Most investors do not invest directly in the company i.e. they are not promoters of the company. Rather they invest in the company through the stock market. This means that they buy shares at a certain value and make a profit only when the price of the shares go up or they get regular dividends from their investments or a combination of both. This is the reason why investors are particularly interested in how the current share price of the company compares with its fundamentals. Market related ratios help investors use the numbers stated on the balance sheet to better their understanding of the same.
What Are Market Related Ratios?
Market related ratios compare the current stock price of the company which is being quoted on the stock exchange to various balance sheet, income statement and cash flow items. One component of all market related ratios is the current stock price.
Why the Stock Price Is Not the Actual Price?
It is important to understand that the quoted stock price is not the actual price of the share. The stock price just means the price that you are paying to obtain a fraction of the earnings of the company. So if you are buying 1 share at USD 10 and there are 100 shares, you own 1% of the company. This 1% ownership means you get 1% of the profit, which in our case is let’s say USD 2. Hence the actual price you are paying is USD 10 to buy a future recurring profit stream of USD 2 per share. Of course these profits subject to risks and that is what makes investing challenging.
Since the quoted stock price is not the actual price, market related ratios offer a window to analysts using which they can gauge whether a stock is over or under valued and then act accordingly.
How Do These Ratios Help In Valuation?
- Expose the Fundamentals: Unless the market is being completely driven by sentiments at a given point of time, market related ratios expose the fundamentals of the company in question. This is because prices in the stock market are generally a reflection of the long term value that investors see in the company.
- Makes It Easier to Maintain Changes in the Stock Price: Investors can compare changes in fundamentals to changes in stock prices to see whether or not the share is fairly valued. Market related ratios have been long used by savvy investors to make successful long term investments.
