Relative Valuation Methods
The relative valuation methods for valuing a stock are to compare
market values of the stock with the fundamentals (earnings, book
value, growth multiples, cash flow, and other yardsticks) of the
stock.
Price/Earnings (P/E) Ratio
The most commonly used guide to the relationship between stock
prices and earnings is the price/earnings (P/E) ratio, computed by
dividing the market price of the stock by its earnings per share. The
P/E ratio indicates the multiple that an investor is willing to pay
for a dollar of a company’s earnings.
There are two widely held assumptions regarding P/E ratios.
The first is that stocks in the same industry have similar P/E
ratios; the second is that stocks tend to trade within a range of P/E
ratios. Pharmaceutical stocks, for example, have similar P/E ratios,
and one of them, Merck, has P/E ratios that trade in a range of 13
to 32 times its earnings.
The P/E ratio shows the number of times that a stock’s price is
trading relative to its earnings, and because stock prices fluctuate,
so do their ratios. Rising P/E ratios generally are linked to higher
stock prices.
You can determine a company’s stock price by multiplying the
P/E ratio by the company’s earnings per share. For example, if a
P/E ratio for a stock is 8 and it is projected to earn $4 per share, the
value of the stock is $32 (8 * $4 per share). If this stock is trading
at a market price of less than $32 per share, it is undervalued.
Amarket price of greater than $32 per share indicates that the stock
is overvalued.
This method of valuation was used to determine that Google’s
stock was undervalued when it was trading in the low $300pershare
range. Google was expected to earn $8 per share and was
trading at a 50 P/E multiple, prompting many analysts to raise
their price targets for Google stock to $400 per share ($8 EPS * 50
P/E ratio).
Another use of the ratio is to divide a company’s market price
by its projected earnings per share. If the market price of a stock is
$30 and its projected earnings per share are $4, the P/E ratio is 7.5.
If analysts think that the appropriate ratio for companies in this industry
is 9, then this stock is undervalued.
Using P/E ratios to value stocks has several weaknesses.
Determining the appropriate P/E ratio is subjective, and P/E ratios
can fluctuate considerably. Theoretically, if earnings per share
increase, the stock price should rise so that the P/E ratio stays the
same. In reality, this situation does not happen often. P/E ratios
can be volatile and fluctuate considerably, making this a difficult
indicator to read over short periods of time. Longer term, P/E
ratios are more accurate in determining whether a company is
over or undervalued.
Another major weakness is the use of earnings per share
(EPS). By definition, earnings per share include extraordinary
gains and losses that are nonrecurring. The inclusion of a onetime
gain overstates earnings per share and causes the P/E ratio to be
lower. Consequently, the stock might appear to be undervalued.
Another stumbling block is the use of historical earnings versus
future earnings, which is discussed further in Table 9–3.
Because of these weaknesses in the use of the P/E ratio, shortterm
results as to the valuation of a stock could be misleading. Over
longer time periods, these aberrations even out, and the P/E ratio
becomes a more meaningful indicator of a company’s stock value.
When comparing the P/E ratios of stocks in different industries,
you should be aware of these differences in computation so that
your yardstick of comparison is the same.
Price/Earnings Growth (PEG) Ratio
The price/earnings growth ratio is the company’s P/E ratio divided
by the company’s estimated future growth rate in earnings per
share. The price/earnings growth (PEG) ratio indicates how much
an investor pays for the growth of a company. For example, a company
with an estimated growth rate of 16 percent and a P/E ratio of
20 has a PEG ratio of 1.25 (20 / 16). For growth rates that are less
than the P/E ratio, the value of the PEG ratio is greater than 1.0.
Agrowth rate that exceeds the P/E ratio results in a value that is less
than 1.0. The lower the ratio, the greater is the potential increase in
stock price, assuming that the company can grow at its projected
growth rate. A stock generally is perceived to be undervalued if the
growth rate of the company exceeds its P/E ratio. A high PEG ratio
implies that the stock is overvalued. Put another way, the lower the
PEG ratio, the less an investor pays for estimated future earnings.
Bear in mind that if the estimated earnings growth rate is inaccurate,
the PEG ratio will be unreliable as an indicator of value.
Table 93
Which Price/Earnings Ratio to Use?
On November 20, 2002, the P/E ratio for the S&P 500 Index was 22, 16, and 49
(The Vanguard Group, 2003, p. 3). Which is the correct number? This situation
might seem confusing, but all three numbers are correct. The different numbers
were caused by the use of different earnings figures:
* Historical earnings are the actual earnings a company reports for the prior year.
* Forward earnings are the estimated earnings a company is expected to earn in
the coming year.
* Operating ernings, or earnings before interest and taxes (EBIT), exclude gains
and losses, interest expense and income, and taxes.
Which one should you use?
Historical earnings show a company’s actual earnings, but the past is not always
accurately projected into the future. The use of historical earnings results in
higher P/E ratios than using forward earnings during periods of earnings growth.
The opposite is also true: In periods of declining earnings growth, the use of
historical earnings results in lower P/E ratios than use of forward earnings.
Forward earnings are only estimates that are determined subjectively by
financial analysts.
The use of net income versus operating income also reflects differences in the ratio
outcome. The use of net income results in higher P/E ratios than does the use of
operating earnings.
When you are comparing P/E ratios, be aware of the different definitions of earnings,
and then consistently base your comparisons of stock valuations on the
same category of earnings. Second, compare the P/E ratio for the stock with the
ratios of stocks in the same industry, and look at the historical trading ranges for
the P/E ratios. For example, in the years 1935 to 2002, the S&P 500 Index had
a high P/E ratio of 46.5 and a low of 5.9, with an average of 15.3, based on
historical earnings (The Vanguard Group, 2003, p. 3).
Several questions might immediately come to mind. How
high is high and how low is low for a PEG ratio? Is a PEG ratio of
3 acceptable, or is it on the high side? The answers to these questions
depend on your interpretation of the data. A popular rule of
thumb is that a stock with a PEG ratio below 1.0 is considered to be
undervalued, and a stock with a PEG ratio of greater than 1.0 is
considered to be overvalued. The PEG ratio should not be used in
isolation in choosing stocks in which to invest but should be
included with additional information about the company’s fundamentals
to determine value.
Table 9–4 compares the PEG ratios of companies in different
industries.
Table 94
Comparison of PEG Ratios
Company 
PEG Ratio 
Microsoft Corporation 
1.38 
Cisco Systems, Inc. 
1.04 
PepsiCo 
1.95 
Johnson & Johnson 
1.75 
ExxonMobil 
1.47 
Citicorp 
1.14 
Google 
1.25 
Boeing 
2.10 
Diamond Offshore 
0.47 
Price–to–Book Value Ratio
Some investors look for stocks whose market prices are trading
below their book values. The book value per share is computed by
deducting the total liabilities from total assets and then dividing
this number by the number of shares outstanding. The use of book
value per share as a valuation tool is not compelling because many
factors overstate or understate the book value of a stock. For example,
buildings and real estate are recorded at historical costs (original
purchase prices), although market prices can be significantly
higher or lower, thereby distorting the book value per share.
Alow value suggests that the stock is undervalued, and a high
value indicates the opposite. As with the P/E and PEG ratios, what
differentiates a stock from being overvalued and undervalued is
determined subjectively.
Investors looking for value stocks would place more emphasis
on finding stocks whose book values are greater than their market
values. Value stocks tend to have lower P/E ratios, lower growth
rates, and lower price–to–book value ratios than growth stocks do.
PricetoSales Ratio
The pricetosales ratio indicates how much an investor is willing
to pay for every dollar of sales for that company. The ratio is computed
by dividing the market price of the stock by the sales per
share. This ratio measures the valuation of a company on the basis
of sales rather than earnings. You should compare the company’s
pricetosales ratio with that of the industry to determine whether
the company is trading at a compelling valuation to its sales base.
The pricetosales ratio was used to value Internetrelated
companies that had no earnings during the stock market boom of
the late 1990s. Alow pricetosales ratio indicates that the company
has room to expand its sales and, therefore, its earnings.
Price–to–Cash Flow Ratio
Earnings are an important determinant of a company’s value, but
the company’s cash position is another important way to assess
value. A company’s statement of changes in cash is a good starting
point for assessing cash flow. Cash flow is computed by adding noncash
charges, such as depreciation and amortization, to net income
(aftertax income). Cash flow per share is computed by dividing the
cash flow by the number of common shares outstanding.
Cash flow per share is considered by many analysts to be a
better yardstick of valuation than earnings per share. The amount
of cash flow a company can generate indicates the company’s
capability to finance its own growth without having to resort to
external funding sources.
The price–to–cash flow ratio is similar to the P/E ratio except
that the cash flow per share is substituted for earnings per share. In
other words, the market price of the stock is divided by the cash
flow per share to equal the price–to–cash flow ratio. As with the
P/E ratio, the lower the price–to–cash flow ratio, the more compelling
is the value of the company. The advantage of using cash
flow over earnings per share is that a company can have negative
earnings per share but positive cash flow per share.


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