Price Multiples: A Primer on Application of Relative Valuation Methods

Price multiples are widely used in financial world for comparative analysis of equities. It provides a quick reference to judge the valuation of the stock with respect to other available options. The valuation could be in terms of measure of earning, sales, cash flow or book value of shares. All these different measures create the confusion in the mind of analyst to choose the appropriate ratio to be used for valuing a stock as different sectors have different attributes and correct valuation techniques should be applied.

P/E Ratio

This is the most commonly used measure in the valuation world, as earning per share (EPS) is regarded as the main driver of stock value. On the long run the P/E differences eventually track the stock performance and its appeal is from the fact of ease of calculation.

Though it is very widely used tool but it is subjected to the discretion of accounting policies being adopted by the management that would destroy the sanctity of comparability. The major impediment of this ratio is its non-applicability for a negative earning company and since earnings are by nature most volatile so it sometimes produces erratic results.

P/E ratios are denoted in two ways:

Trailing P/E Ratio = Market Cap of stock / Last year earning = MPS/ Last Year EPS

Forward /Leading P/E Ratio = Market Cap of stock / Forecasted this year earning = MPS/ Forecasted this Year EPS

The Trailing P/E ratio would be meaningless if the company has done some serious corporate actions (mergers, acquisitions, asset sales, write downs) last year.

Similarly for Leading P/E, if the company’s earnings are volatile in nature the forecasting becomes difficult with any surety.

P/B Ratio

Book value being a cumulative amount is generally positive (if not sustaining huge losses for few years, severely bankrupt) even when the earnings are negative, so it could be used in places where P/E can’t be.

Book value is more stable than earnings and could be used for stocks with fluctuating earnings.

This measure is particularly suited for companies holding liquid assets especially Banks, Insurance companies, NBFCs, etc. It is also very useful for valuing companies expected to go out of business as it deals with the book value of net assets.

P/B ratio can’t be used in comparing two companies who have different models of asset holding due to management decisions. Some might go for building in-house competencies hence bloating asset value whereas some might follow asset light model with outsourcing many of the activities.