In one of the pieces I wrote recently, I pointed out a few of the important financial ratios that come handy when researching and analyzing stocks to buy. However, there are other “ratios” that help in stock selection; they are called market or price multiples.
What are market or price multiples?
Price multiples are the ratios of a stock’s market price expressed in relation to some measure of value per share of the stock. Price multiples are used for stock selection and valuation because they are based on the notion that one cannot judge whether a stock is overvalued, undervalued or fairly valued if one does not know what a share of the stock in question can buy in terms of assets, earnings or other measures of value.
The good thing about market multiples is that they are easy to use and easy to communicate and understand. In fact, a price or market multiple communicates, with a single number, the valuation relationship between a stock’s price and other familiar quantities like earnings, sales, or book value. Price multiples are calculated by dividing the price of a stock by a measure of value per share.
Price multiples make comparison among different stocks easy and possible. This concept is called “the method of comparable.” The method of comparable entails the use of a price multiple to evaluate whether an asset is relatively fairly valued, relatively overvalued or relatively undervalued when compared to a benchmark value of a multiple.
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For example, if you have two stocks, one with a price to sales (P/S) of 1 and another with a price to sales, P/S, of 1.6, if the two stocks are similar in terms of risk, profit margin, and even growth prospect, it becomes easy for the investor to conclude that the stock with a P/S of 1 is undervalued relative to the stock with a P/S of 1.6. The concept of comparable is underscored by the economic principle of one price. This principle denotes that two identical assets should sell for the same price, otherwise, one is over or undervalued relative to the other.
[READ MORE: Financial ratios you need for stock analysis]
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Commonly used price multiples
There are and could be a lot of price multiples to choose from, but the most commonly used ones are Price Earnings, (P/E), Price Sales (P/S), Price Book Value (P/BV) and Price to Cashflow ratios.
Price per share is the most popular valuation measure currently in use. To calculate P/E, you will need to know or calculate the Earnings per Share (EPS) of the stock in question. However, armed with the financial statement of the company whose stock you want to value or analyze, you will get the earnings on the income statement portion of the financial statement.
Then, looking at the capital and owners’ equity section of the balance sheet or the financial statement, you will most likely get information on the issued and/or outstanding number of shares. By dividing the net profit by the outstanding shares, you arrive at the EPS. Some financial statements come with the EPS (actual or diluted) already calculated.
In that case, by dividing the current price of the stock by the pre-calculated earnings per share, you get the price earnings ratio. For example, looking at the recently released Q2 financial statement of Cutix Plc, you will discover on page 3 “Results at a Glance” that the number of shares outstanding is 1,761,322 while the profit after tax is N141,282 (all in thousands), by dividing the profit before tax by the number of shares, you get the earnings per share of 8.02 kobo which compares favourably with the EPS number of 8 kobo provided on the financial statement. According to the same page on the financial statement, the price of Cutix Plc as at October 31, 2019, was N1.4, so by dividing that price by the EPS, you get a P/E ratio of 17.
Drawbacks of P/E Ratio
Though price earnings ratio is easy to calculate and use, it loses it economic meaning if the EPS is negative because a company ended the period in the red. Another drawback is that if a company’s management window dresses or distorts the earnings, EPS gets distorted and therefore, the comparability of P/E gets affected or even distorted as well.
Yet another drawback of the P/E ratio is that because it is based on past earnings per share (EPS), it may not be informative about the future and therefore not credible enough for valuation. To cure this particular drawback, analysts have come to use what they call leading P/E ratio rather than the trailing P/E ratio.
The difference between the two is that the trailing P/E ratio is backwards-looking while leading P/E ratio is forward-looking. In calculating leading P/E ratio, the current price of the stock of interest is divided by the expected earnings per share. In most cases, analysts arrive at leading EPS based on forecasted fundamentals of a company.
In the next piece of this article, I will be looking at Price to Book value as a stock valuation statistic.