Valuation Ratios – Part 1

Equity valuation is a process far too complex to perform by ratio analysis only. Oftentimes, when evaluating a company, a financial analyst has to use a mixture of methods depending on the purpose of the analysis.

There are three basic approaches to equity valuation:

• Asset-based, which considers only the assets of the company;
• Income-based, which considers expected (discounted) cash flows;
• Market-based, which compares company valuation ratios to similar publicly-traded companies or industry norms.

The asset-based method is normally reserved for creditors and special situations like liquidation.

The income-based approach is considered to be superior, but it is burdensome and prone to uncertainty.

Therefore, comparable ratios (or the market-based approach) is often preferred as a quick and simple method of valuation.

Per-Share Metrics

Comparables, as the name suggests, compare a company to its peers. To do that, they use publicly available information and, for the sake of simplicity, often relate to share prices.

The most common valuation ratios use share price in their numerator and require a standardization of the denominator. So, the denominator value is divided by the number of shares outstanding to obtain its per-share value.

One of the most common metrics is known as Earnings per share (EPS). It divides a company’s net income by the number of outstanding shares:

Earnings~per~share~(EPS)=\frac {Net~income-Preferred~Dividends}{Outstanding~number~of~common~shares}

It basically tells us how much income a company earns per one common share. In practice, this is a popular measure because, over the long term, Net Profit is the primary determinant of investment value. EPS, however, is generally unstable from year to year, and sometimes analysts take an average over a period of five or even ten years. This is known as normalized EPS.

One can take any item from any part of a company’s financial statements and divide it by the number of shares outstanding to obtain its per-share value. The most commonly used metrics are:

• Earnings per share (EPS)
• Cash flow per share
• Sales per share
• Book value (of equity) per share
• Dividend per share (DPS)

The P/E Ratio

The Price-to-Earnings ratio is, by far, the most common valuation ratio. It is often simply referred to as the price multiple.  Price-Earnings or P/E ratio takes earnings per share in relation to share price:

PE Ratio= \frac {Price}{Earnings~per~Share}=\frac {Market~Value~of~Equity}{Net~Income}

It tells us how many years these earnings will take to cover thе current equity market value. Generally, the higher the ratio, the more expensive a company is. Oftentimes, high P/E ratios are the result of a market frenzy whereby a company generates too much hype and investors create excessive demand for its stock, thus bidding the price up. When the ratio gets too high, though, it becomes questionable if the company’s profitability justifies the price.

There are two main types of P/E ratios:

• Trailing P/E analyzes earnings for the last 12 months in relation to today’s price.
• Forward P/E considers projected earnings in relation to today’s price.

Typically, the P/E ratio’s advantages are that it examines investment value’s main driver (earnings) and it’s easy to obtain as a comparable. Its disadvantages, however, stem from the fact that earnings are often volatile, can be manipulated, and even negative. In addition, it does not consider the company’s debt burden, but that is true for all other price multiples.

PE Ratio Variations

There are several versions of the PE ratio developed by analysts that attempt to address some of its shortcomings. The rationale remains the same: looking at the relationship between the market value of a company’s equity and the amount of net income it generates. In most cases, the share price forms the numerator, and earnings per share form the denominator. Similarly, a high ratio implies that the company is overvalued.

Cyclically-Adjusted Priceto-Earnings (CAPE) ratio is the first PE variation. It examines average earnings over a 10-year period:

CAPE=\frac {Price}{10~Year~Average~Inflation~Adjusted~Earnings~per~Share}

In practice, some iterations known as normalized PE ratio would take 2-, 3-, 5- or 15-year periods to “normalize” earnings.

The CAPE ratio is favored by practitioners because it smooths earnings’ volatility and cyclicality. It is also fairly improbable that a company can have negative 10-year average earnings and stay in business. However, the metric assumes normal operations of the company and would conceal if there was a decline in earnings over the past few years. Besides, it doesn’t overcome the problem of different accounting practices applied by various companies. Plus, it is backward-looking and doesn’t account for expected business changes.

Average ROE CAPE is the second version of the PE ratio. Unlike CAPE, it uses a different approach to normalize EPS: it takes average ROE over the past 10 years and multiplies it by the current equity book value:

CAPE_{ROE}=\frac {Price}{ROE_{10~Yrs} * Book~Value~per~Share_{At~present}}

The good thing about this ratio is that it reflects the effect of the firm’s size changes. Compared to CAPE, it is a forward-looking measure. The main drawback, however, lies in the fact that it is not well understood, less intuitive, and cumbersome to calculate.

The Earnings Yield comes next. It simply reverses the P/E ratio into an E/P ratio:

E/P~Ratio= \frac {Earnings~per~Share~(EPS)}{Price}

By the same token, a higher ratio implies undervaluation. It is mostly applied in situations where earnings are negative, so we can’t use the PE metric.

Moreover, we can use the PEG ratio. It takes the standard P/E ratio a step further and interprets it as P/E per unit of expected growth. It helps us understand whether the P/E ratio is justified, given expected growth:

PEG~Ratio= \frac {P/E}{Expected~Growth~Rate}

The higher the PEG ratio, the less justified a high P/E is. This suggests that the price is too high relative to both present earnings and future growth expectations. Practically speaking, such a measure is good to apply in situations where a simple PE ratio is suspiciously high: if present or next year’s earnings do not justify it, then perhaps growth expectations might.

You may also come across the so-called Justified PE ratio. It does not change EPS but substitutes the market price in the numerator with an intrinsic price derived from a valuation model. In a way this reverses the P/E framework:

Justified~Price=\frac {Company's~Intrinsic~Value}{Number~of~Shares~Outstanding}
then~Justified~PE=\frac {Justified~Price}{Projected~Earnings}

So, standard P/E takes the market price and examines whether earnings justify it. Justified P/E looks at the company’s fundamentals (including earnings), calculate the company’s intrinsic value, and arrive at a justified share price. Then, they compare justified P/E with the forward P/E. The most common method used to arrive at a justified price is the Gordon Growth Model (a.k.a. the Dividend Discount Model).

Beyond PE

As with every type of fundamental analysis, we need to make sure that we are comparing “apples” to “apples”. Some industries, such as telecommunications or energy, are characterized by relatively high P/E ratios, whereas others, like manufacturing companies, often exhibit low price multiples. It is a matter of how much investors are willing to pay for each dollar earned in a particular sector.

Besides, within the same industry, firms have different capital structures. If the debt/equity ratio of Company A is 70/30, while for B it is 10/90, any price multiple comparisons would not be viable.

So, we should bear in mind that P/E ratios are highly dependent on a firm’s capital structure.

What’s more, analyzing the P/E trends of one company may be of little value, especially when certain one-off events occur. If a firm goes through a major restructuring or acquisition, both share prices and earnings per share may take unexpected directions.

Depending on the valuation method used, the justified price multiple can be mathematically transformed into a completely different equation. To learn more about valuation methods, please review our series on valuation.

In effect, all price multiples can be made justified. To know more about other well-known price multiples, go to Valuation Ratios – Part 2.