How to use the PE, PS and PB ratios to rate a stock
In a previous article, I discussed the traditional and “textbook” method of valuing a stock, along with some modifications to smooth out the inherent irregularity in cash flow levels. In this article, we’ll look at another common way to price a stock, using statistical multiples of a company’s financial metrics, such as earnings, net assets, and sales.
Basically, there are three statistical multiples that can be used in this type of analysis: the price-sales ratio (P / S), the price-book ratio (P / B), and the price-earnings (P / E) ratio. They are all used in the same way when making a titration, so let’s first describe the method and then have a little discussion about when to use the three different multiples, then let’s look at an example.
The multiple base method
Valuing an action in a multiples-based way is easy to understand, but requires some work to get the parameters. Simply put, the goal here is to come up with a reasonable “target multiple” where you think the stock should trade reasonably, given the growth prospects, competitive position, and so on. To get to this “target multiple”, there are a few things to consider:
1) What is the stock’s average historical multiple (P / E ratio, P / S ratio, etc.)? It should take at least a period of 5 years, and preferably 10 years. This gives you an idea of the multiple in the bull and bear markets.
2) What are the average multiples of the competitors? How wide is the variation with respect to the population being investigated and why?
3) Is the range of high and low values very wide or very narrow?
4) What are the future prospects for the action? If they are better than in the past, the “target multiple” could be set higher than historical norms. If they are not that good, the “target multiple” should be lower (sometimes substantially lower). Don’t forget to consider potential competition when thinking about future prospects!
Once you’ve found a reasonable “target multiple,” the rest is pretty easy. First, take the earnings and / or earnings estimates for the current year and multiply the target multiple against them to get a target market capitalization. Then divide that by the share count, optionally adjusting it for dilution based on past trends and any announced share buyback programs. This gives you a “reasonable price” assessment, of which you want to buy 20% or more below for a margin of safety.
If this is confusing, the example later in the article should help clear things up.
When to use the different multiples
Each of the different multiples has its advantage in certain situations:
P / E ratio: The P / E is probably the most common multiple to use. However, I would adjust this to be the price / operating profit ratio instead, where operating profit in this case is defined as earnings before interest and taxes (EBIT – includes depreciation and amortization). The reason for this is to smooth out the one-time events that skew the bottom line of earnings per share value from time to time. P / EBIT works well for profitable companies with relatively stable sales levels and margins. It * doesn’t * work at all for unprofitable businesses and it doesn’t work well for asset-based (banks, insurance companies) or heavy cyclical businesses.
P / B ratio: Price-to-book ratio is most useful for asset-based businesses, particularly banks and insurance companies. Earnings are often unpredictable due to interest differentials and filled with more assumptions than commodity companies when considering such nebulous accounting elements as loan loss provisions. However, assets like deposits and loans are relatively stable (aside from 2008-09), so book value is generally about what they are valued at. On the other hand, book value doesn’t mean much to “new economy” companies like software and service companies, where the primary asset is the collective intellect of employees.
P / S ratio: Price / sales is a useful ratio across the board, but probably more valuable for valuing companies that are currently not profitable. These companies have no earnings to use P / E from, but comparing the P / S to historical norms and competitors could help give you an idea of a reasonable price for the stock.
A simple example
To illustrate, let’s look at Lockheed Martin (LMT).
After conducting some basic research, we know that Lockheed Martin is an established company with an excellent competitive position in what has been a relatively stable industry, defense contracting. In addition, Lockheed has a long history of profitability. We also know that the company is obviously not an asset-based business, so we will go for the P / EBIT ratio.
Looking at price and earnings data for the last 5 years (which requires a spreadsheet job), I determine that Lockheed’s average P / EBIT ratio over that period has been about 9.3. Now I look at the circumstances of the last 5 years and see that Lockheed has weathered some years of strong defense demand in 2006 and 2007, followed by some significant political shocks and a bear market in 2008 and 2009, followed by a market rebound. but problems with the important F-35 program earlier this year. Given the expected slow short-term growth in defense spending, I conservatively theorize that 8.8 is probably a reasonable “target multiple” to use for this action in the short term.
Once this multiple is determined, finding the reasonable price is pretty easy:
The revenue estimate for 2010 is $ 46.95 billion, which would represent an increase of 4% compared to 2009. The estimated earnings per share is 7.27, which represents a decrease of 6.5% compared to 2009 and represents a net margin of 6%. Based on these figures and empirical data, I estimate a 2010 EBIT of $ 4.46 billion (9.5% operating margin).
Now, I simply apply my multiple of 8.8 to $ 4.6 billion to get a target market capitalization of $ 40.5 billion.
Lastly, we need to divide that by the outstanding shares to get a target share price. Lockheed currently has 381.9 million shares outstanding, but typically buy back between 2% and 5% a year. I’ll divide the difference on this and assume the share count will decline 2.5% this year, leaving a year-end count of 379.18 million.
Dividing $ 40.5 billion by 378.18 million gives me a share price target of approximately $ 107. Interestingly, this is close to the discounted free cash flow valuation of $ 109. So, in both cases, I used reasonable estimates and determined that stocks seem undervalued. Using my minimum 20% “margin of safety”, I would only consider buying Lockheed at stock prices of $ 85 or less.
Wrapping it up
Obviously, you can easily connect the price / sale or price / book ratio and, using the appropriate financial values, make a similar valuation based on multiples. This type of stock valuation makes a little more sense to most people and takes into account market-based factors such as multiple different ranges for different industries. However, one must be careful and consider how the future may differ from the past when estimating a “target multiple”. Use your head and try to avoid using multiples that are significantly higher than historical market averages.