Lesson Objective: To value a firm using the price/earnings (P/E) ratio and other valuation multiples.

In-Depth Notes:

1. The Price/Earnings (P/E) Ratio:
The P/E ratio is the most widely used valuation metric. It measures the amount investors are willing to pay for each dollar of earnings.

  • Formula: P/E Ratio = Market Price per Share / Earnings per Share (EPS)

  • Trailing P/E vs. Forward P/E:

    • Trailing P/E: Uses the most recent 12 months of historical earnings (trailing twelve months – TTM).

    • Forward P/E: Uses projected earnings for the next 12 months.

  • Interpretation: A high P/E suggests high growth expectations (or overvaluation); a low P/E suggests undervaluation or low growth prospects. P/E ratios should be compared to industry peers and historical averages.

  • Justified P/E: The P/E ratio that is consistent with the company’s fundamentals (growth rate, payout ratio, required return). The Gordon Growth Model can be used to calculate the justified P/E: Justified P/E = (Payout Ratio) / (Required Return - Growth Rate).

2. Other Valuation Multiples:

  • Price-to-Book (P/B) Ratio: Compares the market value of equity to the book value (net asset value) reported on the balance sheet.

    • P/B Ratio = Market Price per Share / Book Value per Share

    • Interpretation: A P/B below 1.0 suggests the market believes the company’s assets are overvalued on the balance sheet. P/B is particularly relevant for financial institutions (banks, insurers) where assets are marked to market regularly.

  • Price-to-Sales (P/S) Ratio: Compares the market capitalization to the company’s revenue.

    • P/S Ratio = Market Capitalization / Revenue

    • Interpretation: P/S is used for companies with negative earnings (e.g., early-stage tech companies, biotech). It reflects the value of each dollar of revenue.

  • Enterprise Value-to-EBITDA (EV/EBITDA) Ratio: A widely used valuation metric for comparing companies across different capital structures.

    • EV/EBITDA = Enterprise Value / EBITDA

    • Interpretation: EV/EBITDA is unaffected by capital structure differences (EV includes debt, EBITDA is pre-interest) and different depreciation and amortization policies (EBITDA adds back these non-cash charges).

3. Relative Valuation vs. Absolute Valuation:

  • Absolute Valuation: Determines the intrinsic value of a company based on its fundamentals (e.g., DDM).

  • Relative Valuation: Determines the value of a company by comparing it to other similar companies (e.g., P/E, EV/EBITDA). Relative valuation is a market-based approach.

4. Using Multiples in Investment Decisions:

  • Comparable Company Analysis: Comparing a company’s multiples to those of its competitors and industry peers.

  • Historical Analysis: Comparing a company’s current multiples to its historical averages.

  • Regression Analysis: Using regression to estimate the relationship between valuation multiples and key financial drivers.

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