Lesson #16: Relative Valuation Methods
After studying the DCF let me now focus on a few other methods / techniques that are used to value stocks.
These are collectively called “relative valuation” techniques, and consist of –
- Price/ Earnings (P/E)
- Price/Earnings to Growth (P/EG)
- Price/ Book Value (P/BV)
- Price/Sales Ratio (P/S)
- Price/Cash Flow (P/CF)
The reason these are called “relative” valuation techniques is because the value of an asset here is derived from the pricing of comparable or relative assets, standardized using a common variable such as earnings (P/E), cash flows (P/CF), book value (P/BV) or sales (P/S).
Unlike DCF or EPV valuations, which are described as a search for intrinsic value, we are much more reliant on the market when we use relative valuations. We assume that the market is correct in the way it prices stocks, on average, but that it makes errors on the pricing of individual stocks.
An advantage is that relative valuations provide us information as to how the market is currently valuing stocks at several levels (aggregate market, alternative industries, individual stock within industries).
The core idea of relative valuations is to convert the values of companies sharing similar attributes to comparable multiples and then seeing how those stocks stand in relation to their peers.
In this lesson we’ll be exploring only the first four methods listed above.
1. Price to Earnings (P/E)
The P/E ratio of a stock is a simple tool for measuring the markets’ temperature. It is calculated by dividing a stock’s price by the company’s earnings per share or EPS.
P/E Ratio = Price per share / Annual earnings per share
The P/E ratio suggests how much investors are willing to pay for each rupee of a company’s earnings. Higher the P/E, more expensive is a stock, as investors are willing to pay more for each rupee of a company’s earnings.
Here is how you can use P/E as a technique to roughly calculate stock valuations –
- In an industry, identify 5 stocks which are similar to the stock you want to evaluate.
- Assuming the average P/E of these five stocks is (14+18+24+21+20)/5=19.4
- The stock you are evaluating has an EPS of Rs 2.5
- The intrinsic value you calculate using the P/E would be
P = P/E x EPS = 19.4 x 2.5 = Rs 48.5.
- Avoid including stocks with negative P/E ratios, which would be due to the companies having a negative EPS.
- If the business you are studying is in a better situation than its peers on the industry average (like in terms of profitability, management quality etc.), give it some premium to the average P/E.
While it is amongst the easiest valuation multiple to calculate and compare, the P/E is highly prone to manipulation because it is based on the ‘earnings’ number that is an easy candidate for manipulation by companies and their accountants.
2. The PEG ratio
The P/E ratio, in isolation, does not tell about a company’s earnings growth prospects. This is where the ‘price to earnings growth’ or a PEG ratio comes into existence. As against the P/E ratio that compares a stock’s price to its earnings per share, the PEG ratio compares the P/E (numerator) with the expected earnings growth rate (denominator).
PEG = Price to earnings or P/E divided by Earnings growth rate
Despite the fact that the numerator is in ‘multiple’ terms and the denominator in ‘percentage’ terms, the output of the ratio is still a multiple like the P/E ratio. So if a stock’s P/E is 15 times and the company’s earnings are expected to grow by 10% in the next year, the stock’s PEG ratio will be 1.5 (15 divided by 10).
The good thing about PEG is that it puts a value to on the expected growth rate of a company. It can suggest whether a company’s high P/E reflects an excessively high stock price or is a reflection of promising growth prospect of the company.
But then, for companies that do not offer high future growth rates, but have a safe and sound business that will help them to grow steadily, the PEG ratio would show them as overvalued (as the denominator would be lower than the numerator).
To conclude, PEG is just rule of thumb to see how high a stock is trading relative to the company’s expected earnings growth rate.
3. Price to Sales (P/S)
Just like the P/E ratio that compares a stock’s price to its earnings (or net profits) per share, the price to sales ratio (P/S) compares the stock’s prices to the companies’ sales per share.
Price to sales or P/S = Price per share divided by Sales per share
Stocks that trade at a low P/S multiples are viewed as cheap relative to stocks that trade at high P/S multiples.
The good thing about the P/S multiple is that, unlike earnings, sales are not subject to much account manipulation. Although companies can still play around with sales, the manipulation is much harder to do and much easier to check.
Moreover for a small company or a startup where there is a negative number to show for earnings, a P/S ratio can come in handy to calculate the intrinsic value.
Of course if the company is consistently unprofitable then there is no point in focussing on P/S ratio. In essence, every rupee of sales is worth a lot more in a profitable company than it is in a less profitable one.
This relative valuation metric is thus useful only to compare stocks within the same industry and with similar profitability, or when looking at the same company over a period of time.
4. Price to Book Value (P/BV)
Price to book value is …
Price to book value (P/BV) = Price per share divided by Book value per share
Book value of a company is simply its net worth or equity. Book value per share is the net worth divided by the number of shares outstanding.
It is assumed that if the company were to liquidate (close down its business and sell its assets), it would receive in cash the value which is at least equal to its book value – the value at which its tangible assets are carried on the books. This is an incorrect assumption as the true liquidation value might (and most probably will) turn out to be much less than the book value assumed.
The price to book value (P/BV) measures how much are the markets are willing to pay for the measured accounting value of a company’s assets.
Limitations of Relative Valuation Methods
Because relative valuation using the multiples explained above is easy to calculate, no wonder that its use is so widespread. But because it is based on nothing more than casual observations of multiples based on stock prices (which are volatile and fluctuate according to the varying emotions of people involved in the markets), intrinsic value calculation using relative valuation can easily go awry.
Another serious drawback of relative valuation is that the same ease of pulling together a multiple and a group of comparable firms can also result in inconsistent estimates of value where key variables such as risk, growth, or cash flow potential are ignored.
But despite these negatives, relative valuation has some potential advantages over other valuation tools. First, a relative valuation is based upon a multiple and thus it can be calculated with far few assumptions and far more quickly than say a DCF valuation.
In conclusion, relative valuations must never be used in isolation to arrive at a company’s intrinsic value. Instead, it must always be used in conjunction with other tools like DCF for a more accurate gauge of how much a company’s shares are really worth.