Financial Education

Price multiples are a useful way to compare the valuation of a stock over time, against comparable companies or the market as a whole. These multiples are a ratio of the stock’s current market capitalization to one of its underlying accounting fundamentals such as book value (total owners’ equity), sales or net income. Because investors are usually more familiar with share price rather than market capitalization (share price x shares outstanding) the accounting fundamentals are often converted to a per-share basis when using price multiples.

The most common price multiples are:

• Price to earnings (P/E) = (Share price)/(Earnings per share). Since earnings are meant to approximate the money available to shareholders, the P/E ratio expresses how much the investor pays for each dollar of earnings. This is the most frequently used price multiple.
• Price to book value [P/B] = (share price)/(book value per share). This compares the value of the firm today with the capital provided to the company over time.
• Price to sales (P/S) = (share price)/(sales per share). This ratio can be useful for valuing cyclical companies where earnings tend to be more volatile than sales, or situations in which a firm temporarily has little or no earnings.

A high multiple indicates that the market is wiling to pay a high price relative to the underlying fundamental value such as earnings. A company may trade at a high multiple becasue it has high growth prospets and future earnings are expected to be higher than past earnings. A low mulitiple indicates that that the stock is not valued highly - perhaps it has low growth prospects, high risk or is simply undervalued by the market. Value investors tend to search for companies trading at lower multiples than peer companies.

For more information, see all articles on: Financial Statement Analysis, Fundamental Analysis, Investing in Stocks, Ratio Analysis, Security Selection, Valuation

See also:

Rule Driven Sell Disciplines

Ratio Analysis

Market and Limit Orders in Trading

Volume Weighted Average Price (VWAP)

What is a Market?