Price Multiples

The concept of price multiples refers to ratios that compare a company’s share price with a financial metric, allowing for an assessment of the stock’s relative value. These ratios are commonly used by practitioners for screening purposes, identifying stocks for potential purchase or sale based on specified threshold values. Additionally, price multiples are useful for evaluating a group or sector of stocks, with lower ratios often indicating more attractively valued securities.

Key price multiples utilized by security analysts include:

• Price-to-Earnings Ratio (P/E): This is the ratio of the stock price to earnings per share (EPS). The P/E ratio is widely cited by the media and used by analysts and investors. Historical research has shown that stocks with low P/E ratios have been associated with higher future returns.
• Price-to-Book Ratio (P/B): This ratio compares the stock price to the book value per share. There is substantial evidence indicating that lower P/B ratios are correlated with higher future returns.
• Price-to-Sales Ratio (P/S): This ratio is calculated as the stock price divided by sales per share. Research has demonstrated that a low P/S multiple is an effective predictor of future returns.
• Price-to-Cash-Flow Ratio (P/CF): This ratio compares the stock price to a per-share measure of cash flow, such as free cash flow (FCF) or operating cash flow (OCF).

One criticism of price multiples is that they do not account for future prospects if based on trailing or current values. To address this, practitioners often forecast fundamental values or use forward price multiples, which can provide a more forward-looking perspective.

In addition to these traditional price multiples, analysts should be familiar with industry-specific ratios and other metrics used to analyze business performance and financial condition based on financial statement data.

Linking Price Multiples, Present Value Models and Fundamentals

Price multiples can be linked to fundamental analysis through discounted cash flow models, such as the Gordon growth model. For example, the justified forward P/E ratio can be derived using the following relationship:

\[P_0 = \frac{D_1}{r – g}\]

By dividing both sides of the equation by the forecast for next year’s earnings, \(E_1\), we obtain the justified forward P/E:

\[\frac{P_0}{E_1} = \frac{\frac{D_1}{E_1}}{r – g} = \frac{p}{r – g}\]

This equation indicates that the P/E ratio is inversely related to the required rate of return and positively related to the growth rate. However, the relationship between the P/E ratio and the payout ratio (p) may not be straightforward, as a higher payout ratio can imply a slower growth rate due to lower earnings retention for reinvestment.

Question

Which one of the following statements is most accurate?

1. A high price-to-book ratio usually implies the company is in financial turmoil.
2.  A low price-to-earnings ratio can imply the company is undervalued or has higher potential future returns, but it does not necessarily mean high growth prospects.
3. If a companys price to sales ratio increases from its level one year ago, its price to earnings ratio will also increase..

Solution

The correct answer is B.

A low price to earnings ratio can reflect undervaluation, or it can reflect that investors demand a higher expected return because they perceive higher risk or weaker prospects. A low price to earnings ratio alone does not guarantee high future growth.

A is incorrect. A high price to book ratio is more often linked to strong expected profitability, strong growth expectations, or valuable intangible assets that are not fully captured in book value. Financial distress is more commonly associated with a low price to book ratio.

C is incorrect. Price to sales can rise while price to earnings falls if profit margins improve. Example: if price stays at 100, sales rises from 50 to 60, and net income rises from 5 to 12, then price to sales rises from 2.0 to 1.67 which actually falls, so instead flip it: let price rise to 120, sales stay 60, net income jumps to 12. Price to sales rises from 2.0 to 2.0, while price to earnings falls from 20 to 10. The key point is that changes in profit margin can break any guaranteed link between the two ratios