P/E Multiple
What you'll learn
- LOS 20.aContrast the method of comparables and the method based on forecasted fundamentals as approaches to using price multiples in valuation and explain economic rationales for each approach.
- LOS 20.bCalculate and interpret a justified price multiple.
- LOS 20.cDescribe rationales for and possible drawbacks to using alternative
- LOS 20.dCalculate and interpret alternative price multiples and dividend yield.
Price multiples are among the most widely used tools for valuation of equities. Comparing stocks’ price multiples can help an investor judge whether a particular stock is overvalued, undervalued, or properly valued in terms of measures such as earnings, sales, cash flow, or book value per share. Enterprise value multiples relate the total value of a company, as reflected in the market value of its capital from all sources, to a measure of operating earnings generated, such as earnings before interest, taxes, depreciation, and amortization.
Momentum indicators compare a stock’s price or a company’s earnings to their values in earlier periods.
The method of comparables values a stock based on the average price multiple of the stock of similar companies. The economic rationale for the method of comparables is the Law of One Price, which asserts that two similar assets should sell at comparable price multiples (e.g., price to earnings). This is a relative valuation method, so we can only assert that a stock is over or undervalued relative to benchmark value.
The method of forecasted fundamentals values a stock based on the ratio of its value from a discounted cash flow (DCF) model to some fundamental variable (e.g., earnings per share). The economic rationale for the method of forecasted fundamentals is that the value used in the numerator of the justified price multiple is derived from a DCF model: value is equal to the present value of expected future cash flows discounted at the appropriate risk adjusted rate of return.
MK Technologies shares are selling for $50. Earnings for the last 12 months were $2 per share. The average trailing P/E ratio for firms in MK’s industry is 32 times. Determine whether MK is over or undervalued using the method of comparables.
Solution
MK’s trailing P/E is:
MK is relatively undervalued because its observed trailing P/E ratio (25 times) is less than the industry average trailing P/E ratio (32 times).
Shares of Comtronics, Inc., are selling for $30. The mean analyst earnings per share forecast for next year is $4.00, and the long run growth rate is 5%. Comtronics has a dividend payout ratio of 60%. The required return is 14%.
Calculate the fundamental value of Comtronics using the Gordon growth model and determine whether Comtronics shares are over or undervalued using the method of forecasted fundamentals.
Solution
The fundamental value according to the Gordon growth model is:
The fair value P/E ratio based on forecasted fundamentals is:
The observed leading P/E ratio based on the current market price is:
Comtronics is overvalued because the observed P/E multiple of 7.5 is greater than the fair value P/E ratio of 6.67. Notice that we would have come to the same conclusion by comparing market price ($30.00) to intrinsic value ($26.67).
price multiples and dividend yield in valuation.
Price multiples are ratios of a common stock’s market price to some fundamental variable. The most common example is the price to earnings (P/E) ratio. A justified price multiple is what the multiple should be if the stock is fairly valued.
If the actual multiple is greater than the justified price multiple, the stock is overvalued; if the actual multiple is less than the justified multiple, the stock is undervalued (all else equal).
P/E Ratio
There are a number of rationales for using price to earnings (P/E) ratio in valuation:
- Earnings power, as measured by earnings per share (EPS), is the primary determinant of investment value.
- The P/E ratio is popular in the investment community.
- Empirical research shows that P/E differences are significantly related to long run average stock returns.
On the other hand, P/E ratios have a number of shortcomings:
- Earnings can be negative, which produces a meaningless P/E ratio.
- The volatile, transitory portion of earnings makes the interpretation of P/Es difficult for analysts.
- Management discretion within allowed accounting practices can distort reported earnings, and thereby lessen the comparability of P/Es across firms.
We can define two versions of the P/E ratio: trailing and leading P/E. The difference between the two is how earnings (the denominator) are calculated. Trailing P/E uses earnings over the most recent 12 months in the denominator. Leading P/E ratio (a.k.a.
forward or prospective P/E) uses next year’s expected earnings, which is defined as either expected earnings per share (EPS) for the next four quarters, or expected EPS for the next fiscal year.
Trailing P/E is not useful for forecasting and valuation if the firm’s business has changed (e.g., as a result of an acquisition). Leading P/E may not be relevant if earnings are sufficiently volatile so that next year’s earnings are not forecastable with any degree of accuracy.
Byron Investments, Inc., reported €32 million in earnings during the current fiscal year. An analyst forecasts an EPS over the next 12 months of €1.00. Byron has 40 million shares outstanding at a market price of €18.00 per share. Calculate Byron’s trailing and leading P/E ratios.
Solution