Demystifying Valuation: A Primer for Investors

Zach Diaz Dec 05, 2023
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When analyzing publicly traded stocks, there are numerous methodologies that can be used to valuate them, but one of the most common and applicable approaches is through relative valuation or ‘multiples’. Multiples are essentially a financial ratio calculated by dividing the market or estimated value of an asset by a specific item on the financial statements. Hence, multiples come in many forms, but three of the most widely used multiples in equity analysis are price-to-earnings, price-to-sales, and price-to-book.

Price-to-Earnings (P/E)

The price-to-earnings ratio is typically the first thought that pops into investors’ minds when hearing about valuation multiples. The calculation for P/E is the current price per share divided by its earnings-per-share (EPS).

Essentially what P/E tells an investor is how much they are paying or need to be willing to pay per dollar of the company’s earnings. This means that a higher P/E is typically less attractive than a lower P/E, because as an investor you would typically want to pay a cheaper price when deciding between two options. P/E does have limitations though, if a stock’s EPS is negative, in which case an investor will be unable to get a value.

Price-to-sales (P/S) and Price-to-Book (P/B)

Two other ratios, being P/S and P/B, are useful for further comparison or when P/E is inapplicable due to the limitations surrounding earnings and other industry specific factors. The calculation for P/S takes a company’s market capitalization (number of shares outstanding x share price) and divides by its total revenue. The interpretation of P/S is quite similar to P/E as it tells investors how much the market values every dollar of a company’s sales. Similarly, to P/E investors typically want to target a low P/S ratio.

P/B on the other hand measures price-to-book value of equity. The calculation for P/B is the current market cap divided by the book value of equity. To derive book value of equity, investors must look to the balance sheet to determine the difference between assets minus liabilities. P/B has a slightly different interpretation, as it focusses more internally, on how the company is being priced by the market relative to its assets. A P/B ratio of less than 1.0 indicates that the company is being valued less than its equity and can be an indicator of undervaluation. A P/B ratio of 1.0, indicates that the stock is being priced at a fair value compared to the book value of the company.

Although P/E is typically the most widely utilized of the three ratios, P/S and P/B display some advantages. For example, if an investor is analyzing a high growth company that is operating at a loss or has recently suffered a setback in earnings, P/S can provide a better insight. P/B can also be useful in identifying high growth stocks that are severely undervalued due to the company’s early stages. P/B can also be useful in analyzing capital intensive industries such as real estate and energy where earnings are not the primary indicator of current or future success.

Utilizing Valuation Multiples and Takeaways

Now that we understand the basis for these valuation multiples, we can examine their utilization. Over and undervaluation is the most common use, as we can identify which side companies lie on by comparing to their industry and peers.

Another key element for P/E and P/S is deciding to look at trailing or forward measures. Trailing looks at how a company is valued based off the previous twelve months, while forward looks at the next twelve months. Forward measures typically have greater significance in stock analysis because investors are more concerned about future growth, but there are still useful insights that can be drawn from analyzing both concurrently.

Valuation multiples are a broad topic, but the aim of this article was to provide an overview into a few key ones. It is always good to consider multiple metrics when valuating an investment decision and additionally compare these to the industry and peers. Doing this ensures an understanding behind the value of what is being paid for and how it stacks up to other opportunities.

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