Article
If you have ever read any of the imancial media, you have been exposed to the
alphabet soup of the stock market; P/E, P/B, P/S, EV/EBIT, EV/EBITDA. These
abbreviations probably look familiar; each is known as a valuation multiple. They are
helpful when approximating the value of a stock, industry, or even an entire market.
What do these abbreviations mean?
Each multiple has a numerator that represents some measure of a company’s value.
In the examples above, the numerators “P” and “EV” stand for price and enterprise
value, respectively. All of the above multiples are written out fully at the end of the
article. For brevity, we will focus on the most common one: The P/E, or
Price-to-Eamings, ratio./p>
The P/E ratio tells us how many dollars investors are willing to pay for one dollar of
a company’s earnings over a specified time period. Let’s assume a share of XYZ
Company (XYZ) currently trades at $20 and has earnings per share of $2.
Investors are paying $10 for each dollar of XYZ’s earnings, or they are paying a
multiple of 10 on earnings.
The P/E ratio also varies depending on earnings reports and investors’ opinions.
However, a stock’s price doesn’t actually have to change for its P/E ratio to change. If
XYZ reports an earnings increase from $2 to $4 per share, but the stock price stays
at $20, its new P/E ratio is 5- The stock is now half as expensive in terms of earnings.
If XYZ reports new earnings of $1 per share, and the price stays at $20, its new P/E
ratio is 20. The stock is now twice as expensive based on its earnings.
I understand what multiples are, but how do I apply them?
Multiples are used in relative valuation, which means that multiples are useless
without another value to use for reference. Some common multiples used for
comparisons are market averages, industry averages, and a company’s own historical
average. We can’t make a productive decision knowing just that XYZ has a P/E of 10
because we don’t have another value to compare to 10. If XYZ’s multiple is lower
than the comparison multiple, XYZ is considered relatively undervalued. If XYZ’s
multiple is higher than the comparison multiple, XYZ is considered relatively
overvalued.
If XYZ has a P/E of 10 and the S&P 500 has a P/E of 15, we know that XYZ is
undervalued relative to the S&P 500 based on earnings. Ifwe know that XYZ has a
P/E of IO and the other companies in XYZ’s industry have a P/E of 5, we know that
XYZ is overvalued relative to its industry, according to this metric. If XYZ has a P/E
of IO and the historical P/E for XYZ is IO, we know that XYZ is fairly valued relative
to its own historical value in terms of earnings.
Are there any caveats for using multiples?
Multiples can be misleading on any number of occasions. In one scenario, the
denominator of your multiple could be temporarily over- or understated. For
example, XYZ could be trading at $20 on $2 of earnings, for a P/E of 10. XYZ
announces $4 of earnings, but continues to trade at $20 for a P/E of 5- XYZ appears
undervalued. However, when you look through XYZ’s financial statements, you find
out that for the first time in company history, XYZ sold a plant it uses in production.
The gain on the sale of this plant increased earnings by $2 this period. This
one-time event of the plant sale explains the $2 increase in earnings and the
corresponding decrease in P/E. Thus, XYZ likely isn’t undervalued.
Many industries use the P/E. For some, however, the P/E is not the preferred ratio.
Different accounting treatment for banks makes the P/B ratio the preferred ratio.
When using valuation multiples, be sure you are using the correct multiple for your
industry. Remember, valuation multiples provide an approximation of value, not an
exact value.
