One of the typical responses people give when talking about stocks is…”What’s the price?”

In the below commentary, I will point out why price is meaningless (except in a few circumstances), and why multiples point you in the right direction instead. In a follow up article, I will explain more on the types of multiples one can expect. For today, let’s focus on the simplest and most commonly used multiple: P/E ratio, or price-earnings ratio.

First things first, why do people ask “What’s the price?”. The answer is that they are typically looking to judge company value. However, using price alone can be very dangerous:

Cheap Company: $5 per share
Expensive Company: $10 per share

Using price for comparison, Cheap Company seems to be “cheaper” and therefore, should be “bought?” I suggest not. Let us look a little bit deeper:

Cheap Company: $5 per share, $0.50 per share in earnings
Expensive Company: $10 per share, $2 per share in earnings

Now, which would you rather buy? This is where the concept of P/E multiple comes in. Simply put, P/E multiple (x) = Price per share/ Earnings per share.
Calculating the multiple is as follows:

Cheap Company: 5/0.5 = 10x P/E
Expensive Company: 10/2 = 5x P/E

Now, Expensive Company looks like the better deal as we are only paying 5x its earnings for a single share, making it cheaper. Of course, this is assuming everything else is identical.

What is the significance of this “multiple”? Invert the multiple and you get another metric called Equity Earnings Yield = Earnings per share / Price per share.

Cheap Company earnings yield = 0.5/5 = 10%
Expensive Company earnings yield = 2/10 = 20%

The concept of earnings yield is similar to that of “return” – the higher the earnings yield, the better. An earnings yield of 10% implies that, assuming no earnings growth, the company takes 10 years to return the equity capital invested (proof: if you buy Cheap Company at 10x P/E, you pay $0.5 for $5 per share of earnings. To earn back $5, you need 10 years. In contrast, Expensive Company has an earnings yield of 20%, thus needing only 5 years to earn back the original investment. This is why multiples are important.

Why should a stock be trading at a premium (higher multiple) than others?
A few factors affect earnings multiples:
– Future growth rate (higher growth rate, higher multiple. Easy to understand)
– Riskiness (higher risk, lower multiple. Easy to understand)
– Margins (higher margins, higher multiple. Why? Higher margins mean that you need less revenue growth to increase earnings by the same amount)
– Dividend payout ratio (higher ratio, higher multiple. Why? Investor gets a faster return of capital)

Typically, the first two are probably the most important. A little bit more on multiples: There are many types of P/E ratios that can be described:
Last FY: Last financial year
LTM: Last 12 months
NTM: Next 12 months (projected)
CY17: Calendar year 2017
FY17: Financial year 2017

The above is just something to keep in mind when talking about multiples – comparison should always be done on a consistent basis (e.g. comparing company A and B both using LTM basis).

Do note that a low P/E multiple does not automatically make a stock a “better” investment than another stock with a higher multiple – the big question to ask is: Why is this multiple justified?. A low multiple could mean that investors are overly discounting the company’s prospects, for any number of reasons. It could also mean that investors expect EPS (earnings per share) to fall! If this is the case, a low P/E multiple might be justified. (similar concept on investing based on dividend yield alone – a high dividend yield could be a sign that investors are pricing in a dividend cut). Ratio analysis is not a simple answer to replace fundamental analysis – there is just no shortcut!

What makes a low or high multiple?
The short answer is that there is no simple answer to this. It all depends on historical and peer valuation ratios.
However, for a first-cut kind of analysis, investors tend towards the following guideline: The S&P has a long term P/E multiple of 15x. Anything below this may suggest under-valuation, and above this over-valuation (note that this is consistent with what you may expect the market to yield in the long term, which is 1/15 = 7%).

If there is any takeaway, it is this: Price does not tell us anything about value. Rather, it is the multiple that investors put on a stock that tells us whether it is “expensive” or “cheap”. If a stock can be classified as “cheap”, it might be a good indicator to do more research on it, perhaps leading to an investment thesis.

Disclaimer: The information provided is for general information purposes only and is not intended to be a personalized investment or financial advice.

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