Behind the Ratios

The last couple posts on investingdecoded have been decidedly macro in nature. That's not necessarily a bad thing. I am a firm believer that the macro environment is an important part of investing, even if you're doing fundamental bottoms-up analysis. Nonetheless, every investor has to make sure that they are also focusing on specific fundamentals, and today I'd like to discuss one of the most common ways of doing this - multiples analysis. 

If you've never done multiples analysis, I'll try to describe it in a drastic oversimplification. Multiples analysis is essentially valuation a security (we'll focus on stocks/equities) using certain ratios designed to reveal particular aspects of the company (e.g. profitability or asset efficiency). It's very popular in the industry and you'll see many a talking heads on CNBC use multiples like P/E, EV/EBITDA, etc. in giving their assessments on particular stocks. For instance, they'll say "Stock ABC is trading at a 12x P/E while the industry is at 15x. This indicates that it is undervalued because of x, y, and z reasons and is a good buy".

But what do these multiples mean? And how should one use them? It's not as easy at it seems, and many of these multiples provide insights beyond just the number and its relation to another number. 

Popular Multiples

There's a few multiples that are particularly popular in the industry:

P/E (Price to Earnings Ratio) - Perhaps the most commonly used, this is a company's stock price divided by its net income per share (i.e. EPS). It's normally done through taking the last 4 quarters of EPS. The typical number can range anywhere from 0x to 100x (since earnings can be very volatile) but most companies will generally fall anywhere between 10-17x. 

Forward P/E (Forward Price to Earnings) - Similar to P/E except instead of taking the last 4 quarters of earnings, you take the estimated next 4 quarters of earnings. The earnings are usually estimates from sell-side analysts or your own. 

EV/EBITDA (Enterprise Value to EBITDA) - This is another commonly used multiple that takes the company's enterprise value (EV=the total market cap of the stock + debt + preferred stock + minority interest - cash). As you can see, it includes the debt and other aspects of the company's capital structure. To that end, you need to scale that to a earnings metric that includes those components. Enter EBITDA - earnings before interest, taxes, interest, depreciation & amortization. You use this ratio to compare companies that may be similar otherwise, but have a very different mix of equity and debt (i.e. differing capital structures). 

P/B (Price to Book Value) - Similar to P/E, except you replace the denominator with the book value of the company. This is generally used for companies that require a lot of productive assets on their balance sheet to generate profits (e.g. banks). It's less used for companies like technology, where the productive assets are not necessarily stated directly on the BS. 

P/CF (Price to Cash Flow) - I've mentioned in the past how important cash flow is, and this metric emphasizes this again. You can use various types of CF, assuming they're compared correctly. 

P/S (Price to Sales) - Technically this multiple isn't correct (you shouldn't compare Price, which is the stock price only to equity holders to Sales, which is distributed between equity and debt holders). But in cases where EBITDA and Net Income are negative, it can be used. 

D/P (Dividend Yield) - Less used, but it's just the last 12 months dividends divided by price. 

Seems Easy Right? Not So Much

So you take the appropriate multiple for your company and compare it to the industry. Depending on what side it falls to the industry, you have an idea of over or under-valued, right? Wrong! You need to look at multiples as just one piece of the puzzle. Is there a reason why the company is trading at a discount to P/E vs. its peers? In most cases, yes, there's a good reason. Your job is to take find those reasons and make a judgement call. 

Just as importantly, there's important drivers behind these multiples that you need to understand. Different multiples are telling you different things about the markets implied expectations for the company. Let's run through them using equations:

P/E=(1-b)*(1+g)/(r-g) where b=%age of earnings not paid out in dividends, g=earnings growth rate, and r=cost of equity capital. 

Note that the P/E makes a direct implication of what the market expects the companies earnings growth rate should be. 

P/E Forward= (1-b)/(r-g)

Same here. Forward P/E also makes a similar implication.

EV/EBITDA - There's no further breakdown required here. It is what it is.

P/B=(ROE - g)/(r-g) where ROE=return on equity=net income/total shareholder's equity (r and g are the same as above)

Here, you're making an implication of how efficiently the company utilizes shareholder's equity as well as the growth of earnings. 

P/CF=(FCFE*(1+g))/(r-g) where FCFE=free cash flow to equity and g=growth of FCFE

Here, you're making an implication on how fast the cash flows are growing. 

P/S= P/E*(Net Income/Revenue)=P/E*Profit Margin

Making an implication on how profitable the company is as well as it's earnings growth prospects (through the P/E multiple discussed earlier.

So understanding those multiples you're using is extremely important. Most people don't talk enough about what they're implying, but as a investingdecoded reader, now you know! Doing this analysis is vital in any stock analysis, so be sure to use it! Next time, we'll discuss what I feel is one of the most important ratios, but one that isn't as commonly known to layman investors. 

What are your thoughts? 

Questions/Comments/Feedback? Please don't hesitate to let me know. Suggestions on posts you'd like to see? Let me know!

The Standard Disclaimer:
Everything I've written above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary due diligence prior to acting on any recommendations, including consulting a financial adviser.