Price multiples are essential tools in relative valuation, helping investors compare companies quickly. P/E, P/B, and P/S ratios offer insights into a stock's value relative to earnings, book value, and sales, respectively.

These ratios have limitations and should be used alongside other methods. Factors like industry averages, growth rates, and temporal considerations play crucial roles in interpreting multiples accurately for investment decisions.

Valuation Ratios

Price-to-Earnings (P/E) Ratio

• Calculates the market value of a stock relative to its earnings per share
• Determined by dividing the current stock price by the earnings per share (EPS) over the past 12 months
• Indicates how much investors are willing to pay for each dollar of a company's earnings
• Higher P/E ratios suggest investors expect higher growth in the future (Amazon, Tesla)
• Lower P/E ratios may indicate undervalued stocks or slower expected growth (utilities, telecoms)

Price-to-Book (P/B) Ratio

• Compares a company's market capitalization to its book value
• Calculated by dividing the current stock price by the book value per share
• Book value represents the net assets of a company
• P/B ratio below 1 could mean the stock is undervalued (assuming the company is not in financial distress)
• Useful for valuing companies with mostly liquid assets (banks, financial institutions)
• Less useful for companies with significant intangible assets (brand value, intellectual property)

Price-to-Sales (P/S) Ratio

• Values a company based on its revenue rather than earnings
• Calculated by dividing the company's market capitalization by its total sales over the past 12 months
• Useful for valuing growth companies that have yet to generate profits (startups, tech companies)
• Eliminates differences in profit margins between companies
• Low P/S ratio compared to peers could signal an undervalued stock
• High P/S ratio might indicate an overvalued stock or high growth expectations

Temporal Considerations

Trailing Multiples

• Based on a company's past performance, typically over the last 12 months
• Uses historical data, providing a snapshot of the company's current valuation
• More reliable as they are based on actual reported figures
• Less relevant for fast-growing companies or those with significant changes in their business

Forward Multiples

• Use projected future earnings or revenues, typically for the next 12 months
• Rely on analyst estimates and company guidance
• Provide insight into the market's expectations for a company's future performance
• More relevant for valuing high-growth companies (tech sector)
• Subject to the accuracy of the estimates and the company's ability to meet those projections

Benchmarking and Adjustments

Industry Averages

• Comparing a company's multiples to the average of its industry peers
• Helps identify over- or undervalued companies within a sector
• Assumes companies within the same industry have similar growth prospects and risk profiles
• Adjustments may be needed for companies with unique business models or growth rates

Growth-adjusted Multiples

• Accounts for differences in growth rates between companies
• Common growth-adjusted multiples include the PEG ratio (P/E to Growth) and EV/EBITDA/Growth
• PEG ratio divides the P/E ratio by the expected earnings growth rate
• Lower PEG ratios may indicate a stock is undervalued relative to its growth potential (assuming the growth estimates are accurate)
• EV/EBITDA/Growth considers a company's enterprise value, EBITDA, and expected EBITDA growth rate
• Useful for comparing companies with different capital structures and tax rates

Drawbacks

Limitations of Price Multiples

• Multiples are simplistic and do not capture all aspects of a company's financial health or future prospects
• Sensitive to changes in earnings or revenue, which can be volatile from period to period
• Accounting differences between companies can distort multiples (revenue recognition, depreciation methods)
• Multiples do not account for differences in risk profiles or capital structures between companies
• Relying solely on multiples can lead to value traps (companies appearing cheap but with poor fundamentals)
• Multiples should be used in conjunction with other valuation methods and qualitative analysis