Capitalization Ratio

Definition

The term capitalization ratio refers to a calculation that allows the investor-analyst to understand the potential rate of return for a common stock. The capitalization ratio is the inverse of the price to earnings ratio.

Calculation

Capitalization Ratio = Earnings per Share / Price of Common Stock

Where:

  • The earnings per share is normally stated on a fully-diluted basis, which means the value used in the denominator of this metric represents all possible scenarios that can impact the number of shares of common stock outstanding. This can include stock options held by employees as part of the company's incentive compensation program, stock warrants, and any debt that can be converted to common stock. In the same way, earnings should not include the effect of extraordinary items.
  • The price of common stock is the current market price of the security.

Explanation

Market performance measures allow the investor-analyst to understand the company's ability to achieve their high level business profitability objectives. This is usually assessed by examining metrics such as insider transactions, capture ratios, enterprise value, capitalization rates and price to earnings ratios. Market performance metrics provide analysts with a way to determine if a company is going to successfully execute their business plan. One of the ways to estimate the potential return on a common stock is by calculating its capitalization ratio.

When an investor-analyst evaluates the purchase of common stock to hold in their portfolio, one of the metrics to consider is the capitalization ratio. This metric is the inverse of the price to earnings ratio (P/E ratio) and is calculated by dividing fully diluted earnings per share by the current market price of the security. So if the earnings of a company is $1.00 per share and the current market price of the stock is $20.00, the potential return on investment is $1.00 / $20.00, or 5.0%. Using these same values, the price to earnings ratio would be stated as $20.00 / $1.00, or 20.0.

While an investor evaluates the purchase of a common stock, they need to be acutely aware of the implications of this metric. For example, if the market believes a company has tremendous growth potential, its P/E ratio can be 50 or higher. The short-term implication is the stock is providing a return of 1 / 50, or 2.0%. Another way to look at this metric is by evaluating the historical returns of common stocks, which is around 8%. The implication is an average P/E ratio for the entire stock market would be 1 / 8%, or 12.5.

Related Terms

revenue to stock price ratiopurchase discounts ratio, stock options to common shares ratio