In a previous article, I discussed the traditional and “textbook” method of valuing a stock, along with some modifications to smooth out the inherent bumps in cash flow levels. In this article, we’ll look at another common way to value a stock, using statistical multiples of a company’s financial metrics, such as earnings, net assets, and sales.
Basically, there are three statistical multiples that can be used in this type of analysis: the price-to-sales (P/S) ratio, the price-to-book (P/B) ratio, and the price-to-earnings (P/E) ratio. . They are all used in the same way when making a valuation, so let’s first describe the method and then discuss a bit about when to use the three different multiples, then let’s look at an example.
The multiple base method
Multiple valuing an action is easy to understand, but it takes some work to get the parameters. Simply put, the goal here is to arrive at a reasonable “target multiple” at which you believe the stock should reasonably trade, given growth prospects, competitive position, etc. To get to this “target multiple,” there are a few things to consider:
1) What is the stock’s average historical multiple (P/E ratio, P/S ratio, etc.)? It should at least take a period of 5 years, and preferably 10 years. This gives you an idea of the multiple in bull and bear markets.
2) What are the average multiples of the competitors? How wide is the variance against the action under investigation and why?
3) Is the range of high and low values too wide or too narrow?
4) What are the future perspectives of the action? If they are better than in the past, the “target multiple” could be set higher than historical norms. If they’re not that good, the “target multiple” should be lower (sometimes substantially lower). Don’t forget to consider potential competition when thinking about future prospects!
Once you’ve found a reasonable “target multiple”, the rest is pretty easy. First, take current year revenue and/or earnings estimates and multiply the target multiple against them to get a target market capitalization. Then, divide that by the share count, optionally adjusting for dilution based on past trends and announced share buyback programs. This gives you a “reasonable price” valuation, which you want to buy 20% or more below to give yourself a margin of safety.
If this is confusing, the example later in the article should help clear things up.
When to use the different multiples
Each of the different multiples has its advantage in certain situations:
P/E Ratio: P/E is probably the most common multiple to use. However, I would adjust this to be the price-to-operating earnings ratio, where operating earnings in this case is defined as earnings before interest and taxes (EBIT, includes depreciation and amortization). The reason for this is to smooth out the one-time events that skew the final value of earnings per share from time to time. P/EBIT works well for profitable companies with relatively stable sales levels and margins. It *does* not work at all for unprofitable companies, and it doesn’t work well for asset-based (banks, insurance companies) or heavy cyclical companies.
price/benefit ratio: The price-to-book ratio is most useful for asset-based companies, particularly banks and insurance companies. Earnings are often unpredictable due to interest margins and fraught with more assumptions than utility and commodity companies when considering such nebulous accounting items as loan loss provisions. However, assets such as deposits and loans are relatively stable (aside from 2008-09), so they are generally valued at book value. On the other hand, book value doesn’t mean much for “new economy” companies like software and services companies, where the main asset is the collective intellect of employees.
P/S Ratio: The price-to-sales ratio is a useful ratio across the board, but probably more valuable for valuing companies that are currently unprofitable. These companies have no earnings from which to use P/E, but comparing the P/S ratio to historical norms and competitors might help give an idea of a reasonable price for the shares.
a simple example
To illustrate, let’s take a look at Lockheed Martin (LMT).
Through basic research, we know that Lockheed Martin is an established company with an excellent competitive position in what has been a relatively stable industry, defense contracting. In addition, Lockheed has a long track record of profitability. We also know that the company is obviously not an asset-based business, so we’ll go with the P/EBIT ratio.
Looking at the pricing and earnings data for the last 5 years (which requires a bit of spreadsheet work), I determine that Lockheed’s average P/EBIT ratio over that period has been around 9.3. Now I look at the circumstances of the last 5 years and see that Lockheed has gotten through some years of strong defense demand in 2006 and 2007, followed by some significant political changes and a bear market in 2008 and 2009, followed by a market rebound. but problems with the important F-35 program earlier this year. Given the expected near-term sluggish growth in Defense Department spending, my conservative theory is that 8.8 is probably a reasonable “target multiple” to use for this near-term stock.
Once this multiple is determined, finding the reasonable price is fairly easy:
The revenue estimate for 2010 is $46.950 million, which would mean an increase of 4% compared to 2009. The earnings per share estimate is 7.27, which would mean a decrease of 6.5% compared to to 2009, and represents a net margin of 6%. From these figures and empirical data, I estimate a 2010 EBIT of $4.46 billion (9.5% operating margin).
Now, I just apply my multiple of 8.8 to $4.6 billion to get a target market cap of $40.5 billion.
Finally, we need to divide that by the shares outstanding to get a target share price. Lockheed currently has 381.9 million shares outstanding, but typically buys back 2-5% a year. I’ll split the difference on this and assume the share count will decline 2.5% this year, leaving a year-end count of 379.18 million.
Dividing $40.5 billion by $378.18 million gives me a share price target of around $107. Interestingly, this is close to the discounted free cash flow valuation of $109. So in both cases, I used reasonable estimates and determined that the stock appears undervalued. Using my minimum 20% “margin of safety”, I would only consider buying Lockheed at stock prices of $85 or less.
wrapping it up
Obviously, you can easily enter the price-to-sales or price-to-book ratio and, using the appropriate financial values, perform a similar multiple-based valuation. This type of stock valuation makes a little more sense to most people and takes into account market-based factors, such as different multiple ranges for different industries. However, care must be taken to consider how the future may differ from the past when estimating a “target multiple”. Use your head and try to avoid using multiples that are significantly higher than historical market averages.