Price Multiples: A Primer on Application of Relative Valuation Methods
Price multiples are widely used in financial world for comparative analysis of equities. It provides a quick reference to judge the valuation of the stock with respect to other available options. The valuation could be in terms of measure of earning, sales, cash flow or book value of shares. All these different measures create the confusion in the mind of analyst to choose the appropriate ratio to be used for valuing a stock as different sectors have different attributes and correct valuation techniques should be applied.
This is the most commonly used measure in the valuation world, as earning per share (EPS) is regarded as the main driver of stock value. On the long run the P/E differences eventually track the stock performance and its appeal is from the fact of ease of calculation.
Though it is very widely used tool but it is subjected to the discretion of accounting policies being adopted by the management that would destroy the sanctity of comparability. The major impediment of this ratio is its non-applicability for a negative earning company and since earnings are by nature most volatile so it sometimes produces erratic results.
P/E ratios are denoted in two ways:
Trailing P/E Ratio = Market Cap of stock / Last year earning = MPS/ Last Year EPS
Forward /Leading P/E Ratio = Market Cap of stock / Forecasted this year earning = MPS/ Forecasted this Year EPS
The Trailing P/E ratio would be meaningless if the company has done some serious corporate actions (mergers, acquisitions, asset sales, write downs) last year.
Similarly for Leading P/E, if the company’s earnings are volatile in nature the forecasting becomes difficult with any surety.
Book value being a cumulative amount is generally positive (if not sustaining huge losses for few years, severely bankrupt) even when the earnings are negative, so it could be used in places where P/E can’t be.
Book value is more stable than earnings and could be used for stocks with fluctuating earnings.
This measure is particularly suited for companies holding liquid assets especially Banks, Insurance companies, NBFCs, etc. It is also very useful for valuing companies expected to go out of business as it deals with the book value of net assets.
P/B ratio can’t be used in comparing two companies who have different models of asset holding due to management decisions. Some might go for building in-house competencies hence bloating asset value whereas some might follow asset light model with outsourcing many of the activities.
Different accounting standards adopted also may give erroneous results while comparing as some costs might be expensed in some companies while the same being capitalized by others. With US GAAP and IFRS evolving as two major global standards the aberrations due to these are now diminishing.
In an inflationary economy / developing economy the Book Value of assets doesn’t denote the true value of investments and is understated. This makes it more difficult to apply while comparing.
P/B ratio is defined as:
P/B Ratio = Market cap/ Book value of equity = MPS/Book value per share
Book value of equity is calculated as: Common equity = (Total assets – Total liabilities) – Preferred stock (if any)
Though this measure has many advantages, it should be calibrated for making the comparisons meaningful. Especially we need to make adjustments to firms that follow different inventory evaluation method.
Also finance companies have many off-balance sheet items to take advantage of taxations and report a healthy picture, so an analyst should be diligent and standardize the items before comparing.
Price to Sales ratio could be used in all cases as sales would definitely be a positive number. It is also less manipulated than the other figures (though some sales pursuing to shore up the figures at the end happens, still it can’t be done on a larger scale).
This could even be used for distressed firms and the ratio is less volatile than the other two described above.
P/S ratios are very apt to be used in start-up companies as otherwise the other ratios will give meaningless results.
This is the least used ratio among its siblings though it gives quite decent results even for mature industries.
P/S Ratio is defined as:
P/S ratio= Market cap/Total sales = MPS/Sales per share
This ratio doesn’t give the analyst a true picture of the bottom line or the health of the organization as high growth in sales might be at the cost of shrinking margins. So though this ratio will value the firm favorably for high sales achieved but risks a firm with higher margins and lower sales to be valued adversely.
It is advised that this ratio be used in conjunction with valuation parameters.