Calculating and Interpreting Alternative Price Multiples

P/E Ratios

Trailing P/E is calculated using the last period’s earnings as:

$$\text{Trailing P⁄E}= \frac{\text{Market price per share}}{\text{EPS over previous 12 months}}$$

This is preferred when future earnings are unavailable.

Leading P/E is calculated using the next period’s expected earnings as:

$$\text{Leading P⁄E}= \frac{\text{Market price per share}}{\text{Forecasted EPS over next 12 months}}$$

This is preferred when trailing earnings do not reflect the future.

Example: Calculating P/E Ratio

Consider the following information

• Earnings = $50 million
• Forecasted EPS over the next 12 months = $1.2
• Number of outstanding shares = 80 million
• Market price = $20.00 per share

Trailing and leading P/E ratios are closest to:

Solution

$$\begin{align*}\text{Current year EPS} &= \frac{50}{80} = \$0.625\\\text{Trailing P/E} &= \frac{\$20}{\$0.625} =32\\ \text{Leading P/E}&=\frac{\$20}{\$1.2}=16.67\end{align*}$$

Price to Book Value Ratios

Price to book value is calculated as:

$$\text{P⁄B ratio}=\frac{\text{Market value of common shareholders’ equity}}{\text{Book value of common shareholdes’ equity}}$$

$$\begin{align*}\text{Book value of common shareholders’ equity}&=\text{Shareholders’ equity}-\text{Total value of equity claims senior to common stock}\\ \\ \text{Book value per share}&= \frac{\text{Common shareholders’ equity}}{\text{Number of common stock shares outstanding}}\\ \\ \text{Market value of common shareholders’ equity}&=\text{Share price}\times\text{Shares outstanding}\end{align*}$$

This ratio can also be calculated on a per-share basis by dividing both the numerator and denominator by the number of shares outstanding.

Example: P/B Ratio

Consider the following information:

• Current share market price = $15
• Shares outstanding = 100,000
• Common equity book value = $800,000

P/B can be calculated as:

Solution

$$\begin{align*}\text{P⁄B ratio}&=\frac{\text{Market value of common shareholders’ equity}}{\text{Book value of common shareholdes’ equity}}\\&=\frac{(15\times100,000)}{800,000}=1.88\end{align*}$$

A P/B ratio of 1.88 means that an investor is paying 1.88 times the book value for one share. If a comparable company is trading at a lower P/B ratio, then the comparable company is relatively undervalued, assuming the company at the 1.88 P/B ratio is correctly valued.

Price to Sales Ratios

Computing price to sales (P/S) involves the following calculation:

$$\begin{align*}\text{P⁄S ratio}&= \frac{\text{Market price per share}}{\text{Annual net sales per share}}\\ \text{Annual net sales}&=\text{Total sales}-(\text{Returns}+\text{Customer discounts})
\end{align*}$$

An analyst should evaluate a company’s revenue recognition practices before relying on the P/S multiple.

Example: Price to Sales Ratio

Consider the following information:

• Current share market price = $15
• Recently reported net sales = $1,200,000
• Shares outstanding = 100,000
• Benchmark P/S multiple = 6.5

P/S can be calculated as:

Solution

$$\begin{align*}\text{Annual net sales per share}&=\frac{\$1,200,000}{100,000}=12\\ \text{P⁄S ratio}&=\frac{15}{12}=1.25\end{align*}$$

Since the benchmark P/S multiple (6.5) is higher than the subject’s P/S multiple (1.25), the stock appears to be relatively undervalued.

Price to Cash Flow Ratios

The P/CF ratio is calculated as:

$$\text{P⁄CF}= \frac{\text{Market price per share}}{\text{Free cash flow per share}}$$

Example: Price to Cash Flow

Consider the following information:

• Current share market price = $15
• Cash flow from operations = $600,000
• Shares outstanding = 100,000

P/CF ratio can be calculated as:

Solution

$$\begin{align*}\text{P⁄CF}&= \frac{\text{Market price per share}}{\text{Free cash flow per share}}\\ \\ \text{Free cash flow per share}&= \frac{\$600,000}{100,000}=\$6.00\\ \\ \text{P⁄CF}&= \frac{\$15}{\$6}=2.5\end{align*}$$

When comparing the P/CF ratios of different companies, the company with the lower P/CF ratio is relatively undervalued. 

Dividend Yield

The dividend yield is computed as dividend per share divided by the stock price.

There are two types:

i. Trailing dividend yield, calculated as:

$$\text{Trailing dividend yield}= \frac{\text{Most recent yearly dividend}}{\text{Current market share price}}$$

ii. Leading dividend yield, calculated as:

$$\text{Leading dividend yield}=\frac{\text{Next year’s forecasted dividend}}{\text{Current market price}}$$

Example: Dividend Yield

Consider the following information:

• Current market price = $29.00
• Dividends paid in the last four quarters:
  • Q2: 2020 = $0.52
  • Q3: 2020 = $0.55
  • Q4: 2020 = $0.56
  • Q1: 2021 = $0.56
• Next year’s dividend is forecasted to be $2.28.

The trailing dividend yield can be calculated as:

Solution

$$\begin{align*}\text{Trailing dividend yield}&=\frac{\text{Most recent yearly dividend}}{\text{Current market share price}}\\&=\frac{(0.52+0.55+0.56+0.56)}{29}\\&=0.07552≅7.55\%\end{align*}$$

The leading dividend yield can be calculated as:

$$\begin{align*}\text{Leading dividend yield}&=\frac{\text{Next year’s forecasted dividend}}{\text{Current market price}}\\&=\frac{2.28}{29}\\&=0.0786≅7.86\%\end{align*}$$

Question

Consider the following information:

• Expected EPS in the first quarter = 0.30
• Expected EPS in the second quarter = 0.37
• Expected EPS in the third quarter = 0.43
• Expected EPS in the fourth quarter = 0.48
• Current price = $28.00

The forward P/E ratio is closest to:

1. 14.58.
2. 17.72.
3. 23. 33.

Solution

The correct answer is B.

$$\text{Forward P⁄E ratio}= \frac{28.00}{(0.30+0.37+0.43+0.48)}=17.72$$

Reading 25: Market-Based Valuation: Price and Enterprise Value Multiples

LOS 25 (d) Calculate and interpret alternative price multiples and dividend yield.