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.
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
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 41 LOS 41j:
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