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 $300-pershare 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 one-time 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, short-term 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 9-3
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.

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.

Price-to-Sales Ratio

The price-to-sales 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 price-to-sales ratio with that of the industry to determine whether the company is trading at a compelling valuation to its sales base. The price-to-sales ratio was used to value Internet-related companies that had no earnings during the stock market boom of the late 1990s. Alow price-to-sales 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 (after-tax 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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