Which Of The Following Statements Best Describes Free Cash Flow 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 for valuing stocks, along with a few tweaks to smooth out the inherent unevenness 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 earnings, net assets, and sales.

There are basically three statistical multiples that can be used in this type of analysis: the price-to-sales (P/S) ratio, the price-to-book (P/B) ratio, and the price-to-earnings (P/E) ratio. They are all used in the same way in estimation, so let’s first describe the method, then discuss a little about when to use the three different multiples, and then walk through an example.

Multiple method

Valuing a stock multiple is easy to understand, but it takes some work to get the parameters. In short, the goal here is to come up with a reasonable “target multiple” that you believe the stock should reasonably trade at, given its growth prospects, competitive position, and so on. To arrive at this “multi-targeting” you need to consider a few things:

1) What is the average historical multiple of the stock (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 multiple in both bull and bear markets.

2) What are the average multiples for competitors? How wide is the variance relative to the stock being researched and why?

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

4) What are the future prospects for stocks? 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 significantly lower). Don’t forget to consider potential competition when considering future prospects!

Once you’ve come up with a reasonable “target multiple”, the rest is pretty simple. First, take the current year’s revenue and/or earnings estimates and multiply your target multiple by these to get your target market cap. Then divide that by the number of shares, optionally adjusting for dilution based on past trends and any announced share buyback programs. This gives you an estimate of a “reasonable price”, which you want to buy 20% or more below for a margin of safety.

If this is confusing, the example at the end of the article should help clear things up.

When to use different multiples

Each of the different multiples has its own advantage in certain situations:

P/E ratio: P/E is probably the most common multiple to use. However, I would adjust it to be the ratio of price to operating earnings, where operating earnings in this case is defined as earnings before interest and taxes (EBIT – includes depreciation). The reason for this is the smoothing out of one-off events that distort the lowest earnings per share value from time to time. 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 cyclical changes.

P/B ratio: The price-to-book ratio is most useful for asset-based companies, especially banks and insurance companies. Earnings are often unpredictable because of interest rate spreads and are full of more guesswork than commodity companies when you factor in such nebulous accounting items as loan loss provisions. However, assets such as deposits and loans are relatively stable (apart from 2008-09), so book value is generally what is assessed. 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: Price-to-sales is a useful ratio in all segments, but probably most valuable for valuing currently unprofitable companies. These companies do not have earnings from which to use the P/E, but comparing the P/S ratio to historical norms and competitors can help create an idea of ​​a reasonable share price.

Simple example

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

We know from some basic research that Lockheed Martin is an established company with an excellent competitive position in a relatively stable industry, defense contracting. Furthermore, Lockheed has a long track record of profitability. We also know that the company is clearly not in an asset-based business, so we’ll go with the P/EBIT ratio.

Looking at price and earnings data over the past 5 years (which requires a bit of spreadsheet work), I found that Lockheed’s average P/EBIT ratio over that period was around 9.3. Now I look at the circumstances of the past 5 years and see that Lockheed went through several years of high defense demand in 2006 and 2007, followed by significant political upheaval and a market downturn in 2008 and 2009, followed by a market recovery, but problems with the important F-35 program early this year. Given the expected slow near-term growth in DoD spending, I conservatively theorize that 8.8 is probably a reasonable “target multiple” to use for this stock in the short term.

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

Estimated 2010 revenue is $46.95 billion, which would be a 4% increase over 2009. Estimated EPS is 7.27, which would be a 6.5% decrease over 2009 and represents a net a margin of 6%. Based on these figures and empirical data, I estimate 2010 EBIT of $4.46 billion (operating margin of 9.5%).

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

Finally, we have to divide this by the shares outstanding to get the target price of the stock. Lockheed currently has 381.9 million shares outstanding, but typically buys back 2-5% per year. I’ll divide the difference by this and assume that the number of shares this year will decrease by 2.5%, leaving the year-end number at 379.18 million.

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

Wrapping

Obviously, you can simply plug in the price-to-sales or price-to-book ratio and, using the appropriate financial values, make a similar multiple valuation. This type of stock valuation makes more sense to most people and takes into account market factors such as different multiple ranges for different industries. However, care should be taken to consider how the future may differ from the past when evaluating a “target multiple”. Use your head and try to avoid using multiples that are significantly higher than historical market averages.

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