Valuation Multiples
Valuation Multiples
Valuation Multiples
Meaning: P/E ratio relates the market price of company’s stock to its earnings. This ratio is
very popular in the investment community. Earnings power, as measure by EPS, is the
primary determinant of investment value.
Computation:
• P/E ratio = (Market price per share / Earnings per share)
Versions of the P/E ratio
• Trailing P/E ratio
• Leading P/E ratio
• The difference between the two P/Es as mentioned above is how earnings (the
denominator) are computed.
• Trailing P/E uses earnings over the most recent 12 months in the denominator.
• Trailing P/E = Market Price Per Share / EPS over previous 12 months
• Leading P/E ratio, also termed as forward or prospective P/E, uses next year’s
expected earnings.
• Leading P/E = Market Price Per Share / Forecasted EPS over next 12 months
• Trailing P/E ratio is not useful for forecasting and valuation if the firm’s business has
changed. (For example, Firm A might have acquired firm B, then P/Es of firms A in
the current year cannot be compared with the previous year).
• Leading P/E may not be relevant if earnings are sufficiently volatile so that next
year’s earnings are not forecastable with any degree of accuracy.
Interpretation:
• Some analysts argue that stocks with low P/E ratio might be undervalued and stocks
with high P/E ratio might be overvalued. This is the perception of “value investors”.
Value investors short-list the securities that are undervalued in the market based on
low P/E multiplies and then they would many other factors before buying the stocks.
• The opposite view for the above said argument is proposed by “Growth investors”.
Growth investors argue that stocks with high P/E are more likely to have higher
growth opportunities, and hence investors are paying premium for these growth
opportunities.
• At times, P/E of all firms may decrease due to two reasons.
- First, if there is any anticipation of increase in interest rates
- Second, reduction of corporate profits due to general economic conditions.
• P/E ratio can be meaningless if earnings become negative.
• Interpretation of P/Es may become difficult if earnings are volatile.
1
• Sometimes, P/Es across firms cannot be compared if two firms in the same industry
follow different accounting methods, such as depreciation accounting, inventory
valuation, etc.
P/B ratio
Meaning: P/B ratio relates the market price of company’s stock to its book value per share.
Computation:
• P/B ratio = Market price per share / Book value per share
Book value per share = (Net worth / No of equity shares)
Interpretation:
• Firms with higher P/B ratios are more likely to have higher growth opportunities.
• EPS becomes negative whenever the firm reports losses. However, the book value can
be positive even when the firm reports losses. In this scenario, P/B ratio is more
useful than P/E ratio.
• Book value is less volatile than the EPS.
• P/Bs do not reflect the value of intangible economic assets, such as human capital.
• P/Bs can be misleading when there are significant differences in the asset size of the
firms under consideration because in some cases the firm’s business model dictates
the size of its asset base. A firm that outsources its production will have fewer assets,
lower book value, and a higher P/B ratio than an otherwise similar firm in the same
industry that doesn’t outsource.
P/S ratio
Meaning: P/S ratio measures the relationship between the market price of company’s stock
and its net sales per share.
Computation: P/S ratio = Market price per share / Net sales per share
Interpretation:
• P/S is meaningful even for distressed firms, since sales revenue is always positive.
This is not the case for P/E or P/B ratios, which can be negative.
• Sales revenue is less likely to manipulate or distort as EPS and book value, which are
significantly affected by accounting conventions.
• P/S ratios are particularly appropriate for valuing stocks in mature or cyclical
industries and start-up companies with no record of earnings.
2
• High growth in sales does not necessarily indicate high operating profits as measured
by earnings and cash flows.
• P/S ratios do not capture differences in cost structure across companies.
P/CF ratio
Meaning: P/CF ratio measures the relationship between the market price of company’s stock
and its cash flows per share.
Computation:
P/CF ratio = Market price per share / Cash flows per share.
Interpretation:
• Cash flow is harder for managers to manipulate than earnings.
• Price to cash flows is more stable than price to earnings.