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402-Using Ratios and Multiples1
  Course 402:
  Using Ratios and Multiples
  Now that we have reviewed the basics of stock valuation and why it is
  important, it's time to get into the nitty-gritty on specific valuation
  methods. As we discussed in the previous lesson, the most common stock
  valuation approach involves ratios between a stock's market price and an
  element of the underlying company's performance--earnings, sales, book value,
  or something similar. Ratios are very popular with investors because they can
  be calculated easily, and they are readily available from most financial Web
  sites and newspapers.
  
  While valuation ratios have become ubiquitous, it's important to recognize
  their strengths and weaknesses Valuation ratios are handy tools to have at
  your disposal for a quick-and-dirty analysis, but they all require a lot of
  context to be useful.
  
  In this lesson, we will review again the most widely used valuation ratios and
  discuss how to incorporate them into your thinking. We touched on much of this
  subject matter in Lesson 108, but this lesson will dig deeper. Once you
  thoroughly understand the promises and pitfalls of valuation ratios, we will
  move on to more-advanced valuation methods in the next lesson.
  
  
  Price/Sales (P/S)
  One of the most basic valuation ratios is the P/S ratio. The P/S ratio is
  equal to a stock's market price divided by its sales per share.
  
  P/S = (Stock Price) / Sales Per Share
  
  The nice thing about the P/S ratio is that sales are fairly cut-and-dried
  numbers, not subject to much accounting assumption and manipulation like
  earnings can be. Although firms could use accounting tricks to lift sales,
  it's much harder to do and far easier to catch. Moreover, sales are not as
  volatile as earnings, because one-time charges or gains can depress or boost
  earnings temporarily. Plus, the bottom line of economically cyclical companies
  can vary significantly from year to year, but sales are a more stable
  benchmark. Moreover, the P/S ratio can be used for companies that don't have
  positive earnings.
  
  The relative smoothness of sales makes the P/S ratio useful for quickly
  valuing companies with highly variable earnings by comparing their current P/S
  ratios with historic P/S ratios. For example, Motorola MOT has had very
  unstable earnings over the past few years thanks to a large number of one-time
  charges to its earnings, and it has had negative net income in two of the five
  years between 2000 and 2004. With such spotty earnings, a price/earnings ratio
  is not going to help an investor very much. Sales have not jumped around
  nearly as much, however, and this makes the P/S ratio useful. On April 1,
  2005, Motorola's P/S ratio was 1.2, which made the stock about fairly valued
  compared with where it traded in the past.
  
  
  The Drawbacks of P/S
  Despite several advantages, the P/S ratio has some limitations. One major flaw
  is that sales may be worth a little or a lot, depending on a company's
  profitability. If a company is posting billions in sales, but it is losing
  money on every transaction, we would have a hard time pinning an appropriate
  P/S ratio on the shares because we have no idea what level of profits (if any)
  the company will generate.
  
  We will reiterate that when using the P/S ratio, it is important to keep in
  mind that a dollar of earnings has the same value regardless of the level of
  sales needed to create that dollar. A dollar of sales at a highly profitable
  firm is therefore worth more than a dollar of sales for a company with a
  narrower profit margin. Thus, the P/S ratio is generally useful only when
  comparing firms within an industry or industries with similar profitability
  levels, or when looking at a single firm over time.
  
  
  Price/Book (P/B)
  The P/B ratio compares a stock's market price with its book value. (Book value
  is the equity balance an a firm's balance sheet divided by the number of
  shares outstanding.) Conservative investors often prefer the P/B ratio,
  because it offers a more tangible measure of a company's value than earnings
  do. Legendary investor Benjamin Graham, one of Warren Buffett's mentors, was a
  big advocate of book value and P/B in valuing stocks. (See Lesson 504 for more
  on Ben Graham.)
  
  There are caveats to using P/B, just as there are for all the other simple
  ratios we will discuss. The carrying value of an asset on a company's balance
  sheet may not reflect the true value of the asset. For example, a future
  charge to write down the value of an overvalued asset could dramatically
  reduce a firm's book value and change the P/B in one swipe. On the other side
  of the coin, the book value of a company doesn't always accurately measure its
  true worth, especially for firms with lots of intangible assets such as
  patents, databases, and brand names that don't show up on the balance sheet.
  Some assets, like land, are also carried on a company's books at cost. If a
  company has held a property for a long time, chances are the value of the land
  is much greater than what its books state.
  
  The P/B ratio is also tied to return on equity (remember, ROW is equal to net
  income divided by average book value) in the same way that price/sales is tied
  to net margin (equal to net income divided by sales). Taking two companies
  that are otherwise equal, the one with a higher ROE will have a higher P/B
  ratio.
  
  The reason is clear--a firm that can compound book equity at a much higher
  rate is worth far more because absolute book value will increase more quickly.
  
  
  Price/Earnings (P/E)
  P/E is the most popular valuation ratio used by investors. It is equal to a
  stock's market price divided by the earnings per share for the most recent
  four quarters. The nice thing about P/E is that accounting earnings are a much
  better proxy for cash flow than sales. Moreover, earnings per share results
  and estimates about the future are easily available from just about any
  financial data source imaginable.
  P/E = (Stock Price) / EPS
  The P/E ratio measures how much investors are willing to pay for a company's
  earnings. Generally speaking, the higher the P/E ratio, the more investors are
  willing to pay for a dollar's worth of a company's earnings. Stocks with high
  P/Es (typically those with a P/E exceeding 30) usually have greater future
  growth prospects, while stocks with low P/Es (typically those with a P/E below
  15) tend to have lesser future growth prospects. However, a P/E ratio by
  itself does not say much about a stock's valuation.
  
  The most useful way to use a P/E ratio is to compare it with a certain
  benchmark. Good benchmarks are the P/E of another company in the same
  industry, the P/E of the entire market, or the same company's P/E at a
  different point in time. Each of these approaches has some value, as long as
  you know the limitations.
  
  For example, a company that is trading at a lower P/E than its industry peers
  could be a good value, but even firms in the same industry can have very
  different capital structures, risk levels, and growth rates, all of which
  affect the P/E ratio. All else equal, a firm that has better growth prospects,
  lower risk, and lower capital reinvestment needs should be rewarded with a
  higher P/E ratio.
  
  You can also compare a stock's P/E with the average P/E of the entire market.
  However, the same limitations of industry comparisons apply to this process as
  well. The stock you are investigating might be growing faster (or slower) than
  the average stock, or it might be riskier (or less risky). In general,
  comparing a company's P/E with those of industry peers or with the market has
  some value, but you should not rely on these approaches to make final buy or
  sell decisions.
  
  Comparing a stock's current P/E with its historical P/E ratios can also be of
  value. This is especially true for stable firms that have not undergone major
  business shifts. If you find a solid company that is growing at roughly the
  same rate with roughly the same business prospects as in the past, but is
  trading at a lower P/E than its long-term average, you should start getting
  interested. It's entirely possible that the company's risk level or business
  outlook has changed, in which case a lower P/E is warranted, but it's also
  possible that the market is simply pricing the shares at an irrationally low
  level.
  
  
  Price/Earnings: The Drawbacks
  The P/E ratio also has some important drawbacks. A P/E ratio of 15 does not
  mean a whole lot by itself; it is neither good nor bad in a vacuum. As we
  discussed previously, the P/E ratio only becomes meaningful with context.
  
  However, keep in mind that using P/E ratios only on a relative basis means
  that your analysis can be skewed by the benchmark you are using. After all,
  there will be periods when entire industries will become overvalued. In 2000,
  an Internet stock with a P/E of 75 might have looked cheap when the rest of
  its peers had an average P/E of 200. In hindsight, neither the price of the
  stock nor the benchmark made sense. Just remember that being less expensive
  than a benchmark does not mean something is cheap, because the benchmark
  itself may be vastly overpriced.
  
  When you're looking at a P/E ratio, also make sure that the "E" part of the
  equation makes sense and is representative of a company's ongoing profits. A
  few things can distort the P/E ratio. First, firms that have recently sold off
  a business can have an artificially inflated "E" and a lower P/E as a result.
  In late 2000, software-maker Oracle ORCL had a very low P/E based on its prior
  four quarters' earnings--until you dug into the numbers and saw that the
  company had booked a $7 billion gain by selling its stake in Oracle Japan.
  Based on operating earnings, the stock was not cheap at all.
  
  Second, reported earnings can sometimes be inflated (or depressed) by one-time
  accounting charges and gains. As a result, the P/E ratio can be misleadingly
  high or low. For example, on April 1, 2003, biotech firm Genentech DNA was
  trading for $35.02 a share and had earned $0.12 per share over the previous
  four quarters, giving it what appeared to be a sky-high trailing P/E of 292.
  But Genentech's 2002 earnings were depressed by charges related to litigation
  and earlier redemption of its stock. Excluding those charges, Genentech had
  $0.92 a share in "pro forma" earnings in 2002, giving it a P/E of 38. This is
  still not exactly cheap, but a far cry from 292.
  
  Third, cyclical firms that go through boom and bust cycles--semiconductor
  companies and auto manufacturers are good examples--require a bit more
  investigation. Although you would typically think of a firm with a very low
  trailing P/E as cheap, this is precisely the wrong time to buy a cyclical firm
  because it means earnings have been very high in the recent past, which in
  turn means they are likely to fall off soon. Likewise, a cyclical stock is
  going to look the most expensive when its "E" has bottomed and is about to
  start growing again.

  Lastly, there are two kinds of P/Es--a trailing P/E, which uses the past four
  quarters' worth of earnings to calculate the ratio, and forward P/E, which
  uses analysts' estimates of the next four quarters' earnings to calculate the
  ratio. Because most companies are increasing earnings from year to year, the
  forward P/E is almost always lower than the trailing P/E, sometimes markedly
  for firms that are increasing earnings at a very rapid clip. Unfortunately,
  estimates of future earnings by Wall Street analysts--the consensus numbers
  you often read about--are consistently too optimistic. As a result, buying a
  stock because its forward P/E is low means counting on that future "E" to
  materialize in its entirety--and that usually doesn't happen.