Apart from the dividend discount models, many analysts use price multiples for valuing the stocks. There are many reasons for using the price multiples. One, the DDM models can be very sensitive to the inputs such as the growth rate. Two, price multiples are very easy to calculate and can be quickly used for comparing stocks within a sector. Usually an analyst will compare the price multiple for a stock with a benchmark value based on an index or industry group.
There are four commonly used price multiples:
- Price to Earnings (P/E): Stock price divided by the earnings per share.
- Price to Cash flow (P/CF): Stock price divided by the cash flow per share. The cash flow could be operating cash flow or free cash flow.
- Price to Sales (P/S): Stock price divided by sales per share.
- Price to Book Value (P/BV): Stock price divided by book value per share.
Price multiples can be used for equity valuation in two ways: price multiples based on comparables and price multiples based on fundamentals.
While using price multiples based on comparables, the price multiple is calculated based on the actual market price of the stock and is compared to a benchmark to evaluate whether the stock is undervalued, overvalued or fairly valued. This is the most commonly used form of price multiples. The idea behind this is that most stocks within the same industry or peer group should be trading at comparable prices.
When using price multiples based on fundamentals, the price multiple is calculated based on the forecasted value of the stock calculated using a valuation model such as DDM.
In this method, an analyst will first calculate the fair value of a stock using a valuation model, for example, the Constant Dividend Discount Model. Then he will divide this fair value with one of the stock’s fundamental such as earnings, sales, book value, or cash flow to arrive at the price multiple.
A price multiple calculated using fundamentals is also called justified multiple. For example, if P/E ratio is calculated with price derived using dividend discount model, then it will be referred to as justified P/E.
Since such P/E is calculated using the expected value of the stock, it is also referred to as leading P/E, as compared to trailing P/E where past data is used.
The justified P/E is the P/E at which the stock should be trading based on its fundamentals. If the P/E based on the market price is different from justified P/E it signals that the stock is undervalued or overvalued. For example, if the justified P/E is 8, and the actual P/E based on market price is 12, then the stock is overvalued, and vice verse.