financial statements are easier to understand
- Allows comparisons between companies of different sizes
- Provides details about the market trends
- Highlights valuable information about the company’s value
- Users can simply analyze a company without having to go through full financial statements
Investors can count on these percentages when deciding about investing in a company on a short or long term. In addition, companies with low share prices but with high potential can increase their profitability with investors, leading to potential success in a short term.
Disadvantages Of Market Value Ratios
- Market structure is not stable in all industries and sectors
- Financial statistics may become unclear due to estimations
- Accounting of a company is not accurate reflected in these ratios
- Current prices depend most on previous prices and information
Due to the fact that current prices depend on previous trends, it is almost impossible to determine if the shares will be more profitable on a long-term. Let’s take a small car workshop that has been having very few customers in the past year and currently the price of their shares is low, but they are planning to adopt a new marketing strategy. If investors buy their shares but the company fails, then this investment will be a major loss for the market. Therefore, sometimes it is unclear if the market value ratios will provide real information about future prices.
Market value ratios offer valuable information from an investor’s point of view. However, they do not reflect the entire company’s financial status, which may become a major challenge. Overall, they are a powerful tool that provides insights about a company’s value on the market, establishing share prices depending on history, current prices, competitors share ratios and many more. For what is worth, next time you will be hearing these terms you will fully understand what they mean and how they are calculated.