Using Multiples to Gauge ValueDownload printable PDF
One of the goals of stock analysis is to determine whether a company’s stock is “cheap” or “rich,” given its current stock price and financial situation. Popular methods of stock valuation include the use of a variety of ratios or multiples that compare a stock’s current price per share to an element of a firm’s financial statements—such as earnings, sales, book value, cash flow, or dividends. This issue of Stock Investor News looks at how to use the multiples in the program to help assess a stock’s worth.
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Multiples as Used in Value Investing
Value investors seek companies with low price multiples in the belief that through neglect or overreaction to bad news, the market has not correctly evaluated the potential of the company. They argue that although the market may be efficient in the long run, emotions often dominate in the short run. These emotions can overtake rational analysis, pushing a stock’s price above its intrinsic value during periods of euphoria and below its true worth in the wake of bad news.
How to Interpret the Multiples Tab
The Multiples tab in Stock Investor Pro displays the more popular financial multiples. Examining these multiples can help you to gain a better understanding of a company’s value and gauge whether the stock may be a potential buy. At the end of this article, you will find definitions of the key multiples found in the program.
For this discussion, Merck & Co. Inc. (MRK) is used, with data corresponding to that found in Stock Investor Pro as of July 26, 2013. While the focus is placed on the company’s price-earnings ratio, many of the principles covered in this discussion are applicable to the other ratios found on the Multiples tab.
Looking at the Multiples tab for Merck & Co., the current price-earnings ratio for Merck is 24.7, which is derived by dividing the current stock price of $48.49 by the fully diluted earnings per share from continuing operations for the last four quarters (trailing 12 months) of $1.96. This value places Merck in the 68th percentile of the entire database. This means that among companies in the database that have a valid current price-earnings ratio value, 68% have a lower current price-earnings ratio than Merck, while 32% have a higher current price-earnings ratio than Merck. Percentile rank data is available for selected data fields in Stock Investor Pro. They are found in the % Rank data category.
Merck’s current price-earnings ratio has risen significantly over the last year, from 19.6 one year ago, but it is below its historical averages, represented by the three-year, five-year, and seven-year average ratios. The three-year average of 55.6 is simply the average of the price-earnings ratios for each of the last three years, which for Merck are 21.2 for 2012, 16.7 for 2011 and 129.0 for 2010 (also shown in the Multiples tab). In order to calculate this field, a company must have had positive earnings per share for each of the last three fiscal years. Also note that in 2010, Merck traded at a historically high price relative to earnings. This was due to a huge drop in earnings that year, from $5.65 per share in 2009 to $0.28 per share in 2010. The Multiples tab also shows how Merck’s price-earnings ratio ranks in the entire database of companies historically and compared to its sector and industry. In Stock Investor Pro, there are three-, five- and seven-averages for price-earnings ratio, price-book-value ratio, price-sales ratio, price-to-cash-flow ratio, and price-to-free-cash-flow ratio. Percent rank data and industry and sector medians are available for these fields.
Graham’s Historical Average Multiple
The program also offers some additional earnings-related multiples as well as price-earnings-to-growth (PEG) ratios. The final price-earnings ratio based on historical earnings shown on the Multiples tab is the price-earnings ratio using the average fully diluted earnings per share from continuing operations for the last three fiscal years (labeled PE using Average EPS - 3 years). This figure is calculated by dividing the current stock price by the average of the fully diluted earnings per share from continuing operations for the last three fiscal years. This field is used in the Graham Defensive-Industrial and Graham Defensive-Utility screens in the program. To bypass the impact of special charges on the earnings per share and management’s discretionary use of reserve accounts, as well as to smooth the impact of the business cycle, Benjamin Graham often averaged earnings over a period of several years.
Analysis of multiples provides investors with a relatively easy means of discerning the market’s opinion of a company as well as insight into its “fair” stock value. Value investors can use multiples to locate companies that warrant further analysis.
Stock Investor Price Multiples
Price to Earnings per Share: Also called the price multiple, the price-earnings ratio is the most popular multiple. Calculated by dividing the current stock price by diluted earnings per share from continuing operations for the last four quarters (trailing 12 months). The price-earnings ratio embodies the market’s expectations regarding a company’s growth prospects and risk. High price-earnings ratios generally represent strong future growth prospects. A low price-earnings ratio represents the market’s low earnings growth expectations for the firm, or the high risk of the firm actually achieving growth. The usefulness of this ratio is limited to those firms that have positive earnings. In addition, earnings are more subject to management assumptions and manipulation than other income statement items (such as sales).
Price to Book Value per Share: Calculated by dividing the current stock price by book value per share for the last fiscal quarter. Book value per share is calculated by subtracting total liabilities from total assets and then dividing by the number of shares outstanding. The price-to-book ratio provides a relatively stable measure of value that can be compared to the market (stock) price. Roughly three-quarters of those companies that have a non-meaningful price-earnings ratio have positive book value. However, a company can also have a non-meaningful price-to-book-value ratio. Over time, many events occur that can distort the book value figure to the point where it bears little resemblance to current economic values. For example, inflation may leave the replacement cost of capital goods within the firm far from their stated book value. Or, the purchase of a firm may lead to the establishment of goodwill, an intangible asset, boosting the level of book value. Different accounting practices across industries may also come into play.
Price to Sales per Share: Calculated by dividing the current stock price by the sales per share for the last four fiscal quarters (trailing 12 months). Unlike earnings and book value, sales are less subject to management assumptions and more difficult to manipulate. Furthermore, all companies that are going concerns have sales, and positive ones at that. Therefore, the vast majority of companies will have meaningful price-sales values. Lastly, sales tend to be less volatile than earnings, making the price-to-sales ratio a more reliable means of valuation. However, price-to-sales ratios do not generally work well for financial firms such as banks, where sales are not a driving force. Also, the price-sales level is driven by profit margins, which tend to vary from industry to industry. Companies in industries with low profit margins, such as supermarkets, tend to sell with very low price-to-sales ratios. For this reason, it is best to compare price-to-sales ratios across companies in similar industries or lines of business.
Price to Cash Flow per Share: Calculated by dividing the current stock price by cash flow per share for the last four fiscal quarters (trailing 12 months). Cash flow has traditionally been calculated by adding non-cash expenses back to earnings after taxes and subtracting dividend payments. Non-cash expenses such as depreciation, depletion, and amortization are expenses that appear on the income statement but require no cash outlays. They represent the accountant’s attempt to measure the reduction of the book value of assets as these assets are depleted. While dividends are a discretionary item, they are a real cash outlay that is not tax deductible and is not reflected in earnings. This measure of cash flow, however, has many weaknesses that arise out of the use of accrual accounting, which attempts to match expenses to revenues when the revenues can be expected or recognized. Decisions regarding the capitalization of expenses, the recognition of revenues, the creation of reserves against losses, and the write-off of assets are just a few of the factors that may vary from firm to firm.
Price to Free Cash Flow per Share: Calculated by dividing the current stock price by free cash flow per share for the last four fiscal quarters (trailing 12 months). Free cash flow is derived by subtracting capital expenditures and dividend payments from cash from operations. Operating cash flow comes from the company’s statement of cash flows and is designed to measure the company’s ability to generate cash from day-to-day operations as it provides goods and services to its customers. It considers factors such as cash from the collection of accounts receivable, the cash incurred to produce any goods or services, payments made to suppliers, labor costs, taxes, and interest payments. This free cash flow figure is considered the excess cash flow that the company can use as it deems most beneficial. Free cash flow is based on cash accounting instead of on earnings based on accrual accounting.
Dividend Yield: An inverse multiple, yield is calculated by dividing the indicated dividend by the current stock price. This field is only meaningful for the roughly 35% of the companies in the Stock Investor database that pay a dividend. Whether a company pays a dividend hinges largely on the current resting point of the company and its industry life cycle. New firms or those that are undergoing rapid growth rarely pay dividends, as this money is better spent on investing in the company’s growth. Over time, as a company matures, the number of internal projects a company can invest in declines and they begin paying out excess profits as dividends. Some investors seek out firms with high, stable dividend yields with the belief that they represent undervalued opportunities. A high dividend yield also serves as protection against further price declines.