Equity Investments - Using Price Multiples

Advantages of the ratios are as follows:

Price-to-Earnings (P/E)

  • Easy to use
  • Most commonly used measure of valuation
  • Studies have indicated a strong correlation to long-term returns.

Price-to-Book Value (P/BV)

  • Tends to be a stable valuations metric because balance sheets do not fluctuate much quarter-to-quarter.
  • Can be used as a valuation metric even when firms report an EPS loss.
  • Good metric to value firms in distress

Price-to-Sales (P/S)

  • Sales tend to be a realistic number and are not influenced as heavily by accounting issues.
  • Good metric to value firms in distress.
  • Can be used as a valuation metric when firms report a loss.

Price-to- Cash Flow (P/CF)

  • Cash flow is a truer metric of a company's results in comparison to earnings.
  • It is more difficult for managements to manipulate cash flow - tends to be less volatile than earnings.
  • Studies have indicated that it is a reliable metric over the longer-term.

Drawbacks for each multiple are as follows:

Price-to-Earnings (P/E)

  • Cannot be used for firms when they report a loss in earnings.
  • Earnings can be volatile given various inputs.
  • Earnings are more easily manipulated by managements.

Price-to-Book Value (P/BV)

  • Does not take into account the relative asset size when comparing firms.
  • Accounting metrics can skew the results.
  • Book value is not an accurate measure of actual market value.

Price-to-Sales (P/S)

  • Sales do not always translate to profits which can leave out the cost component.
  • Difficult to value companies with different cost structures.
  • Accounting issues related to revenue recognition can still alter sales.

Price-to- Cash Flow (P/CF)

  • Some items are not included, such as non-cash revenue.

Using the following data on Newco and Oldco, determine each company's P/E, P/BV, P/S and P/CF ratios and then interpret the results.

Data for Newco and Oldco

Answer:

Given the above results, Newco appears to be undervalued relative to Oldco on the basis of the P/E ratio. The two companies appear to be fairly valued on a relative basis with respect to the P/S ratio. Based on the B/V and P/CF ratios, Oldco appears to be undervalued relative to Newco.

Conclusion
Within this section we've discussed the top-down approach of security valuation, the Dividend Discount Model (DDM), the various methods of stock market, industry, and company analysis, and technical analysis.

In the Fixed Income section we will learn bond basics.

Introduction
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