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Price/Earnings valuation metric
Price to earnings multiple is the most extensively used valuation metric by all categories of investors for valuation of a stock. The ratio is found out by dividing the market price of stock to its earnings. It represents how many times the stock is trading for each unit of its earnings.
P/E= Market price per share/ Earnings per share
Invariably, P/E has been used by the entire investment community on the premise that it is primarily the earnings of a firm that determines its investment value and makes for a promising proposition. For industries such as software and services where primary assets of a firm are human capital, P/E would be the right indicator.
Though P/E is widely used, all metrics have limitations. The fact that earnings may be negative makes working out this ratio a futile exercise in such a scenario. Also, management of a company can manipulate its earnings by capitalizing on accounting loopholes. This may render the metric as an inadequate means of evaluating a stock.
Price/Book Value valuation metric
This valuation ratio compares the stock price per share to its book value.
P/BV= Market Price per share/ Book value per share
Book value of equity is basically the common shareholders' equity and can be expressed as the difference between assets and liabilities.
Book value of a firm is usually positive even though its earnings may be negative. Also, sometimes EPS may be very volatile. In these circumstances P/BV would provide a better valuation of a stock than P/E. For businesses which are very asset intensive and where assets are the major drivers of their earnings, Book value would be more appropriate. Banks, investment companies, insurance companies hold liquid assets and derive bulk of their profits from them. For such companies, the book value has bearing on the stock prices and hence P/BV would be the right metric for the stock evaluation. P/BV ratio will also be useful for valuation of companies that are entering into liquidation.
However, the P/BV metric as a tool for evaluating a stock may be fraught with error on account of different accounting conventions which may lead to an unclear picture of investment in a firm. Also, it is a common practice to remove intangible assets while using this ratio. Investment value of research and development and intangible assets like intellectual property may lead to an inadequate evaluation here.
Price/ Free Cash flow valuation metric
Price to cash flow ratio is arrived at by dividing the stock price to the cash flow generated by each share. Operating cash flow, free cash flow or EBITDA may be used as the denominator of the ratio.
P/ CF= Market price per share/ cash Flow per share
Cash flow= Net income + Depreciation + Amortization+ other non cash expenses
Free Cash flow is the cash flow available to the common stockholders after all operating expenses, interest and principal payments, investment in working capital and investment in fixed assets.
Cash flows are more difficult to manipulate than the earnings. For firms which have incurred major capital expenditure and have attenuated earnings on account of high depreciation or amortization, cash flows are a better indicator to gauge a stock investment than earnings. Also, P/CF is a more stable ratio and addresses the issue of differences in the quality of reported earnings.
Price/sales valuation metric
Like cash flows, sales revenue also can't be easily manipulated. The ratio is found out by dividing the stock price to the sales generated per share.
P/S= Market price per share/ sales per share
P/S ratio is a useful valuation metric in case of firms whose earnings have eroded or firms which have been recently incorporated and do not have adequate earnings so as to understand their real value proposition. The multiple is also apt for cyclical industries as their earnings are very volatile. Also, in case of a takeover where earnings have been completely eroded, sales revenue would be a reasonably fair measure. The metric is useful even for distressed firms as the sales revenue would be positive for a firm even though its earnings may be negative.
One major limitation of using sales is that it does not incorporate the cost structures of different companies. This makes comparing firms difficult. Also, malpractices of revenue recognition may distort the ratio.
In conclusion.....
All valuation metrics have their own advantages and limitations. Which metric is more relevant depends on the nature of the firm, its characteristics and the events that occur in the firm as already discussed. However, P/E is the standard and most employed valuation metric regardless of the investor category.
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