How to use PE, PS and PB ratios to evaluate stocks

In a previous article, I discussed the traditional and “improvised” method of valuing stocks, as well as several modifications to smooth out the inherent inequality of cash flow levels. In this article, we will look at another common way to value stocks using statistical multiples of a company’s financial metrics such as earnings, net assets and sales.

There are basically three statistical multiples that can be used in this type of analysis: price-to-sales ratio (P / S), price-to-book ratio (P / B) and cost-to-earnings (P / E) ratio. They are all used equally in evaluation, so let’s first describe the method and then discuss a bit if using three different multiples, and then consider an example.

Multiple method

Evaluating stocks in several ways is easy to understand, but requires some work to obtain parameters. In short, the task here is to come up with a reasonable “target multiple”, which, in your opinion, should be justified, given the growth prospects, competitive position and so on. To come up with this “target multiplier”, there are a few things to keep in mind:

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

2) What are multiples for competitors? How wide is the variance regarding the stocks being investigated, and why?

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

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

Once you’ve come up with a clever “target multiple,” everything else is pretty easy. First, take an estimate of revenue and / or revenue for the current year and multiply the target multiplicity by them to obtain the target market capitalization. You then divide this by the number of shares, optionally adjusting it for dilution based on past trends and any announced share repurchase programs. This gives you a “reasonable price” estimate from which you want to buy 20% or more for a margin of safety.

If this is confusing, the example further in the article should help sort it out.

If you use different multiples

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

P / E ratio: P / E is probably the most common plural to use. However, I would like to adjust this to be the ratio of price to operating profit instead, where operating profit in this case is defined as profit before interest and taxes (EBIT – includes depreciation and amortization). The reason for this is the smoothing of one-time events that from time to time distort earnings per share. P / EBIT works well for profitable companies with a relatively stable level of sales and profitability. This * does * not work at all for unprofitable companies and works poorly for asset-based companies (banks, insurance companies) or heavy cyclical companies.

P / B ratio: The cost-to-book ratio is most useful for asset-based companies, especially banks and insurance companies. Revenues are often unpredictable due to interest rate spreads and are full of more assumptions than firms with basic products and services given such vague accounting elements as loan loss provisions. However, assets such as deposits and loans are relatively stable (except in 2008-2009), so the book value is usually what they are valued at. On the other hand, the book value is not of great importance for the “new economy” enterprises, such as software and service firms, where the main asset is the collective intelligence of employees.

P / S ratio: The price-to-sales ratio is a useful attitude towards everyone, but probably the most valuable for assessing currently unprofitable companies. These firms do not have earnings from which to use P / E, but comparing the P / S ratio with historical norms and competitors can help give an idea of ​​a reasonable share price.

A simple example

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

After doing some basic research, we know that Lockheed Martin is a well-known firm with an excellent competitive position in a relatively stable industry, defense contracts. In addition, Lockheed has a long track record of profitability. We also know that the company is obviously not based on assets, so we will use a P / EBIT ratio.

Looking at price and profit data for the last 5 years (which requires some work with tables), I determined that the average P / EBIT Lockheed ratio for this period was approximately 9.3. I now look at the circumstances of the last 5 years and see that Lockheed experienced several years of strong defense demand in 2006 and 2007, followed by significant political shifts and market downturns in 2008 and 2009 and then a market rebound, but problems with an important program The F-35 earlier this year. Given the Defense Department’s expected slow growth in the short term, I conservatively assume that 8.8 is probably a reasonable “target multiple” to use for this stock in the near future.

Once this is a multiple determined, finding a reasonable price is pretty easy:

The estimated profit in 2010 is $ 46.95 billion, which will be 4% more than in 2009. Estimates of earnings per share are 7.27, which will be 6.5% less than in 2009, and is 6% of net margin. Based on these figures and empirical data, I estimate profit in 2010 at $ 4.46 billion (operating margin of 9.5%).

Now I’m just applying my multiple of $ 8.8 to $ 4.6 billion to get a target market capitalization of $ 40.5 billion.

Finally, we need to divide this by the stock in circulation to get the target stock price. Lockheed currently has 381.9 million shares outstanding, but typically repurchases 2-5% per annum. I will divide the difference by this and assume that the number of shares will fall by 2.5% this year, leaving 379.18 million at the end of the year.

Dividing $ 40.5 billion by $ 378.18 million gives me a target share price of about $ 107. Interestingly, this is close to the discounted estimate of free cash flow of $ 109. So in both cases, I used reasonable estimates and determined that the stocks looked undervalued. Using my minimum 20% “strength margin,” I would consider buying a Lockheed at a stock price of $ 85 or less.

Wrap it up

Obviously, you can easily connect the price-to-sales ratio or the price to the book and, using appropriate financial values, make a similar estimate based on several. This kind of stock valuation makes a little more sense to most people and takes into account market factors such as different different ranges for different industries. However, when assessing the “target multiple” must be careful and consider how the future may differ from the past. Use your head and try to avoid using multiples that are much higher than historical market averages.