Multiple Price Models Study Session 14, LOS 59.b
Quality Circle #6
13 Apr 2009
LOS 59 b: calculate and interpret P/E, P/BV, P/S, and P/CE
Price to Earnings Ratio (P/E): market price per share / earnings per share (EPS)
Trailing P/E: use EPS over previous 12 months
Leading P/E: use EPS over next 12 months
Advantages: widely used, P/E rankings are significantly related long-run stock returns
Drawbacks: earnings can be negative, manipulated, or volatile
Price to Book Value Ratio (P/BV): market value of equity / book value of equity
(or market price per share / book value per share)
Book value of equity = total assets total liabilities - preferred stock
Advantages:
- Book value is usually positive and more stable than EPS
- Appropriate measure of net asset value, useful to value companies that are expected to go
out of business
- It helps explain differences in long-run average returns
Drawbacks:
- Do not recognize assets that are not on the balance sheet (human capital)
- Can be misleading due to different accounting methods
- Inflation and technological changes can cause great differences in BV and MV
Price to Sales Ratio (P/S): market value of equity / total sales
(or market price per share / sales per share)
Advantages:
- sales revenue is always positive, not easy to manipulate, not as volatile
- appropriate for start-up and distress companies
Drawbacks:
- does not reflect operating margin or cost structures across companies
- sales figure are affected by revenue recognition methods
Price to Cash Flow (P/CF): Ratio market value to equity / cash flow
(or market price per share / cash flow per share)
Advantages: cash flow is difficult to manipulate and more stable earnings figure
Drawbacks: many definitions of cash flows are used, need to ensure consistency
4 definitions of cash flow: earning plus noncash charges (CF), adjusted cash flow (adjusted CFO),
free cash flow to equity (FCFE), and earnings before interest, taxes, depreciation, and
amortization (EBITDA)
CF = net income + depreciation + amortization
Adjusted CFO = CFO + [(net cash interest outflow) x (1-tax rate)]
1. The current price of XYZ, Inc., is $40 per share with 1,000 shares of equity outstanding. Sales are $4,000
and the book value of the firm is $10,000. What is the price/sales ratio of XYZ, Inc.?
A) 10.000.
B) 0.010.
C) 4.000.
2. General, Inc., has net income of $650,000 and one million shares outstanding. The profit margin is 6
percent and General, Inc., is selling for $30.00. The price/sales ratio is equal to:
A) 2.77.
B) 0.65.
C) 10.83.
3. An increase in a firms stock price will, all else equal, cause the price to cash flow (P/CF) ratio to:
A) there is insufficient information to tell.
B) increase.
C) decrease.
4. Given the following information, compute price/book value.
Book value of assets = $550,000
Total sales = $200,000
Net income = $20,000
Dividend payout ratio = 30%
Operating cash flow = $40,000
Price per share = $100
Shares outstanding = 1000
Book value of liabilities = $500,000
A) 5.5X.
B) 2.0X.
C) 2.5X.