How PE, PS and PB reports are used to assess a stock

In a previous article, we discussed the traditional and “manual” method of valuing a stock, along with some changes to smooth out the inherent bumpiness in cash flow levels. In this article, we’ll take a look at another common way to value a stock, using multiple statistics of a company’s financial values, such as earnings, net assets, and sales.

In principle, there are three multiple statistics that can be used in this type of analysis: the price-to-sales ratio (P / S), the book-price ratio (P / B) and the price-to-earnings ratio (P / S) E) ratio. All of these are used in the same way to make an assessment, so let’s first describe the method and then discuss a little about when to use the three different multiples, and then go through an example.

The method based on several

Evaluating a stock in a multi-based manner is easy to understand, but it takes work to get the parameters. In short, the goal here is to come up with a reasonable “multiple target” at which you think the stock should trade reasonably, given the growth prospects, the competitive position and so on. To come up with this “multiple target”, you need to consider a few things:

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

2) What are the average multiples for competitors? How wide is the variance from the investigated stock and why?

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

4) What are the future prospects for the stock? If they are better than in the past, the “multiple target” could be set higher than historical norms. If they are not as good, the “multiple target” should be smaller (sometimes substantially smaller). Remember to consider potential competition when thinking about your future prospects!

Once you come up with a reasonable “multiple target”, the rest is pretty easy. First, take estimates for the current year for revenue and / or earnings and multiply the target multiples to obtain a target market capitalization. Then divide this by the number of shares, optionally adjusting it for dilution based on previous trends and any announced stock repurchase programs. This gives you a “reasonable price” rating from which you want to buy 20% or more for a margin of safety.

If this is confusing, the example below in the article should help clarify things.

When using multiple differences

Each of the multiple differences has their advantage in certain situations:

P / E ratio: P / E is probably the most common multiple to use. However, I would adjust this to be the ratio of price to operating income, if operating income in this case is defined as earnings before interest and taxes (EBIT – includes depreciation and amortization). The reason for this is to smooth out unique events that from time to time distort the value of earnings per share. P / EBIT works well for profitable companies with relatively stable levels of 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 heavy cyclicals.

P / B ratio: The price-book ratio is most useful for asset-based companies, especially for banks and insurance companies. Gains are often unpredictable due to interest rate differences and are full of more assumptions than core commodities and services firms when considering such nebulous accounting items as provisions for loan loss. However, assets, such as deposits and loans, are relatively stable (excluding 2008-2009), so the carrying amount is generally measured. On the other hand, the book value does not mean much to “new economy” enterprises, such as software and service companies, where the main assets are the collective intellect of employees.

P / S ratio: The price-sales ratio is generally useful, but probably the most valuable for evaluating unprofitable companies today. These firms have no gains from using P / E, but comparing the P / S ratio to historical norms and competitors could help with an idea of ​​a reasonable price for the stock.

A simple example

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

From basic research, we know that Lockheed Martin is a well-established company with an excellent competitive position in what has been a relatively stable industry, contracting defense. Moreover, Lockheed has a long experience of profitability. We also know that the company is obviously not an asset-based business, so we will go with the P / EBIT ratio.

Looking at the last 5 years of price and earnings data (which requires a spreadsheet), I find that Lockheed’s average P / EBIT ratio during this period was around 9.3. Now, I consider the circumstances of the last 5 years and see that Lockheed worked in a few years of strong defense demand in 2006 and 2007, followed by some significant political upheavals and a down market in 2008 and 2009, followed by a return of market, but problems with the important F-35 program earlier this year. Given the expected slow short-term increase in defense department spending, I conservatively theorize that 8.8 is probably a reasonable “multiple target” to use for this short-term stock.

Once this multiple is determined, finding a reasonable price is fairly easy:

The revenue estimate for 2010 is $ 46.95 billion, an increase of 4% over 2009. The estimate for earnings per share is 7.27, a decrease of 6.5% from 2009, and represents a net margin of 6%. From these figures and empirical data, I estimate a 2010 EBIT of $ 4.46 billion (9.5% operating margin).

Now, I’m simply applying the multiple of 8.8 to $ 4.6 billion to get a $ 40.5 billion target market cap.

Finally, we need to divide this into outstanding shares to get a target price for the action. Lockheed currently has 381.9 million shares outstanding, but usually buys 2-5% per year. I will divide the difference in this regard and I assume that the number of shares will decrease by 2.5% this year, leaving a number at the end of the year of 379.18 million.

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

Wrapping it

Obviously, you can easily connect the price-sales or price-book ratio and, using the appropriate financial values, you can perform a similar valuation based on several. This type of stock valuation makes a little more sense to most people and takes into account market factors, such as different multiple ranges for different industries. However, we need to be careful and consider how the future may differ from the past when estimating a “multiple target”. Use your head and try to avoid using multiples that are significantly higher than historical market averages.

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