Which One Of The Following Is Not An Empirical Formula How to Use P-E, P-S, and P-B Ratios to Value a Stock

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How to Use P-E, P-S, and P-B Ratios to Value a Stock

In a previous article, I discussed the traditional and “textbook” method of stock valuation with some modifications to smooth out the inconsistencies in cash flow levels. In this article, we’ll look at another common way to value stocks, using statistical multiples of a company’s financial metrics, such as revenue, net assets, and sales.

Basically, three statistical multiples can be used in such an analysis: the price-to-sales (P/S) ratio, the price-to-book ratio (P/B) and the price-to-earnings ratio (P/). E) relationship. They are all used in the same way in estimation, so we will first describe the method and then discuss a little about when to use the three different multipliers, then go through an example.

A multi-based method

The multifaceted valuation of stocks is easy to understand, but getting the parameters requires some work. In short, the goal is to find a reasonable “target multiple” at which you think the stock should reasonably trade given its growth prospects, competitive position, and so on. There are a few things you should consider to find this multi-target.

1) What is the stock’s average historical multiple (P/E ratio, P/S ratio, etc.)? You should take a period of at least 5 years and preferably 10 years. This gives you an idea of ​​the range of both bull and bear markets.

2) What are the average multipliers of the competitors? What is the difference to the stock under study and why?

3) Is the range of high and low values ​​very wide or very narrow?

4) What are the future prospects of the stock? If they are better than in the past, the “target multiple” could be set above historical norms. If they are not as good, the “target multiplier” should be lower (sometimes significantly lower). When thinking about future prospects, don’t forget to consider potential competition!

Once you find a reasonable “target multiple”, the rest is pretty easy. First, make projections of current year revenue and/or earnings and multiply the target multiple by these to arrive at the target market capitalization. You then divide that by the number of shares, adjusting if necessary for dilution based on past trends and any announced share buyback programs. This will give you a “reasonably priced” estimate of which you want to buy 20% or more for margin of safety.

If this is confusing, the example later in the article should help clear things up.

When to use different multiples

Each different time has its advantages in certain situations:

P/E ratio: P/E is probably the most common multiple used. However, I would instead adjust it to the ratio of price to operating profit, where operating profit in this case is defined as profit before interest and taxes (EBIT – includes depreciation and amortization). This is to smooth out one-off events that occasionally skew earnings per share. P/EBIT is good for profitable companies with relatively stable sales and margins. It *doesn’t* work at all for unprofitable companies, and it doesn’t work well for asset-based companies (banks, insurance companies) or strong cyclical companies.

P/B ratio: The price-to-book ratio is most useful for asset-based companies, especially banks and insurance companies. Profits are often unpredictable due to interest rate differentials and are fraught with more assumptions than core products and services companies when accounting for nebulous accounting items like loan loss provisions. However, assets such as deposits and loans are relatively stable (except for 2008-09) and so book value is generally what they are valued at. On the other hand, book value doesn’t mean much for “new economy” companies like software and service companies, where the primary asset is the collective intellect of employees.

P/S ratio: The price-to-sales ratio is generally useful, but probably most valuable in valuing companies that are currently unprofitable. These companies don’t have earnings from which to use the P/E, but comparing the P/S ratio to historical norms and competitors can help give an idea of ​​a reasonable share price.

A simple example

To illustrate, let’s look at Lockheed Martin ( LMT ).

From some basic research, we know that Lockheed Martin is an established company with an excellent competitive position in a relatively stable industry, the defense industry. Additionally, Lockheed has long-term profitability. We also know that the company is obviously not an asset-based business, so we go by the P/EBIT ratio.

Looking at the last 5 years of price and earnings data (which requires some spreadsheet work), I find that Lockheed’s average P/EBIT ratio over that period has been around 9.3. Now I consider the circumstances of the last five years and see that Lockheed has worked through some years of strong defense demand in 2006 and 2007, followed by some significant political upheaval and market downturns in 2008 and 2009, followed by a market recovery, but problems with the important F-35 program in its at the beginning of the year. Given the expected slow growth in DoD spending in the near term, I would conservatively argue that 8.8 is probably a reasonable “target multiple” to use for this stock in the near term.

Once this multiple is determined, finding a reasonable price is quite simple:

The 2010 revenue forecast is $46.95 billion, which would be 4% more than 2009. Projected earnings per share are 7.27, which would be a 6.5% decline from 2009 and represent a 6% net margin. Based on these numbers and empirical data, I estimate 2010 EBIT to be $4.46 billion (9.5% operating profit margin).

Now I just apply my 8.8 multiple to the $4.6 billion to get a market cap of $40.5 billion.

Finally, to get the stock’s target price, we need to divide it by the shares outstanding. Lockheed currently has 381.9 million shares outstanding, but typically buys back 2-5% per year. I split the difference and expect the number of shares to decline by 2.5% this year, leaving 379.18 million by the end of the year.

Dividing $40.5 billion by $378.18 million gives the stock a price target of about $107. Interestingly, this is close to the discounted free cash flow value of $109. So, in both cases, I have used reasonable estimates and found that the stock looks undervalued. Using my 20% minimum “margin of safety”, I would only consider buying Lockheed at a share price of $85 and below.

Wrapping it up

Obviously, you can easily combine the price to sales or price to book ratio and do a similar multi-basis valuation using the correct financial values. This kind of stock valuation makes more sense to most people and takes into account market-based factors such as different multiple ranges for different industries. However, one must be careful when estimating the “target multiplier” and consider how the future may differ from the past. Use your head and try to avoid using multiples that are significantly higher than historical market averages.

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