Accounting Rate Of Return Is Based On Cash Flow How to Use P-E, P-S, and P-B Ratios to Value a Stock

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How to Use P-E, P-S, and P-B Ratios to Value a Stock

In a previous article, I discussed the traditional and “textbook” approach to valuing stocks with some modifications to address the inherent constraints on cash flow levels. In this article, we’ll look at another common way to value a stock, using statistical multiples of a company’s financial metrics, such as earnings, net assets, and sales.

There are basically three statistical multiples that can be used in this type of analysis: the price-to-sales (P/S) ratio, the price-to-book (P/B) ratio, and the price-to-earnings (P/E) ratio. They’re all used in the same way when evaluating, so we’ll first describe the method and then discuss a little about when to use the three different multipliers, then look at an example.

Multiple-based method

Valuing a stock with a multiple-based approach is easy, but getting the parameters requires some work. In short, the idea here is to come up with a reasonable “target multiple” that you believe the stock should trade reasonably for given its growth prospects, competitive position, and so on. To come up with this “goal multiple”, you should consider a few things:

1) What is the stock’s average historical ratio (P/E ratio, P/S ratio, etc.)? You should take a minimum of 5 years and preferably 10 years. This gives you an idea of ​​the multiples in both bull and bear markets.

2) What are the average multiples for competitors? How wide is the variance against stocks being investigated and why?

3) Is the range of high and low values ​​too wide or too narrow?

4) What are the future prospects for the stock? If they are better than in the past, the “target multiple” can be set higher than historical norms. If it’s not that good, the “target multiple” should be lower (sometimes much lower). Don’t forget to consider potential competition when considering future prospects!

Once you come up with a reasonable “target multiple”, the rest is pretty easy. First, take the current year’s projections for revenue and/or earnings and multiply the target against them to get the target market capitalization. You then divide it by the number of shares, optionally adjusting for dilution based on past trends and any announced stock buyback programs. This gives you a “fair price” valuation, from which you need to buy 20% or more for a margin of safety.

If this is confusing, an example later in the article will help clarify things.

When to use different multipliers

Each of the different multipliers has an advantage in certain situations:

P/E ratio: P/E is probably the most common multiple to use. However, I would adjust this as a price-to-operating earnings ratio, where operating earnings in this case is defined as earnings before interest and taxes (EBIT – including depreciation and amortization). The reason for this is to smooth out one-time events that reduce bottom-line earnings per share value over time. P/EBIT works well for profitable companies with relatively stable levels of sales and margins. It does not work at all for unprofitable companies and does not work well for asset-based companies (banks, insurance companies) or heavy cyclicals.

P/B ratio: The price-to-book ratio is most useful for asset-based companies, particularly banks and insurance companies. Earnings are often unpredictable due to interest spreads and are fraught with more assumptions than basic product and service organizations when you consider such obscure accounting items as loan loss provisions. However, assets such as deposits and loans are relatively stable (aside from 2008-09), and so book value is usually their value. On the other hand, book value means little to “new economy” businesses such as software and service firms, where the primary asset is the collective intelligence of employees.

P/S ratio: Price-to-sales is a useful ratio across the board, but perhaps most valuable for evaluating companies that are currently unprofitable. These companies don’t have any earnings to use P/E, but comparing the P/S ratio to historical norms and competitors can give an idea of ​​the stock’s fair value.

A simple example

For example, let’s look at Lockheed Martin (LMT).

After doing some basic research, we know that Lockheed Martin is an established firm with an excellent competitive position in a relatively stable industry, defense contracting. Furthermore, Lockheed has a strong track record of profitability. We also know that the firm is clearly not an asset-based business, so we will go by the P/EBIT ratio.

Looking at the past 5 years of price and earnings data (which takes some spreadsheet work), I determine that Lockheed’s average P/EBIT ratio over that period is about 9.3. Now I look at the scenarios over the last 5 years and see that Lockheed has worked through some strong defense demand years in 2006 and 2007, followed by some significant political changes and a recession in 2008 and 2009, followed by a market rebound but with issues at the start of this year with significant F -35 programs. Given the expected slow near-term growth in defense spending, I conservatively argue that 8.8 is probably a reasonable “target multiple” to use for this stock in the near term.

Once these multiples are determined, finding a fair price is pretty easy:

Revenues for 2010 are forecast at $46.95 billion, a 4% increase over 2009. Earnings per share is 7.27, which would be 6.5% lower than in 2009, and represents a 6% net margin. From these figures and empirical data, I estimate a 2010 EBIT of $4.46 billion (9.5% operating margin).

Now, I simply apply my 8.8 multiple to $4.6 billion to get a target market cap of $40.5 billion.

Finally, we need to divide it by the shares outstanding to get the target share price. Lockheed currently has 381.9 million shares outstanding, but typically buys back 2-5% a year. I’ll split the difference and assume that the number of shares will decrease by 2.5% this year, leaving the number at 379.18 million at the end of the year.

$40.5 billion divided by 378.18 million gives me a target share price of about $107. Interestingly, this is close to the discounted free cash flow valuation of $109. Therefore, in both cases, I have used reasonable estimates and determined that the stock appears to be undervalued. Using my 20% minimum “margin of safety”, I would only consider buying Lockheed at a share price of $85 and below.

Wrapping it up

Of course, you can easily plug in the price-to-sales or price-to-book ratio and, using the appropriate financial values, perform the same multiple-based valuation. This type of stock valuation makes a little more sense for most people and accounts for market-based factors such as different multiple categories for different industries. However, one should be careful and consider how the future may differ from the past when predicting “target multiples”. Use your head and try to avoid using multiples that are significantly higher than historical market averages.

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