Rationales for the usage of price multiples in equity valuation

If you are investor and you read the analyst report, you may wonder why they used price multiples such as P/E, P/BV, P/S and P/CF ratios in equity valuation. Well, I have consolidated the rationales and their drawbacks here. Hope you find them useful.

Rationales for using price-to-earnings (P/E) ratios in valuation:

• Earnings power, as measured by earnings per share (EPS), is the primary determinant of investment value.
• The P/E ratio is popular in the investment community.
• Empirical research shows that P/E differences are significantly related to long-run average stock returns.

The drawbacks of using the P/E ratio are:

• Earnings can be negative, which produces a useless P/E ratio.
• The volatile, transitory portion of earnings makes the interpretation of P/E difficult for analysts.
• Management discretion within allowed accounting practices can distort reported earnings and thereby lessen the comparability of P/E ratios across firms.

Advantages of using the price-to-book value ratio (P/BV) include:

• Book value is a cumulative amount that is usually positive, even when the firm reports a loss and EPS is negative. Thus, P/BV can typically be used when P/E cannot.
• Book value is more stable than EPS, so it may be more useful than P/E when EPS is particularly high, low, or volatile.
• Book value is an appropriate measure of net asset value for firms that primarily hold liquid assets. Examples include finance, investment , insurance, and banking firms.
• P/BV can be useful in valuing companies that are expected to go out of business.
• Empirical research shows that P/BV ratios help explain differences in long-run average returns.

Disadvantages of using P/BV include:

• P/BV ratios do not recognize the value of nonphysical assets such as human capital.
• P/BV ratios can be misleading when there are significant differences in the asset intensity of production methods among the firms under consideration.
• Different accounting conventions can obscure the true investment in the firm made by shareholders, which reduces the comparability of P/BV ratios across firms and countries. For example, research and development costs (R&D) are expensed in the U.S., which can understate investment and overstate income over time.
• Inflation and technological change can cause the book and market value of assets to differ significantly, so book value is not an accurate measure of the value of the shareholders' investment. This makes it more difficult to compare P/BV ratios across firms.

The rationales for using the price to sales (P/S) ratio include:

• P/S is meaningful even for distressed firms, since sales revenue is always positive. This is not the case for P/E and P/BV ratios, which can be negative.
• Sales revenue is not as easy to manipulate or distort as EPS and book value, which are significantly affected by accounting conventions.
• P/S ratios are not as volatile as P/E multiples. This may make P/S ratios more reliable in valuation analysis.
• P/S ratios are particularly appropriate for valuing stocks in mature or cyclical industries and for start-up companies with no record of earnings.
• Like P/E and P/BV ratios, empirical research finds that differences in P/S are significantly related to differences in long-term average stock returns.

The disadvantages of using P/S ratios are:

• High growth in sales does not necessarily indicate operating profits as measured by earnings and cashflow.
• P/S ratios do not capture differences in cost structures across companies.
• While less subject to distortion than earnings or cashflows, revenue recognition practices can still distort sales forecasts. For example , analysts should look for company practices that speed up revenue recognition. An example is sales on a bill-and-hold basis, which involves selling products and delivering them at a later date. This practice accelerates sales into an earlier reporting period and distorts the P/S ratio.

Rationales for using the price to cashflow (P/CF) ratio include:

• Cash flow is harder for managers to manipulate than earnings.
• Price to cashflow is more stable than price to earnings.
• Reliance on cashflow rather than earnings addresses the problem of differences in the quality of reported earnings, (a problem when using P/Es).
• Empirical evidence indicates that differences in P/CF ratios are significantly related to differences in longrun average stock returns.

Drawbacks to the P/CF ratio:

• Some items affecting actual cashflow from operations are ignored when the EPS plus noncash charges estimate is used. For example, noncash revenue and net changes in working capital are ignored.
• From a theoretical perspective, free cash flow to equity (FCFE) is probably preferable to cash flow. However, FCFE is more volatile than straight cashflow.