How to use PE, PS and PB ratios to value a stock

In an earlier article, I discussed the traditional and “textbook” method of valuing a stock, along with a few tweaks to smooth out the inherent bumpiness 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 earnings, net assets, and sales.

There are roughly three statistical multiples that can be used in this type of analysis: the price-to-sales ratio (P/S), the price-to-book ratio (P/B), and the price-to-earnings ratio (P/B). E) ratio. They are all used the same way when doing a valuation, so let’s first describe the method and then talk a bit about when to use the three different multiples, and then go through an example.

The multiple method

Valuing a stock in a multiple way is easy to understand, but it takes some effort to get the parameters. In a nutshell, the goal here is to come up with a reasonable “target multiple” that you think the stock should reasonably trade given its growth prospects, competitive position, and so on. To come up with this “target multiple”, there are a few things to consider:

1) What is the average historical multiple of the stock (P/E ratio, P/S ratio, etc.)? You take a minimum period of 5 years 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 large is the deviation compared to the proportion under investigation, and why?

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

4) What are the future prospects for the share? If they are better than in the past, the “target multiple” can be set higher than historical norms. If they’re not that good, the “target multiple” should be lower (sometimes significantly lower). When thinking about future prospects, don’t forget to consider potential competition!

Once you’ve figured out a reasonable “target multiple”, the rest is pretty easy. First, take current year estimates for income and/or earnings and multiply the target multiple by that to get a target market cap. You then divide that by the number of shares, possibly adjusting for dilution based on past trends and announced share buyback programs. This gives you a “fair price” rating, of which you want to buy 20% or more for a margin of safety.

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

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 commonly used multiple. However, I would modify this to make the price to operating profit ratio instead, where operating profit in this case is defined as earnings before interest and tax (EBIT – including depreciation and amortization). The reason for this is to smooth out one-time events that skew earnings per share from time to time. P/EBIT works well for profitable companies with relatively stable revenue and margin levels. It *doesn’t work* at all for unprofitable companies and doesn’t work well for asset-based companies (banks, insurance companies) or heavily cyclical companies.

P/B ratio: The price-to-book ratio is most useful for asset-based businesses, especially banks and insurance companies. Earnings are often unpredictable due to interest rate differentials and are loaded with more assumptions than basic products and services companies when you look at vague accounting entries like loan loss provisions. However, assets such as deposits and loans are relatively stable (apart from 2008-2009), and so the book value is generally what they are valued at. On the other hand, book value doesn’t mean much to “new economy” companies, such as software and service companies, where the primary asset is the collective intellect of employees.

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P/S system: Price-to-sales ratio is a useful ratio across the board, but probably the most valuable for valuing currently unprofitable companies. These companies have no earnings to use the P/E, but comparing the P/S ratio to historical standards and competitors can help you get 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 an established company with an excellent competitive position in what has been a relatively stable industry, defense contracting. In addition, Lockheed has a long track record of profitability. We also know that the company is clearly not an asset-based company, so we go for the P/EBIT ratio.

Looking at the price and earnings data for the past 5 years (which requires some spreadsheet work), I find that Lockheed’s average P/EBIT ratio over that period was about 9.3. Now I look at the circumstances of the last 5 years and see that Lockheed operated with strong defense demand for several years in 2006 and 2007, followed by some significant political turmoil and market decline in 2008 and 2009, followed by a recovery of the market but problems with the important F-35 program early this year. Given the expected slow growth of defense spending in the near term, 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, it is quite easy to find the reasonable price:

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

Now I just apply my 8.8 multiples to $4.6 billion to get a target market cap of $40.5 billion.

Finally, we need to divide that by shares outstanding to get a price target. Lockheed currently has 381.9 million shares outstanding, but typically buys back 2-5% per year. Splitting the difference on this, I 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.

If I divide $40.5 billion by 378.18 million, I get a price target 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 looks undervalued. Using my minimum “margin of safety” of 20%, I would only consider buying Lockheed at stock prices of $85 and less.

Packing it

Of course, you can simply plug in the price to sales ratio or book value and do a similar multiple valuation with the right financials. This kind of inventory valuation makes a little more sense to most people and takes into account market-based factors such as the different ranges 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 significantly higher than historical market averages.