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10.3 Market Multiples Approach

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. Explain how to use a market multiple to evaluate a stock price.
  2. Calculate a stock valuation given the necessary data using a market multiple.

If we try to compare two companies that are in the same line of buisness and approximately the same size, we would expect them to have certain features in common and, perhaps, behave in similar ways. This is the basis for a popular approach to stock valuation based called the market multiples approach.

“Market multiples” is a generic term for a class of many different indicators that can be used to value a stock. Probably the most familiar is using the price to earnings (P/E) ratio (first discussed in chapter 4), and it is used in the following manner: if we know that the average P/E ratio for companies in our sector is 25, and we know the expected earnings (that is, net income) per share of our company is $2 per year, then an appropriate valuation for our stock should be $2 × 25 = $50.

Of course, we can use a competitor’s P/E ratio, if we think it more appropriate than an industry average. Or we can use our company’s historic P/E ratio. Or a trending average over years. This approach is both versatile and simple to use, which might explain its popularity with the financial press.

But what do we do if earnings are expected to be negative? Does this imply that our stock price is also negative? Of course not! Many companies have emerged from negative earnings (perhaps due to a slumping economy) only to skyrocket in value. The simplicity of ratio analysis is its major weakness, as it is impossible to capture everything about a company in one ratio. Other ratios and metrics can be used, if we believe them to be a good indicator of the company’s value. Common ratios (many are mentioned in chapter 5) are price to book, price to EBIT, price to EBITDA, price to sales, etc. but virtually anything can be used if it is justifiable (price to headcount, price to watermelons…). It is important, however, that we don’t attempt to use ratios solely because they are convenient or only because they support the result we desire; we should try to use reason to explain why a given metric is useful, and examine the data to determine if a meaningful relationship exists to aid is in our valuation efforts.

Key Takeaways

  • Though using P/E ratios to value a stock is the most common approach, any key metric can be chosen (though some will be more appropriate than others!).
  • Comparing to the industry, a competitor, or the same company over time can all yield valuable information about the stock’s value.
  • Garbage in, garbage out. The accuracy of this method will depend upon the usefulness of the metric used, and no one measure can fully capture the complexity of a company.

Exercises

  1. A competitor has 25 million shares outstanding at a stock price of $36 and expected annual net income of $50 million dollars. What is the competitor’s P/E ratio? If our company’s expected annual net income is $100 million and our shares outstanding total 20 million, what is an appropriate valuation for our stock?
  2. Why might a company’s P/E ratio change over time?
  3. A company has rapid sales growth, but has yet to turn a profit. Why would the price to sales (P/S) ratio be a superior metric to the P/E ratio for arriving at a stock price?