Skip to ContentGo to accessibility pageKeyboard shortcuts menu
OpenStax Logo
Principles of Finance

11.1 Multiple Approaches to Stock Valuation

Principles of Finance11.1 Multiple Approaches to Stock Valuation

Menu
Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Define and calculate a P/E (price-to-earnings) ratio given company data.
  • Determine relative under- or overvaluation indicated by a P/E (price-to-earnings) ratio.
  • Define and calculate a P/B (price-to-book) ratio given company data.
  • Determine relative under- or overvaluation indicated by a P/B (price-to-book) ratio.
  • Define and detail alternative valuation multipliers, including P/S (price-to-sales) ratio, P/CF (price-to-cash-flow) ratio, and dividend yield.

The Price-to Earnings (P/E) Ratio

Experienced investors use a number of different methods to evaluate information on companies and their common stock before deciding on any potential purchase. One of the most popular techniques used by investors and analysts is to study a company’s financial statements in order to uncover basic fundamental information on the company. This involves calculating a number of financial ratios that help identify trends, bringing elements of operational performance to light and allowing for clearer analysis and evaluation.

A well-proven analytical approach for investors to use in evaluating common stock is to review the overall market value of the company that issues a stock. One of the most consistently used calculations in this analysis, which has important applications in company and common stock evaluation, is the price-to-earnings (P/E) ratio.

The P/E ratio is computed using the following formula:

P/E Ratio=Price per ShareEarnings per ShareP/E Ratio=Price per ShareEarnings per Share

The P/E ratio is extremely useful to analysts in that it shows the expectations of the market. Essentially, the P/E ratio is representative of the price an investor must pay for every unit of current (or future) corporate earnings.

Bottom-line earnings are a critical factor in valuing common stock. Investors will always want to know how profitable a company is now as well as how profitable it will be in the future. When a company’s bottom line remains relatively flat over a period of time, leaving earnings per share (EPS) relatively unchanged, the P/E ratio can be interpreted as the payback period for the original amount paid for each share of common stock.

For example, the common stock price of Cameo Corp. is currently at $24.00 a share, and its EPS for the year is $4.00. Cameo’s P/E ratio is calculated as

P/ECameo=$24.00$4.00=6P/ECameo=$24.00$4.00=6

This ratio would typically be expressed in the form 6 ×6 ×. Essentially, this means that investors are willing to pay up to six dollars for every one dollar of earnings. It can also be stated that Cameo stock is currently trading at a multiple of six.

The P/E ratio is typically expressed in two primary ways. The first is as a metric listed by most finance websites and often carries the notation P/E (ttm). This refers to the Wall Street acronym for “trailing 12 months” and signals the company’s operating performance over the past 12 months.

Another form of the P/E ratio is known as the forward (or leading) P/E. This uses future earnings projections rather than actual trailing amounts. The leading P/E, sometimes called the estimated price to earnings, is useful for comparing current earnings to future earnings and helps provide a clearer picture of what earnings may look like, assuming there are no major changes in the company’s operations or accounting treatments.

Referring back to our calculation for Cameo Corp. above, because the current EPS was used in the calculation, this ratio would be classified as a trailing P/E ratio. If we had used an estimated or projected EPS as the denominator in the calculation, it would then be considered a leading P/E ratio.

Analyzing a company’s P/E ratio alone or within a vacuum will actually tell an analyst very little. It is only when a company’s P/E is compared to historical P/E ratios or the P/E ratios of other companies in the same industry that it becomes a useful tool for analysis. One of the most important benefits of using comparative P/E ratios is that they can standardize stocks with different prices and various earnings levels.

Generally speaking, it is very difficult to make any conclusions about a stand-alone stock value, such as whether a stock that has a ratio of 8 ×8 × is a good buy at its current price or if a stock with a P/E ratio of 35 ×35 × is too expensive, without performing any relevant comparisons or further analysis.

Analysts have many different ways to interpret P/E ratio data. One of the most common interpretations is that firms with high P/E ratios should be growth companies. Also, a high P/E ratio could mean that a stock’s price is high relative to earnings and possibly overvalued. This could signal a possible undesired downward adjustment in market price in the future.

We can extrapolate from the argument above to put forward the idea that stocks with low P/E ratios should be stabler, more mature organizations. A low P/E might indicate that the current stock price is low relative to earnings and that there may be an opportunity to take advantage of upward price movements and potential investment gains through stock price appreciation.

While this information is often very useful for evaluating stocks and making investment decisions, caution must always be used, as a current stock price may simply be out of line with the company’s earning potential, which would mean that price adjustments are likely to occur in the short term. This is why experienced analysts and investors will use multiple evaluation techniques when conducting stock analysis and evaluation and not rely solely on insights provided by a single set of facts or one form of statistical measurement.

The Price-to-Book (P/B) Ratio

Another financial ratio commonly used by investors and analysts is the price-to-book (P/B) ratio, also called the market-to-book (M/B) ratio. This is a financial metric used to evaluate a company’s current market value relative to its book value.

The market value, or market capitalization, of a company is defined as the current price of all its outstanding shares of common stock. This is essentially equal to the total value of the company as perceived by the market. For all intents and purposes, the book value is representative of the residual of a company after it has liquidated all assets and paid off all of its liabilities.

Book value can be determined by performing some financial analysis on a company’s balance sheet. Essentially, analysts will use the P/B ratio to compare a business’s available net assets relative to the current sales price of its stock. The price-to-book-value ratio formula is

 P/B Ratio=Market Price per ShareBook Value per Share P/B Ratio=Market Price per ShareBook Value per Share

One of the primary uses of the P/B ratio is to understand market perceptions of a particular stock’s value. It is often the metric of choice for evaluating financial services firms such as real estate firms, insurance companies, and investment trusts. The P/B ratio has a notable shortcoming, however, in that it does not evaluate companies that have a high level of intangible assets such as patents, trademarks, and copyrights.

Ultimately, this ratio will tell an analyst exactly how much potential investors are willing to pay for each dollar of asset value. The PB(M/B) ratio is computed by dividing the current closing price of the stock by the company’s current book value per share, which is calculated by either of the following two equations:

P/B Ratio =  Market CapitalizationNet Book ValueP/B Ratio = Price per ShareNet Book Value per ShareP/B Ratio =  Market CapitalizationNet Book ValueP/B Ratio = Price per ShareNet Book Value per Share

Net book value is equal to net assets, or the total assets minus the total liabilities of the company.

Analysts often consider a low P/B ratio (less than 1) to indicate that a stock is undervalued and a higher ratio (greater than 1) to mean that a stock is overvalued. A low ratio may be an indication that something is wrong with the company or that an investor may be paying too much for any residual value should the company be liquidated.

However, many market experts will argue the exact opposite of the above interpretations. Because of these discrepancies in interpretation and overall variance of opinion, the use of alternate stock valuation metrics, either in addition to or in place of the P/B ratio, is always worth exploring.

In conclusion, the P/B ratio can help a company understand if its net assets are comparable to the market price of its stock. However, as with the P/E ratio, it is always a good idea to compare P/B ratios of companies within the same industry and use them in conjunction with other metrics and analytical methodologies.

Alternative Multipliers

There are two main types of valuation metrics multiples used to value common stock. These are equity multiples and enterprise value (EV) multiples. Additionally, there are two primary methods by which to perform analysis using these multiples. These methods are comparable company analysis (comps) and precedent transaction analysis (precedents).

Experienced financial analysts advocate the use of multiples in valuation analysis for a number of reasons, the most important being that they help generate realistic and sound judgments of enterprise values (total company values), they are relatively easy to use and interpret, and they can provide helpful information on a company’s overall financial condition when used appropriately.

However, it should be noted that simplicity may have some important disadvantages. When such complex information is reduced to a single equation or final value, it can easily be misunderstood, and the influence of important factors may be masked or lost in the evaluation process.

What’s more, the calculation of multiples represents a snapshot in time for a firm and cannot easily show how a company grows or progresses. Thus, these calculations are only applicable to short-term analysis, not to long-term scenarios.

Equity Multiples

Equity multiples are especially useful for investment decisions when an investor aspires to minority positions in companies. Below are some common equity multiples used in valuation analyses.

The price-to-earnings (P/E) ratio, which we discussed earlier, is probably the most common equity multiple used in stock valuation because it is relatively simple to calculate and all necessary data are easily accessible by analysts and investors. The market-to-book (M/B), or price-to-book (P/B), ratio is also useful if assets primarily drive a company’s earnings. Again, it is computed as the proportion of share price to book value per share.

Dividend yield is another form of equity multiple and is primarily used when conducting comparisons between cash returns and investment types. Dividend yield is computed as the proportion of dividend per share to share price. The price-to-sales (P/S) ratio is an additional metric used for firms that are experiencing financial losses. The P/S ratio is often used for quick estimates and is computed as the proportion of share price to sales (or revenue) per share.

Another useful metric is the price-to-cash-flow (P/CF) ratio. The P/CF ratio is used to compare a company’s market value to its operating cash flow (or the company’s stock price per share to its operating cash flow per share). This measurement is suitable only in certain cases, such as when a company has substantial noncash expenses (e.g., depreciation or amortization). In some situations, companies may have positive cash flows but still show a bottom-line loss due to large noncash expenses. The P/CF ratio is helpful for arriving at a less distorted view of such a company’s value.

While these various metrics are important, a financial analyst must always consider that companies often operate under their own unique sets of circumstances that ultimately will influence many of these equity multiples.

Enterprise Value (EV) Multiples

The following are some common EV multiples used in valuation analyses:

Gordon growth model is as follows

Enterprise ValueRevenueEnterprise ValueRevenue
Enterprise ValueEBITEnterprise ValueEBIT
Enterprise ValueEBITDAEnterprise ValueEBITDA
Enterprise ValueEBITDAREnterprise ValueEBITDAR

EV multiples take an increasingly important role when value decisions surround recent mergers and acquisitions. Enterprise value (EV) is a measurement of the total value of a company. Companies often believe that EV offers a more accurate representation of a firm’s total value than a basic market capitalization method. Generally, EV is perceived to offer an aggregate value of the firm as an enterprise, which is a more comprehensive measurement (see Figure 11.2).

Pie chart showing the market value of equity, which occupies a greater portion of the chart against the market value of net debt minus cash and equivalent.
Figure 11.2 Enterprise Value: The Complete Picture

Following are two of the most common enterprise values metrics used in valuing companies and their common stock:

EV/Revenue (EV/R). Also called EV/Sales, EV/R is a valuation metric used to understand a company’s total valuation compared to its annual sales levels. EV/R can help provide an analyst with an idea of exactly how much investors pay for every dollar of a company’s sales revenue.

EV/R is considered a relatively crude metric but can be useful when analyzing companies that have different methods of revenue recognition. P/E ratios, for example, can be significantly affected by changes in the accounting policies of companies being evaluated. This is another reason why multiple metrics should be used in valuations.

Additionally, EV/R is a useful measure for companies that are consuming cash or experiencing financial losses. Such companies may be start-ups or emerging technology firms that have not fully matured and are still in a growth stage of development.

EV/EBIT. A firm’s earnings before interest and taxes (EBIT) is an indicator of its profitability before the effects of interest or taxes. EBIT is also referred to as operating earnings, operating profit, and profit before interest and tax.

  • EV/EBITDA. EV/EBITDA is a ratio that compares a company’s enterprise value (EV) to its earnings before interest, taxes, depreciation, and amortization (EBITDA). EBITDA is often used by analysts as a substitute for cash flow and can be applied to capital analysis using tools such as net present value and internal rate of return. It is relatively easy to calculate, as all information required to compete the calculation is available from any publicly traded company’s financial statements. Because of this, the EV/EBITDA ratio is a commonly used metric to compare the relative values of different businesses.
  • EV/EBITDAR. Another form of valuation based on enterprise value is EV/EBITDAR. This metric divides enterprise value by earnings before interest, tax, depreciation, amortization, and rental costs (EBITDAR). This multiple is used in businesses that have substantial rental and lease expenses, such as hotel chains and airlines. Capital investment can differ significantly for these firms, and when assets are leased, these companies tend to have artificially lower debt and operating income compared to firms that actually own their assets.

EV/Capital Employed. The EV-to-capital employed ratio is a measure of enterprise value compared to the level of capital used by a business. For example, a business with a large capital basis is bound to carry a large enterprise value simply due to its large capital holdings.

Final Thoughts on Valuation Ratios and Multiples

There are many equity and enterprise value multiples used in company valuation, but the discussions above cover those that are most commonly used. In any case, gaining a thorough understanding of each multiple and its related concepts can help analysts make better use of these metrics in their stock analysis and valuation efforts. Also, as discussed, it is important that analysts and technicians use multiple ratios and alternate measures for any evaluation of a company and its common stock. Not doing so will limit the ultimate interpretation of the results, can lead to incorrect conclusions, and may cause fundamental mistakes in overall investment strategy.

Do you know how you learn best?
Kinetic by OpenStax offers access to innovative study tools designed to help you maximize your learning potential.
Order a print copy

As an Amazon Associate we earn from qualifying purchases.

Citation/Attribution

Want to cite, share, or modify this book? This book uses the Creative Commons Attribution License and you must attribute OpenStax.

Attribution information
  • If you are redistributing all or part of this book in a print format, then you must include on every physical page the following attribution:
    Access for free at https://openstax.org/books/principles-finance/pages/1-why-it-matters
  • If you are redistributing all or part of this book in a digital format, then you must include on every digital page view the following attribution:
    Access for free at https://openstax.org/books/principles-finance/pages/1-why-it-matters
Citation information

© May 20, 2022 OpenStax. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution License . The OpenStax name, OpenStax logo, OpenStax book covers, OpenStax CNX name, and OpenStax CNX logo are not subject to the Creative Commons license and may not be reproduced without the prior and express written consent of Rice University.