This page discusses the rationales for various market-based valuation metrics. The goal is to use price multiples to evaluate a security’s value relative to its applicable benchmark multiple. The economic rationale assumes the law of one price for similar assets; that is, companies that are similar in nature should be similarly priced.
Price to Earnings
- Uses: Often
- Pros: Earning power is the chief driver of investment value; widely recognized
- Cons: Subject to distortion; volatile; can be negative
- Formula: Forward P/E = (D1/E1)/(r-g) = (1-b)/(r-g); Trailing P/E = ((D0(1+g))/E0)/(r-g) = (1-b)(1+g)/(r-g); Forward P/E franchise model = 1/r + ((ROE-r)/(ROExR))x((g)/(r-g)), where g = b x ROE and b is retention rate
Price to Book
- Uses: Companies composed of chiefly liquid assets (marketable securities) like financial/insurance/investments/banks; companies without a going concern assumption
- Pros: shows the investment that common shareholders have in the firm; is positive; stable
- Cons: Inflation, technology, and accounting can distort book value; may omit critical assets not on balance sheet (human capital)
- Formula: Forward P/B = 1 + PV future residual earnings/B; Trailing P/B = (ROE-g)/(r-g)
Price to Sales
- Uses: Mature and cyclical companies
- Pros: Less subject to distortion; stable; positive
- Cons: Does not account for cost structure or firms losing money, use EV/S as an alternative
- Formula: P/S = ((E/S)(1-b)(1+g))/(r-g), where E/S is long term forecasted profit margin
Price to Cash Flow
- Uses: Often
- Pros: Less subject to manipulation; stable; positive
- Cons: Ignores items that can be distorted; FCFE can be volatile
- Formula: P/CF =P/(E+Non Cash Charges)
Dividend Yield
- Uses: Value type companies
- Pros: Is a componenet of total return; dividends are less risky
- Cons: Not all companies pay dividends; does not use all information available; displacement of earnings
- Formula: D/P = (r-g)/(1+g)
Enterprise Value to Earnings Before Interest and Taxes and Depreciation and Amortization
- Uses: Often; acquisitions
- Pros: Allows for different capital structure; controls for depreciation and amortization; positive
- Cons: Overestimates CFO when working capital is rising; FCFF is stronger for capital intensive firms
- Formula: EV/EBITDA = (Market value of CS+PS+Debt – cash & short term investments)/(NI+I+T+D&A); EV/FCFF = (Market value of CS+PS+Debt – cash & short term investments)/(NI+I-Tax savings+D&A-working capital-fixed capital)
A DuPont Analysis, which explains how ROE compares to an industry may also be used. This shows a company’s tax burden, interest burden, operating margin, asset turnover, and financial leverage:
ROE = (NI/EBT) x (EBT/EBIT) x (EBIT/Sales) x (Sales/Assets) x (Assets/Equity)
(Information on this page was originally gathered from the CFA Level II Program Curriculum)
