One of the goals of stock analysis is to determine whether a company’s stock is a “fair value” 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.

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.

The Multiples tab in Stock Investor Standard and 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 is a “good” buy. The box on page 4 provides definitions of the key multiples found in the program.

For this discussion of Stock Investor’s key multiples, Merck & Co., Inc. (MRK) is used, with data corresponding to that found in Stock Investor Pro as of December 28, 2001. 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 Figure 1, the current price-earnings ratio for Merck is 19.3, which is derived by dividing the current stock price of $59.55 by the fully diluted earnings per share from continuing operations for the last four quarters (trailing 12 months) of $3.08. This value places Merck in the 58th percentile of the entire Stock Investor database. This means that for those companies that have a current price-earnings ratio value, 58% of the companies in the database have a lower current ratio, while 42% have a higher current ratio than Merck. Percentile rank data is available for selected data fields in Stock Investor Standard and Pro. They are found in the % Rank data category.

Merck’s current price-earnings ratio has fallen significantly over the last year, from 33.3, the price-earnings ratio from one year ago (1 Year Ago), to 19.3 currently (Figure 1). This value is calculated by dividing the stock price from one year ago, in this case the closing price for December 2000 ($93.63), by the sum of the quarterly diluted earnings per share from continuing operations for quarters five through eight (Q5 to Q8), which is $2.81. Based on this information, the decline in the ratio over the last year is partly attributed to an increase in earnings from quarters five through eight to quarters one through four ($2.81 versus $3.08). However, most of the ratio decline is due to the 36% decrease in the stock price that has taken place since the end of December of last year.

The next question would be whether the decline in Merck’s price is related to overall market activity, or if it represents weakness in the company itself. For Merck, its stock price has underperformed the S&P; 500 by 28% over the last 52 weeks, as shown by the 52-week relative strength on the Share Statistics tab of the Overview section in Stock Investor.

In Stock Investor Standard and Pro, you will find 1 Year Ago values for the price multiples—price-earnings, price-book value, price-sales, price-cash flow, and price-free cash flow—as well as for dividend yield.

Merck’s current price-earnings ratio is also well below its historical levels, represented by the three-year, five-year, and seven-year average ratios. The three-year average of 30.3 is simply the average of the price-earnings ratios for each of the last three years, which for Merck are 26.2, 30.3, and 34.5 (Figure 1). In order to calculate this field, a company must have had positive earnings per share for each of the last three fiscal years. We can also see that, historically, Merck’s price-earnings ratio has a higher percentile rank (more richly valued) among the entire database and has been more in line with sector and industry norms. In Stock Investor Standard and Pro, there are three- and five-year averages for price-earnings, price-book value, price-sales, price-cash flow, and price-free cash flow and in Pro there are also seven-year averages for these fields. Percent rank data and industry and sector medians are available for these fields.

Another way to use the price multiples in Stock Investor is to examine the historical trends in a given variable. In Stock Investor Standard, you are given five years of annual average multiples data while in Stock Investor Pro there are seven years of annual data. Since 1997, Merck’s price-earnings ratio has declined from 35.2 to its current level of 19.3.

The average price-earnings ratio for a given year is the average of the high and low price-earnings ratio for that year. The high price-earnings ratio is calculated by dividing the high stock price for the year by the annual fully diluted earnings per share from continuing operations. The low price-earnings ratio for the year is calculated using the low stock price for the year.

To avoid confusion, it is best to think of the annual data in terms of Y1, Y2, Y3, etc. instead of the calendar years assigned to them. The 2000 (Y1) average price-earnings ratio for Merck is 26.2. This is calculated by taking the average of the high and low price-earnings ratios for 2000. The high price-earnings ratio for Y1 is the high price for Y1, $95.25—divided by the fully diluted earnings per share for Y1, $2.90, which is 32.8. Repeating the same process for the low price-earnings ratio—low price Y1 of $56.80 and fully diluted earnings per share from continuing operations of $2.90—results in a value of 19.6. Averaging the high price-earnings ratio (32.8) and low price-earnings ratio (19.6) gives the 2000 (Y1) average of 26.2.

Stock Investor Standard and Pro also offer 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 (P/E 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 Stock Investor Standard and Pro. 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, Graham often averaged earnings over a period of several years. The average of these three annual earnings figures for Merck is $2.50 [(2.90 + 2.45 + 2.15) ÷ 3]. Dividing Merck’s current stock price of $59.55 by this average leads to the value of 23.8 (Figure 2).

Both Stock Investor Standard and Pro also contain “forward” or estimated price-earnings ratios based on the current stock price and the estimated earnings for the current fiscal year and for each of the next two fiscal years. Meaningful price-earnings ratios over time are predicated on the underlying assumptions (interest rates, expected growth rates, etc.) not changing significantly, which is not always the case. Forward price-earnings ratios, however, are calculated using estimated earnings based on the current fundamentals.

With Merck, the annual earnings estimates for the current fiscal year and for each of the next two fiscal years are $3.13, $3.14, and $3.49, respectively. Given that the earnings elements of the calculation are rising while price is held constant, it is no surprise that the forward or estimated price-earnings ratios for Merck are 19.0, 19.0, and 17.1 (Figure 1). All of these are below Merck’s current price-earnings ratio value. Based on these forward price-earnings ratio figures, Merck again rests in the middle of the Stock Investor database as well as below the industry and sector medians provided for these data fields.

One of the most popular techniques used to seek out both growth and value involves finding stocks with low price-earnings relative to earnings growth. Stock Investor Standard and Pro offer four of these price-earnings-to-growth (PEG) ratios. The first, PE to Growth - 5 Years, is computed by dividing the current price-earnings ratio by the historical five-year growth rate in fully diluted earnings per share from continuing operations. For Merck, this is 19.3 divided by 17.0, or 1.1 (Figure 2). The general rule of thumb is that a PEG ratio below one indicates that a stock may be undervalued, while a stock with a PEG ratio above one may be overvalued. Value investors attempt to purchase a stock with some demonstrated earnings growth before the market recognizes the company’s potential and bids up the price-earnings ratio. Based on this figure, Merck appears to be slightly overvalued.

A variation on the PEG ratio uses the estimated growth rate in earnings per share instead of the historical growth rate—dividing the current price-earnings ratio by the estimated growth rate in earnings. One limitation of using this PEG ratio is that only about 3,300 of the companies in the Stock Investor database have an estimated earnings growth rate. Dividing the current price-earnings ratio for Merck (19.3) by its estimated growth rate in earnings (11.3) results in the PE to Estimated Growth - 5 Years value of 1.7 (Figure 2). Since the estimated growth rate is lower than the historical growth rate, this PEG ratio is higher than the one discussed earlier and, thus, Merck appears to be even more “overvalued.”

The last PEG ratio presented on the Multiples tab is the PE to Dividend Adjusted Growth - 5 Years. For this field, which is used in the Peter Lynch screen, the standard PEG ratio is adjusted to reflect the dividend yield. This adjustment acknowledges the contribution that dividends make to an investor’s return. It is calculated by dividing the current price-earnings ratio (19.3 for Merck) by the sum of the five-year historical growth rate (17.0) and the current dividend yield (2.4), which is 19.4. The result for Merck is a dividend-adjusted PEG ratio of 1.0 (Figure 2).

Conclusion

Analysis of these multiples provides investors with a relatively easy means of discerning the market’s opinion of the company as well as insight into a company’s “fair” value. Value investors can use multiples to locate companies that warrant further analysis.

Price-Earnings Ratio:

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).

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 which 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.

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.

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.

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.

An inverse multiple, yield is calculated by dividing the indicated dividend by the current stock price. This field is only meaningful for the roughly 25% 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.