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)

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