How to Use P-E, P-S, and P-B Ratios to Value a Stock

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In a previous article, I discussed the traditional and “manual” method of valuing a stock, as well as some modifications to smooth out the fluctuations inherent in cash flow levels. In this article, we’ll look at another common way to value a stock, using statistical multiples of a company’s financial measures, such as profits, net assets, and sales.

There are basically three multiple statistics that can be used in this type of analysis: Price to Sales Ratio (P / S), Price to Book Ratio (P / B), and Price to Earnings (P / E) Ratio. . All of them are used in the same way to make an assessment, so let’s first describe the method, then discuss a bit about when to use the three different multiples, and then look at an example.

The multiple basis method

Valuing a stock in multiple ways is easy to understand, but requires some work to get the parameters. In a nutshell, the object here is to find a reasonable “target multiple” at which you think the stock should reasonably trade, taking into account growth prospects, competitive position, etc. To arrive at this “multiple target”, you must take into account a few elements:

1) What is the stock’s average historical multiple (P / E ratio, P / S ratio, etc.)? You should take at least a 5 year period, and preferably 10 years. This gives you an idea of ​​the multiple of the bullish and bearish markets.

2) What are the multiple means for competitors? How big is the deviation from the stock under investigation, and why?

3) Is the range of high and low values ​​very wide or very narrow?

4) What are the future prospects of the stock? If they are better than in the past, the “target multiple” could be set higher than historical norms. If they are not as good, the “target multiple” should be lower (sometimes significantly lower). Remember to take potential competition into account when thinking about the prospects for the future!

Once you’ve found a reasonable “target multiple”, the rest is pretty easy. First, take the current year’s income and / or profit estimates and multiply the target multiple against them to get a target market cap. Then you divide that by the number of shares, possibly adjusting it for dilution based on past trends and any announced share buyback programs. This gives you a “reasonably priced” valuation, from which you want to buy 20% or more below for a margin of safety.

If this is confusing, the example later in the article should help clarify matters.

When to use the different multiples

Each of the different multiples has its advantage in certain situations:

P / E ratio: P / E is probably the most common multiple to use. However, I would rather adjust that to be the price / operating profit ratio, where operating profit in this case is defined as earnings before interest and taxes (EBIT – including depreciation and l ‘amortization). The reason for this is to smooth out one-off events that from time to time skew the net earnings per share. P / EBIT works well for profitable businesses with relatively stable levels of sales and margins. It * doesn’t * work at all for unprofitable businesses, and doesn’t work well for asset-based businesses (banks, insurance companies) or heavy cyclicals.

P / B ratio: The price-to-book ratio is particularly useful for asset-based businesses, especially banks and insurance companies. Profits are often unpredictable due to interest spreads and are full of more assumptions than basic goods and services companies when you consider such nebulous accounting elements as loan loss allowances. However, assets such as deposits and loans are relatively stable (apart from 2008-09), and so it is usually on the book value that they are valued. On the other hand, book value doesn’t mean much to “new economy” companies like software and service companies, where the primary asset is the collective intellect of the employees.

P / S ratio: The price / sales ratio is a useful ratio at all levels, but probably the most valuable in assessing currently unprofitable businesses. These companies have no profit from which to use the P / E, but comparing the P / S ratio to historical standards and to competitors could help give an idea of ​​a reasonable price for the stock.

A simple example

To illustrate, let’s look at Lockheed Martin (LMT).

By doing some basic research, we know that Lockheed Martin is a well established company with an excellent competitive position in what has been a relatively stable industry, defense contracts. In addition, Lockheed has a long history of profitability. We also know that the business is obviously not an asset-based business, so we’re going to use the P / EBIT ratio.

Looking at the price and earnings data for the past 5 years (which requires some spreadsheet work), I determine that Lockheed’s average P / EBIT ratio over this period has been around 9.3. Now I look at the circumstances over the past 5 years and see that Lockheed went through a few years of strong defense demand in 2006 and 2007, followed by significant political upheaval and a bear market in 2008 and 2009, followed by a rebound in the market but problems with the important F-35 program at the beginning of this year. Given the expected slow near-term growth in Defense Department spending, I think cautiously that 8.8 is probably a reasonable “target multiple” to use for this short-term stock.

Once this multiple has been determined, finding the reasonable price is quite easy:

The 2010 revenue estimate is $ 46.95 billion, which would represent a 4% increase over 2009. The earnings per share estimate is 7.27, which would represent a decrease of 6.5% compared to 2009, and represents a net margin of 6%. From these figures and empirical data, I estimate a 2010 EBIT of 4.46 billion dollars (9.5% operating margin).

Now I’m just applying my multiple of $ 8.8 billion to $ 4.6 billion to get a target market cap of $ 40.5 billion.

Finally, we need to divide this by the outstanding shares to get a target price. Lockheed currently has 381.9 million shares outstanding, but typically repurchases 2-5% per annum. I’m going to divide the difference on this and assume that the number of shares will decrease by 2.5% this year, leaving a count of 379.18 million at the end of the year.

Dividing $ 40.5 billion by $ 378.18 million gives me a target price of about $ 107. Interestingly, this is close to the discounted free cash flow valuation of $ 109. So, in both cases, I used reasonable estimates and determined that the stock appears undervalued. Using my minimum 20% “safety margin”, I would only consider buying Lockheed at stock prices of $ 85 and below.

To wrap up

Obviously, you can easily insert the price-to-sales or price-to-book ratio, and using the appropriate financial values, perform a similar multiple valuation. This type of stock valuation makes a bit more sense for most people and takes into account market-based factors, such as different ranges of values ​​for different industries. However, one must be careful and consider how the future may differ from the past when estimating a “target multiple”. Use your head and try to avoid using multiples that are significantly higher than historical market averages.



Source by Steven D Alexander

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