Price Multiples

Price multiples that are used by security analysts include the following:

  • Price-to-earnings ratio (P/E): Stock price per share divided by earnings per share. Arguably the most referenced price multiple, evidence suggests low P/E multiple stocks tend to generate higher future returns.
  • Price-to-book ratio (P/B): Stock price per share divided by book value per share. Evidence suggests P/B multiples are inversely related to future rates of return.
  • Price-to-sales ratio (P/S): Stock price per share divided by sales. Evidence suggests that a low P/S multiple is the most useful multiple for predicting future returns.
  • Price-to-cash-flow ratio (P/CF): Stock price per share divided by free cash flow (FCF) per share or operating cash flow (OCF) per share.

Question

Which one of the following statements is most accurate?

A. If a company’s price-to-sales ratio increases from its value one year prior, the price-to-earnings ratio must have also increased

B. A high price-to-book ratio usually implies the company is in financial turmoil

C. A low price-to-earnings ratio usually implies the company has relatively few growth prospects

Solution

The correct answer is C.

While a low P/E doesn’t always mean the company has minimal growth prospects, expected future growth and relative P/E tend to move in the same direction.

Option A is incorrect. While a rising stock price may increase both P/S and P/E over time, the two ratios can move in different directions as profit margins fluctuate.

Option B is incorrect. A low, not high, P/B usually implies the company may be close to or in the midst of financial distress.

Reading 49 LOS 49j:

Calculate and interpret the following multiples: price to earnings, price to an estimate of operating cash flow, price to sales, and price to book value

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