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There are several advantages of P/E multiples:

- Earnings drive the stock value.
- The P/E ratio is simple to calculate and widely used.
- According to research, differences in P/E is related to the long-run average return on the stocks.

The drawbacks of using P/E ratios are:

- Companies with negative earnings produce negative P/Es that do not make economic sense.
- The recurring component of earnings that is the most important can be challenging to separate from the non-recurring component.
- The discretion of management to choose among the different accounting makes a comparison of P/E among different companies difficult.

In calculating the P/E, the numerator commonly used is the current price of the common stock. When selecting the EPS to be used as the denominator, two issues must be considered:

- The time horizon over which the earnings are measured.
- Adjustments to accounting earnings for proper comparison among different companies.

There are two major alternative definitions of P/E:

Calculated as the current market share price divided by the most recent four quarters’ EPS (trailing 12-month EPS).**Trailing P/E or current P/E:**Calculated as the current market share price divided by next year’s expected earnings.**Forward P/E or leading P/E:**

For proper comparison purposes, an analyst should use the same variation of earnings when calculating P/E ratios.

In situations where there is a significant acquisition or significant change in financial leverage, a forward P/E would be more appropriate than a trailing P/E.

P/E ratios are based on a single period’s EPS. If that number is negative or is not an accurate representation of a company’s earnings, an analyst can use a long-run average calculation of EPS. P/Es based on this normalized EPS are called normalized P/Es.

When calculating a P/E, one must consider:

- Potential dilution of EPS.
- Non-recurring components of earnings that are company-specific.
- Transitory components of earnings as a result of cyclicality.
- Differences in accounting methods.

The forward P/E earnings component can be calculated as:

- The subsequent four quarters earnings.
- The following 12 months’ earnings.
- The next fiscal year’s earnings.

Analysts must be consistent in their calculation of P/E when comparing stocks.

The ratio of a share’s market price to its book value per share refers to the price to book value (P/B).

Advantages of price to book ratio are:

- Book value per share can be used when EPS is negative or zero as book value is generally positive even when earnings are negative/zero.
- Book value per share is stable compared to EPS and could be more meaningful when EPS is abnormally high/low.
- For financial sector companies with significant holdings of liquid assets, P/B is more meaningful as book values reflect current market values.
- P/B is more appropriate when valuing companies that are expected to close operations.
- Research shows that differences in P/B are related to differences in long-run average return.

Limitations of P/B ratios include:

- There may be critical company assets that are not recognized on the financial statements, like human capital, good reputation, etc.
- P/B may be misleading when there are considerable differences in the value of assets between the companies being examined.
- Differences in accounting methods may make comparisons difficult, e.g., rules on capitalization of R&D vary across accounting standards.
- Due to how some assets are reported on the balance sheets, e.g., at fair value or historical cost, these assets’ market values and book values may be significantly different.
- Share issuances or repurchases may distort historical comparisons. When a firm repurchases shares at a price higher than the current book value per share, it lowers the total book value per share of the company.

The P/B ratio may need adjusting to:

- Make it more accurately reflect the value of shareholders’ investment.
- Make it more helpful in making comparisons among different stocks.

These adjustments include:

- Subtracting intangible assets like goodwill on the balance sheet from common shareholders’ equity to estimate the
.**tangible book value per share** - For companies using different inventory recognition methods like FIFO or LIFO, adjustments must be made to these inventory figures to have them recognized similarly.
- Adjustments for significant off-balance sheet assets and liabilities must be made for a more accurate comparison, e.g., a guarantee to pay a debt in case of default.

Advantages of P/S are:

- Sales are less subject to manipulation than other fundamentals like book value or EPS.
- Sales are positive even when EPS may be negative.
- Sales are more stable since they do not have to reflect the effect of operating and financial leverage.
- Research shows that differences in P/S multiples are related to differences in long-run average returns.
- P/S ratios are appropriate for valuing mature, cyclical, and loss-making companies.

P/S limitations include:

- A company may have a high growth in sales when its operating profits are negative. For a company to continue operating in the future, it needs to generate earnings.
- The P/S ratio does not account for differences in cost structures between businesses.
- Different revenue recognition practices have the potential to distort P/S.

Advantages of price to cash flow are:

- Earnings are more susceptible to manipulation than cash flow.
- Cash flow is more stable than earnings and is, therefore, more stable than P/E.
- Using price to cash flow addresses the differences in the quality of earnings.
- Research shows that differences in price to cash flow ratios are related to differences in long-run average returns.

Disadvantages of price to cash flow are:

- Items that affect actual cash flow from operations, such as non-cash revenue, are disregarded.
- FCFE is more suitable for valuing a company than operating cash flow.
- Operating cash flow can be enhanced by securitizing accounts receivable to speed up a company’s operating cash inflow or by outsourcing accounts payable to slow down the company’s operating cash outflow.
- Operating cash flow from the cash flow statement prepared under IFRS may not be comparable to operating cash flow prepared under US GAAP because IFRS allows more flexibility in the classification of interest paid, interest received, and dividends received.

There are four major definitions of cash flow that can be used to calculate P/CF:

- Net income plus non-cash charges like depreciation and amortization. It is calculated as EPS plus per share depreciation, amortization, and depletion on a per-share basis.
- The cash flow from operations figures on the cash flow statement. Adjustments for items that are not expected to continue into the future or differences in accounting standards may be required.
- Free cash flow to equity (FCFE).
- EBITDA.

Advantages of using dividend yields are:

- The dividend yield is a component of total return.
- Dividends are a less risky component of total return than capital appreciation.

Disadvantages of dividend yield are:

- The dividend yield is only one component. Using dividend yield ignores the other components of return.
- A higher dividend yield implies a lower earnings growth rate going forward.

The trailing dividend yield is calculated using the dividend rate divided by the share’s current market price. The dividend rate is the annualized amount of the most recent dividend. For companies paying dividends on a quarterly basis, the dividend rate is calculated as four times the most recent quarterly per-share dividend. For companies that pay semiannual dividends, the dividend rate is usually calculated as the most recent annual per-share dividend.

The leading dividend yield is calculated as the forecasted dividends per share over the next year divided by the share’s current market price.** **

## Question

Which of the following would

most likelybe used as the earnings component of the forward P/E ratio?

- Non-recurring earnings.
- The following four quarters earnings.
- Diluted EPS.
## Solution

The correct answer is B.The next four quarters, the next 12 months’ earnings, and the following fiscal year earnings can be used as the earnings component of the forward P/E ratio.

A is incorrect.The non-recurring component of earnings is a part of earnings that are not expected to persist into the future.

C is incorrect.Diluted EPS is an item that should be considered when calculating trailing EPS.

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

*LOS 25 (c) Describe rationales for and possible drawbacks to using alternative price multiples and dividend yield in valuation.*