Distance A 2.5 Year Old Should Be Able To Do How to Use P-E, P-S, and P-B Ratios to Value a Stock

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

In a previous article, I discussed the traditional and “textbook” method of valuing stocks, along with some modifications to smooth out the inherent deterioration in levels of cash flow. 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 earnings, net assets, and sales.

There are basically three statistical multiples that can be used in this type of analysis: the price-to-sales (P/S) ratio, price-to-book (P/B) ratio, and price-to-earnings (P/ E) ratio. All of them are used in the same way to make an estimate, so let’s first describe the method and then discuss a little about when to use the three different multiples, then go through an example.

The Multiple Base Method

Valuing a stock in a multiple way is simple to understand, but it takes some work to get the parameters. In summary, the goal here is to come up with a reasonable “target multiple” that you believe the stock should reasonably trade at, given growth prospects, competitive position, etc. To come up with this “target multiple”, there are a few things you should consider:

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

2) What are average multiples for competitors? How wide is the variance against the stock being researched, and why?

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

4) What are the future prospects for the stock? If they are better than in the past, the “target multiple” could be set higher than historical norms. If they are not that good, the “target multiple” should be lower (sometimes quite a bit lower). Don’t forget to consider potential competition when thinking about future prospects!

Once you’ve come up with a reasonable “target,” the rest is pretty easy. First, take current year estimates for revenue and/or income and multiply the target multiple against them to get a target market capitalization. Then you divide that by the share count, optionally adjusting it for dilution based on past trends and any announced share buyback programs. This gives you a “reasonable price” valuation that you want to buy 20% or less of for a margin of safety.

If this is confusing, the example later in the article should help clear things up.

When to Use the Different Multiples

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

P/E ratio: The P/E is probably the most common multiple to use. However, I would adjust this to be the price-to-operating income ratio instead, where operating income in this case is defined as earnings before interest and taxes (EBIT – includes depreciation and amortization). The reason for this is to smooth out one-time events that from time to time obscure the bottom line earnings per share value. P/EBIT works well for profitable companies with relatively stable levels of sales and margins. It *doesn’t* quite work for unprofitable companies, and doesn’t work well for asset-based firms (banks, insurance companies) or heavy cyclers.

P/B ratio: The price-to-book ratio is most useful for asset-based firms, especially banks and insurance companies. Earnings are often unpredictable due to interest rate spreads and are fraught with more assumptions than basic product and service firms when you consider such nebulous accounting items as loan loss provisions. However, assets such as deposits and loans are relatively stable (2008-09 aside), and so book value is generally what they are valued at. On the other hand, book value doesn’t mean much for “new economy” businesses like software and service companies, where the primary assets are the collective intellect of employees.

P/S ratio: Price-to-sales is a useful ratio in general, but probably most valuable for valuing currently unprofitable companies. These companies do not have earnings from which to use a P/E, but comparing a P/S ratio against historical norms and competitors could help give an idea of ​​a reasonable price for the stock.

Simple Example

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

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

Looking at the last 5 years of price and earnings data (which takes some spreadsheet work), I determine that Lockheed’s average P/EBIT ratio over that period was around 9.3. Now I consider the circumstances over the past 5 years and see that Lockheed experienced some strong defense demand years in 2006 and 2007, followed by some significant policy changes and a market downturn in 2008 and 2009, followed by a market rebound 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 conservatively theorize that 8.8 is probably a reasonable “target multiple” to use for this stock in the near term.

Once this multiple is determined, finding the acceptable price is quite easy:

2010 revenue estimate is $46.95 billion, which would be a 4% increase from 2009. Earnings per share estimate is 7.27, which would be a 6.5% decrease from 2009, and represents a 6% net margin. From these figures and empirical data, I estimate a 2010 EBIT of $4.46 billion (9.5% operating margin).

Now, I simply apply my 8.8 multiple to $4.6 billion to get a market cap target of $40.5 billion.

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

Dividing $40.5 billion by 378.18 million gives me a stock price target of approximately $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 looks undervalued. Using my minimum 20% “margin of safety”, I would only consider buying Lockheed at share prices of $85 and below.

Wrapping It Up

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

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