Equity Multiples are multiples scaled against the market value of equity, such as Price/Earnings (PE) or Price/Sales (PS) ratios. Equity multiples require two inputs; one for the market value of equity and one for the variable to which equity is being scaled or measured against. Equity multiples are often used as quick valuations of firms and shares as the information for calculation of these multiples is easily obtained publicly for the purpose of making valuations. The common equity multiples that the On Equation platform calculates are the Price Earnings (PE) ratio, the Price to Book Value (PBV) ratio, Price to Sales (PS) ratio, and the Price Earnings Growth (PEG) ratio.
The price to earnings ratio (PE Ratio) is the measure of the share price relative to the annual net income earned by the firm per share. PE ratio shows current investor demand for a company share. A high PE ratio generally indicates increased demand because investors anticipate earnings growth in the future.
The price to book ratio, also called the P/B or market to book ratio, is a financial valuation tool used to evaluate whether the stock a company is over or undervalued by comparing the price of all outstanding shares with the net assets of the company. In other words, it’s a calculation that measures the difference between the book value and the total share price of the company. Companies that have no earnings or that are losing money do not have a P/E ratio since there is nothing to put in the denominator.
The price to sales ratio is a valuation ratio that compares a company’s stock price to its revenues. It is an indicator of the value placed on each dollar of a company’s sales or revenues.
The 'PEG ratio' (price/earnings to growth ratio) is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company's expected growth. In general, the P/E ratio is higher for a company with a higher growth rate.
As the calculations of equity multiples are relatively simple, the On Equation app takes multiple inputs at once and scales against equity in order to produce multiple ratios at once. The common variables used for these calculations are listed below.
Market value per share is obtained by simply looking at the share price quote in the market. This value can be found by researching the current market exchange price per share for a company.
Earnings per share is the value of dividends paid out per share issued by a company. This can be found on stock exchange sites or obtained from general purpose financial statements issued by a company.
The book value of shares for a firm is the book value of equity of a firm divided by the number of shares outstanding. The book value of equity is calculated by subtracting the book value of liabilities of a firm from the book value of assets of a firm. The values for assets, liabilities, and shares outstanding can be found in general purpose financial statements issued by a firm, generally on the balance sheet.
The sales revenue per share of a firm is calculated by taking the total revenue of a firm in a particular period or year and dividing it by the number of outstanding shares of that firm for the same period. The values for outstanding shares and revenue can be found on general purpose financial statements issued by a firm; outstanding shares are listed on the balance sheet, while revenue is found on the profit and loss (or income) statement.
The expected growth rate is the rate of growth a company is expected to experience between periods. This growth rate can be calculated using historical financial data from the financial statements of a company being analysed. Historical data used to predict future growth rates isn’t always accurate as the economic world is always changing, but it does provide a good starting point for growth analysis.
Assume we are analysing a firm utilising the equity multiples approach. From appropriate sources we gather financial statements of the firm for this financial period and review stock exchange data on the internet to get a market value for its share price. From the stock exchange, we see the firm has a listed share price (MVS) of $100 per share. From here, with a value of $100 for MVS, we can begin calculating equity multiples for the purpose of valuation of the firm.
Examining the firm’s balance sheet we see that it paid out a dividend of $6 per share for this financial period, putting EPS at $6. We already know the value for MVS is $100 and can now calculate the PE ratio for the firm as follows:
PE = MVS / EPS
PE = S100 / $6
PE = 16.67
The PE ratio for the firm is 16.67. As the PE ratio is an indication of the expected price paid per share by investors, the higher the PE ratio, the more likely a firm’s shares may be overvalued. Comparing the PE ratio of this particular firm to its market price, it can be observed that this firm is trading at roughly 16 times its earnings. However, the PE ratio is better used as a comparative measure to the PE ratio of other firms within that industry. A PE ratio of 16.67 may seem unattractive compared to the market value of that firm’s shares, however 16.67 may be extraordinarily high compared to another firm in the industry that may only have a PE ratio of 11.8, or an average industry PE of 14.34. In this industry comparison, our example firm’s shares may be considered overvalued.
We see on the balance sheet of the firm that it has $1 billion in assets, $750 million in liabilities, and 30 million outstanding shares for this period. Subtracting liabilities from assets, we get a book value of equity of $250 million, which we divide by the number of outstanding shares of 3,000,000 to get a book value per share of $83.33. As we have already established the MVS for this company is $100 per share, we can calculate the PBV ratio as follows:
PBV = MVS / BVS
PBV = $100 / $83.33
PBV = 1.2
The Price to Book ratio calculates at 1.2, meaning the market price of the shares is 1.2 times the firm’s book value, signalling that this firm’s shares may be overvalued.
Observing values on the profit and loss (or income) statement of the firm, the firm has reported a revenue of $400 million for this period. Dividing the revenue by the number of shares, as stated above, the Sales Revenue per Share (SPS) equates to $133.33 per share. With this SPS value and the MVS stated above, we can work out the value for the PS ratio as:
PS = MVS / SPS
PS = $100 / $133.33
PS = 0.75
The Price to Sales ratio for this firm, based on sales revenue and the market value of its shares, is found to be 0.75. The lower the Price to Sales ratio, the more attractive the firm is for investment. As this PS value of 0.75 is considerably low, this firm may be rather attractive for investment prospects.
The Price Earnings to Growth ratio takes the PE ratio and divides it by the rate of growth of the firm. As the PE ratio was calculated above to be 16.67, only the value for growth must be obtained to calculate the PEG ratio. Assume we collect data on the firm for the last 5 years and are able to calculate a growth value (g) of 5% for the firm. With this figure we can now calculate the value of the PEG ratio.
PEG = PE / g
PEG = 16.67 / 5
PEG = 3.33
The Price Earnings to Growth ratio for this firm is 3.33. Like the PE ratio, the PEG ratio is useful when comparing a firm to other firms within the industry or the firm’s industry’s average. For instance, if another firm within the industry had a PEG ratio of 2.33, it could be asserted that our firm was far more attractive as an investment possibility over the other firm. If the average PEG ratio for the industry was higher than our firm’s PEG ratio, however, an investor may be less inclined to invest in our example firm, based on this lower PEG ratio.
Using equity multiples in valuation analysis helps make sound judgments for analysts and companies. This is especially true when equity multiples are used appropriately because they provide valuable information about a company’s financial status. Furthermore, equity multiples are relevant because they revolve around key statistics related to investment decisions. Finally, the simplicity of multiples makes them easy to use for most analysts.
However, this simplicity can also be considered a disadvantage because of the fact that it simplifies complex information into just a single value. This simplification can lead to misinterpretation and makes it challenging to break down the effects of various factors.
Investment decisions make use of equity multiples especially when an investor aspires for minority positions in companies. However, a financial analyst must take into account that companies have varying levels of debt that ultimately influence equity multiples.
The Price Earnings (PE) ratio relates a company's share price to its earnings per share. A high PE ratio could mean that a company's stock is over-valued, or else that investors are expecting high growth rates in the future.
The Price to Book Value (PBV) ratio measures the market's valuation of a company relative to its book value. The market value of equity is typically higher than the book value of a company. PBV ratios under 1 are typically considered solid investments.
The Price to Sales (PS) ratio is a key analysis and valuation tool that shows how much investors are willing to pay per dollar of sales for a stock. A low PS ratio could imply the stock is undervalued while a ratio that is higher-than-average could indicate that the stock is overvalued.
The Price to Earnings Growth (PEG) ratio enhances the Price Earnings (PE) ratio by adding in expected earnings growth into the calculation. The PEG ratio is considered to be an indicator of a stock's true value, and similar to the PE ratio, a lower PEG may indicate that a stock is undervalued.
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