Every since the price-to-earnings ratio (P/E) was made famous, inspired investors have borrowed that same underlying logic to value companies by comparing stock price, or an equivalent, given business value, to almost everything else besides earnings. Other commonly seen multiples are price-to-revenue multiple, price-to-assets multiple, and price-to-equity multiple. But always be reminded that a multiple itself is not as the same as an valuation tag on a stock; it is the result of comparing whatever a value derived from other valuation techniques(like discounting future cash flows), or simply the stock price as traded, to a company’s fundamentals, of which often cited are earnings, revenues, assets, or equity. Investors use multiples to further evaluate any given stock values so as to help make more informed investment decisions. Some stock screeners depend on multiples to first filter out overheated stocks having seemingly high multiples, as these simple two digit numbers (in most cases) are designed to tell how far away it is for investors to recover their investments from a company’s future earnings or revenues, or for the company to grow its assets or equity to equal the amount investors have put in. The magnitude of recovering or growing changes in direct relation to the scale of a multiple.
The assumption here is that a lower multiple is always preferred over a higher one when evaluating stocks of different companies, so that it wouldn’t be too far away in terms of recovering investments for, or growing assets/equity to, the full, invested amount. For example, when presented with P/E ratios of 15 and 50 on two different stocks of two competing companies in the same business category, the common wisdom is that you pick up the stock with a P/E ratio of 15 over the one with 50. A lower price-to earnings ratio also means cheaper stock price. While we make sure that we pay less for everything else in life, saving nickels and dimes at stores, why would we want to give away thousands more on expensive stocks, like the one with a price-to-earnings ratio of 50, when “15” is available on sale? One more rational has to do with the concept of margin of safety-how you view the constant battle between the so-called “buy low sell high” and “buy high sell higher.” The degree of concern for safety separates the two camps. Great investors, like Warren Buffett, and his teacher Benjamin Graham, have always advocated for seeking margin of safety. In this case of 15 vs. 50, investing in the lower P/E ration stock brings in much more margin of safety, as the higher P/E ratio stock leaves too much room for price to fall. In essence, using multiples provides a consistent playground for comparing values of different stocks, and at the same time identifies the interplay between the value of each stock and its business performance.
Using multiples for stock valuations can be safely rewarding, but sometimes unfairly conservative, that is, having both pros and cons. One big drawback about this valuation metric is that the calculation of multiples doesn’t involve any forward looking, absolutely no future forecasts accounted for. When comparing business fundamentals, only historical data are used-MRFY(Most Recent Fiscal Year), MRQ(Most Recent Quarter), or TTM(Trailing Twelve Month). But the most basic valuation principle prescribes that the present value of a business shall be the consideration of its FUTURE earning power. Clearly, the solo use of multiples without making any reference to forecasted data, especially when aggressive future growth rate has been expected, is largely blind sighted. The consequence? Well, it could hugely affect the investment bottom line. Therefore, an updated assumption now ought be that not all stock prices with higher multiples are unjustified. Avoiding some of these high-flying multiples could mean potential loss of investment returns. If a company’s sales revenue is going to double next year, its current stock price would have a reason to command a higher multiple of price-to-revenue, maybe two times of that of its peers, because when the double growth is realized next year, the higher multiple would be brought down to the average level. Backed by strong anticipation of continued growth, stock price could keep running higher, with only the accompanied, dauntingly high multiples scaring the forward-blinded buyers away to stay put in their safety nest, seeing hardly any returns on their guarded principal, when their target’s safely-priced value and the resulted, depressed multiple are in fact out of poor future prospects that they are blinded from seeing. Once the kind of future consideration is taken and adjustment is made upon an original multiple, this simple arithmetic valuation metric is no doubt the one tool in investor toolbox that is often resorted to.