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## How to Use P-E, P-S, and P-B Ratios to Value a Stock

In a previous article, I discussed the traditional and “textbook” method for valuing stocks, with some modifications to smooth out the inherent bumpiness in cash flow levels. In this article, we’ll look at another common way to determine stock value, using statistical multiples of a company’s financial metrics, such as earnings, net assets, and sales.

There are three statistical properties 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 evaluating, so let’s first describe the method and then discuss a little about using the three different multipliers, then go through an example.

**Multi-based method**

Valuing a stock in a multi-based way is simple to understand, but getting the parameters takes some work. In short, the object here is to come up with a reasonable “target multiple” based on how you believe the stock should trade fairly, growth prospects, competitive position, etc. To come up with this “target multiple”, there are some things you should consider:

1) What is the stock’s average historical multiple (P/E ratio, P/S ratio, etc.)? You must take at least a 5-year term, and preferably 10 years. This gives you an idea of the multiple in both bull and bear markets.

2) What are the average multiples for competitors? How widely is the differential against stocks being investigated, and why?

3) Is the range of high and low values too wide, or too narrow?

4) What are the future prospects for the stock? If they are better than in the past, the “target multiple” can be set higher than historical standards. If they are not good, the “target multiple” should be lower (sometimes much lower). Don’t forget to consider potential competition when thinking about future possibilities!

Once you come up with a reasonable “target multiple”, the rest is pretty easy. First, take the current year’s projections for revenue and/or earnings and multiply the target against them to get the target market capitalization. Then you divide it by share count, optionally adjusting for dilution based on past trends and any announced stock buyback programs. This gives you a “fair value” rating, from which you may want to buy 20% or more for a margin of safety.

If this is confusing, the example following the article should help clear things up.

**When to use different multiples**

Each of the different multipliers has its advantages in certain situations:

**P/E ratio**: P/E is probably the most common multiple to use. However, I would adjust it instead to the price-to-operating income ratio, where operating income in this case is defined as interest and taxes (EBIT – includes depreciation and amortization). The reason for this is to smooth out one-time events that reduce the bottom line earnings per share price from time to time. P/EBIT works well for profitable companies with relatively stable levels of sales and margins. It doesn’t work at all for unprofitable companies, and doesn’t work well for asset-based firms (banks, insurance companies) or heavily cyclical ones.

**P/B ratio**: The price-to-book ratio is most useful for asset-based firms, especially banks and insurance companies. Earnings are often unpredictable due to interest spreads and are filled with more guesswork than basic manufacturing and service firms when you consider such ambiguous accounting items as loan loss provisions. However, assets such as deposits and loans are relatively stable (except in 2008-09), and so book value is generally their value. On the other hand, book value doesn’t make much sense for “new economy” businesses like software and service firms, where the primary asset is the collective wisdom of employees.

**P/S ratio**: Price-to-sales is a useful ratio across the board, but perhaps most valuable for valuing companies that aren’t currently profitable. These firms have no earnings P/E to use, but comparing the P/S ratio to historical norms and competitors can help give an estimate of fair value for the stock.

**A simple example**

For example, let’s look at Lockheed Martin (LMT).

By doing some basic research, we know that Lockheed Martin is an established firm that has an excellent competitive position in a relatively stable industry, having defense contracts. Furthermore, Lockheed has a long track record of profitability. We also know that the firm is clearly not an asset-based business, so we will go by the P/EBIT ratio.

Looking at the last 5 years of price and earnings data (which takes some spreadsheet work), I determine that Lockheed’s average P/EBIT ratio over that period has been around 9.3. Now I look at the past 5 years and see that Lockheed has worked through some strong defense demand years in 2006 and 2007, followed by some significant political changes and a market downturn in 2008 and 2009, then a market recovery but problems this year. Early important F-35 program. Given the expected slow near-term growth in Defense Department spending, I conservatively theorize that 8.8 is probably a reasonable “target multiple” for this stock to use in the near term.

Once this multiple is determined, finding a fair value is very easy:

The 2010 revenue estimate is $46.95 billion, which would be a 4% increase from 2009. Earnings per share estimates are 7.27, which would be a 6.5% decline from 2009, and represent a 6% net margin. From these figures and empirical data, I estimate a 2010 EBIT of $4.46 billion (9.5% operating margin).

Now, I simply apply my 8.8 multiple to $4.6 billion to get a target market cap of $40.5 billion.

Finally, we need to divide by the shares outstanding to get the target share price. Lockheed currently has 381.9 million shares outstanding, but typically buys back 2-5% a year. I’ll split the difference and assume the share count will fall 2.5% this year, leaving a year-end count of 379.18 million.

Dividing $40.5 billion by 378.18 million gives me a target share price of about $107. Interestingly, this is close to the discounted free cash flow valuation of $109. So, in both cases, I have used reasonable estimates and determined that the stock appears to be undervalued. Using my 20% minimum “margin of safety”, I would only consider buying Lockheed at a share price of $85 and below.

**Wrapping it up**

Of course, you can easily plug in the price-to-sales or price-to-book ratio and, using reasonable financial values, do the same multi-based valuation. This type of stock valuation makes a little more sense to most people, and accounts for market-based factors such as different multiple ranges for different industries. However, one must be careful and consider how the future may differ from the past when estimating “target multiplicity.” Use your head and try to avoid using properties that are significantly higher than the historical market average.

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