29 October 2006

Valuation Metrics - Price

Valuation metrics help determine whether a company's shares are fairly priced in an absolute sense, relative to other companies, and relative to the historic norms for the company.

In an earlier article, we identified several "per-share" valuation metrics, such as Earnings per Share.  We will now mention a few other well-known valuation metrics.

Market Value or Market Capitalization

A company's Market Value is its current share price multiplied by the number of common shares outstanding.  Market Value is the metric used to classify companies as Small, Mid, or Large  Capitalization ("cap"). These categories aren't precise, but small-cap stocks generally have Market Values less than $1 billion, mid-cap stocks have Market Values less than $10 billion, and large-cap stocks have market values of many billions of dollars.

Trailing Price to Earnings (P/E)

Given the way investors and analysts sprinkle P/E values in their conversations and reports, one might think that all other metrics are superfluous.  Although it is certainly important, the P/E has to be handled with great caution.  It is calculated by dividing Market Value by Net Income, which is equivalent to the Share Price divided by the Earnings per Share.  The result is a dimensionless quantity ($/$) that can be 10 or less for slow-growth companies, 10 to 20 for the more typical company, and off the chart for fast burners.

Keep in mind that the "E" value of a P/E can be more arbitrary than you might first think.  Does it reflect GAAP Net Income, or have certain gains and losses been excluded (if so, which ones)?

On 30 September 2006, PepsiCo's share price had spiked up to $65.26.  It had earned $2.94 ($0.88 + $0.80 + $0.60 + $0.65) during the previous four quarters, so the trailing P/E on that basis was about 22.

A different perspective of the P/E ratio can be gained by looking at its inverse: the E/P or Earnings Yield.  Dividing the EPS by the share price indicates how much the company yielded in earnings for each invested dollar, not unlike a bond's income yield.  Of course, a company's earnings are variable, and an investor can't directly get his or her hands on the earnings yield.

PepsiCo's P/E of 22 in September 2006 translates into an E/P earnings yield of about 4.5 percent. The earnings yield for healthy companies is usually less than the income yield on high-grade securities because of the expectation that the earnings will grow over time.  Bond yields are generally fixed, which is not a bad thing, but it limits their upside.

Forward P/E

In the discussion above all "E" earnings values corresponded to the company's Net Income during the last, or "trailing," four quarters. Given an expectation for earnings growth, the P/E ratio is also calculated using the predicted earnings for the future or "forward" period. (We prefer to look at the next four quarters, but the next fiscal year is more commonly used.)  If earnings are increasing, the forward P/E ratio will be less than the trailing P/E ratio and a high share price will seem more reasonable.

P/E to Growth (PEG)

As mentioned above, the P/E ratio tends to reflect expectations that the company will earn more money in the future.  The PEG ratio, which at first seems rather odd, tries to get at this relationship.  It is calculated by dividing the P/E ratio by the expected earnings growth rate in percent.  If we take Pepsico's P/E ratio of 22 in September 2006 and divide it by the 11 percent increase in Net Income then predicted by professionals, Pepsico's PEG ratio would then have been 2.0.

Value investors prefer the PEG ratio to be closer to (or below) 1.0.

Price/Operating Income and Price/Cash Flow

Because Net Income can vary significantly due to one-time or non-operational factors, it can be insightful to substitute Operating Income, Net Operating Profit After Taxes (NOPAT), Cash Flow from Operations (CFO), Free Cash Flow (FCF), or some other measure for the "E" value of the P/E ratio.  Individual analysts have their own preferences.

Enterprise Value / Cash Flow

Similar to Price/Cash Flow, Enterprise Value / Cash Flow from Operations substitutes Enterprise Value for Market Value.  Enterprise Value (EV) is Market Value, plus Debt (long- and short-term), minus the company's Cash and Short-term Investments.  EV is considered a better estimate of the cost to a corporate acquirer than the Market Value because the acquirer is assuming the debt, less any cash on hand that can be used to pay off the debt.

Price/Book value

This ratio is calculated by dividing the share price by the Book Value per share (i.e., Stockholders' Equity divided by Shares Outstanding).

Price/Sales (Price/Revenues)

The Price-to-Sales Ratio (PSR) is calculated by dividing the share price by annual Sales (or Revenue) per share. It can also be found by dividing Market Value by annual Sales (or Revenue).  The PSR is most useful when comparing valuations of companies in the same industry.

This article was last modified on 26 April 2010.

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