In the stock market, there are far more moving pieces than some beginners may think. For instance, the price of a stock is dependent on a variety of variables. Fortunately, they can be easily understood using price-associated valuation multiples.
A price multiple is simply any ratio that uses a company’s market capitalization and divides by the sum of a specific financial metric. This can include earnings, revenue, free-cash-flow, book value, and more.
At first, price-oriented ratios can seem daunting and slightly confusing. Luckily, there’s not many inputs investors have to perform in order to obtain the most accurate valuation multiple, which can be especially helpful soon after a quarterly report from a company.
There are a handful of important ratios investors should learn to solidify their investing strategy. While the ratio is important to know, so is recognizing the ideal number between each metric since they are all different.
Price-to-Earnings (P/E)
The price to earnings ratio is a multiple used to determine the valuation of a company using the market capitalization (price) and dividing by the earnings (net income).
Example: Company A has a $1 billion market capitalization and earnings of $100 million. This would result in a P/E ratio of 10. Although, if Company A grows its market capitalization to $1.5 billion through shareholder excitement but doesn't grow earnings, the P/E is now 15.
For the past 40 years, the average SandP 500 P/E ratio is around 20.
The P/E ratio of a company at any given time can depend heavily on the industry the company operates within. All things being equal, a company is more expensive the higher its price moves relative to its earnings.
Price-to-Sales (P/S)
This price multiple is similar to P/E. However, earnings (net income) are instead swapped with sales (revenue). This way, the market capitalization is divided by its sales.
Example: Company A has a market capitalization of $1 billion but generates $500 million in sales, This means the P/S multiple is 2. This is similar to the first example.
In general, you will typically see a P/S ratio below 3, although some companies and industries can have a much higher P/S ratio due to growth prospect and investor optimism.
Professor Damodaran at the NYU Stern School of Business has a useful page that tracks the P/S ratio across different industries in the US.
Below is a useful quote from the then-CEO of Sun Microsystem that gives us some insights on how to look at a high P/S ratio.
“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero RandD for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?” – Scott McNealy (CEO Sun Microsystems), Business Week, 2002
Price-to-Book (P/B)
Unlike other metrics which utilize quarterly or yearly recurring financials to determine the multiple, the P/B ratio uses the book value of a company. This can be calculated by subtracting liabilities from assets on the company’s balance sheet.
Example: Company A has $750 million in assets and $50 million in liabilities. Once subtracted from each other, the book value of Company A is $700 million. If the same company trades at a market capitalization of $1 billion, then the P/B multiple would be 1.42. Typically this means the company is overvalued.
The P/B multiple should be below 1. However, this is only the case with banks and financial institutions. It’s unlikely to see a technology company trade at such a low P/B when they are constantly acquiring assets, while banks grow much slower and maintain assets.
Price-to-Free-Cash-Flow (P/FCF)
This multiple can be slightly more confusing. Nonetheless, it’s arguably more important than the other multiples on this list. Investors like to look at FCF as it is crucial to a company’s survival (you will go bankrupt when you run out of cash) and is a primary indicator of its ability to generate additional revenues.
The P/FCF ratio takes a company’s market capitalization and divides it by its free-cash-flow.
Example: If Company A has a market capitalization of $1 billion and generates FCF of $175 million, the P/FCF multiple is 5.7. To find the best multiple, investors can compare industry average valuations. In the most cases however, the lower the better.
FCF is the final sum of cash at the end of the operating period. In other words, the cash available after paying operating expenses. FCF can be used to pay dividends, pay back debt, participate in share buybacks, acquire businesses, or simply sit in an account.
How Analysts Use Price Multiples
If you hadn’t already guessed, price multiples are used by all types of investors, even professional equity analysts. There are a few ways analysts use these ratios.
First, each multiple has a trailing-twelve-month and a forward-twelve-month version. Although, this is typically more common with the price-to-earnings ratio than any other multiple. With these ratios, analysts can then form a much broader picture by looking at historical data to observe if the stock has always traded a high, low, or fair valuation throughout its price history.
For example, Apple (NASDAQ: AAPL) shares currently trade at roughly $190 per share with a P/E ratio of 31. Using historical data, we can observe that Apple shares are trading at a higher valuation relative to its historical average. More research needs to be done, but at first glance, the valuation may be too high for an investor to feel comfortable purchasing shares. After all, stocks move in cycles and this is a higher-valued moment in the broad market cycle.
Multiples by Industry
Now that valuation multiples have been explained, it's time to explain more in detail of how they differ depending on the industry or sector. A great example of how multiples can be sky-high in one sector while dirt-cheap in another is technology and financials.
The technology sector trades at an average P/E multiple of 35, while the financial sector trades at a 12 P/E. There are a couple of reasons why the stock market prices these sectors so dramatically different. First, the technology sector is primed for higher earnings growth considering the market cycle we are currently in. Some years, however, financial companies are favored, but this simply isn’t the case right now.
Secondly, the technology sector is much newer, at least with this generation of tech such as cloud, electric vehicles, artificial intelligence, and software products. Where more growth is predicted, higher multiples typically follow shortly after.
Related Readings
An introduction to Asset Allocation
Inflation, Prices and ETF Strategies
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
