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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 stock valuation, with a few adjustments to smooth out fluctuations in cash flow levels. In this article, we’ll look at another common way to value a stock, using multiples of a company’s financial metrics, such as earnings, net assets, and sales.
There are three basic ratios that can be used for this type of analysis: the price-to-market ratio (P/S), the price-to-book (P/B) ratio, and the price-to-earnings (P/E) ratio. They are all used in the same way in valuation, so let’s first explain the method and discuss a little about when to use the three different multiples, then look at an example.
Valuing a stock using a multivariate method is easy to understand, but it takes some work to find the parameters. In short, the key here is to come up with a reasonable “multiple target” that you believe the stock should trade fairly, given its growth prospects, competitive position, and so on. To come up with this “multiple target”, there are a few things to consider:
1) What is the stock’s historical average multiple (P/E ratio, P/S ratio, etc.)? You must take at least 5 years, and preferably 10 years. This gives you an idea of the frequency in both bull and bear markets.
2) What is the average frequency of your competitors? How wide is the difference against researched stocks, and why?
3) Is the range of high and low prices too wide, or too narrow?
4) What are the future expectations for the stock? If they are better than before, the “repetitive target” can be set higher than historical norms. If they are not good, the “target frequency” should be lower (sometimes much lower). Don’t forget to consider potential competition when considering future prospects!
Once you come up with a reasonable “repeat target”, the rest is easy. First, take the current year’s forecast of revenue and/or earnings and multiply the target against them to get the target market capitalization. Then you divide that by the dividend count, choosing to adjust for dilution based on past trends and any announced stock buyback programs. This gives you a “fair price” price, where you want to buy 20% or more below the margin of safety.
If this is confusing, an example later in the article should help clarify things.
When to use different Multis
Each of the different types has its advantages in certain situations:
The P/E ratio: IP/E is probably the most commonly used multiplexer. However, I will adjust this to the cost of working capital instead, where operating income in this case is defined as earnings before interest and taxes (EBIT – includes depreciation and amortization). The reason for this is to adjust for one-time events that lower earnings per share over time. IP/EBIT works best for profitable companies with stable sales levels and margins. It *doesn’t* work at all for unprofitable companies, and it doesn’t work well for asset-based firms (banks, insurance companies) or heavy bikes.
P/B ratio: The price-to-book ratio is very useful for asset-based firms, especially banks and insurance companies. Earnings are often unpredictable due to interest rate spreads and are more speculative than basic product and service firms when you consider such statistical factors as loan loss provisions. However, assets such as deposits and loans are stable (2008-09 aside), and thus book value is broadly appreciated. On the other hand, book value does not mean much in “new economy” businesses such as software and service firms, where the main asset is the collective mind of employees.
P/S ratio: Price-to-market is a useful ratio across the board, but the most important one for valuing unprofitable companies right now. These firms do not have earnings to use P/E, but comparing the P/S ratio against historical norms and competitors can help give an idea of the fair value of the stock.
A Simple Example
To illustrate, let’s look at Lockheed Martin (LMT).
From doing basic research, we know that Lockheed Martin is an established firm with an excellent competitive position in what has always been a stable industry, the defense contractor. Furthermore, Lockheed has a long record of profitability. We also know that the firm is not an asset-based business, so we will go with the P/EBIT ratio.
Looking at the last 5 years of price and earnings data (taking a spreadsheet job), I find that the average P/EBIT for Lockheed over that period has been about 9.3. Now I look at the situation in the last 5 years and I can see that Lockheed has worked in some strong defensive years in 2006 and 2007, followed by significant political shakeups and a market downturn in 2008 and 2009, followed by a market rebound but problems with the important program of the F-35 earlier this year. Given the expected slow growth in defense spending, I estimate that 8.8 is probably the “multiple target” that could be used for this stock in the near future.
Once this frequency is determined, finding the right value is very easy:
Estimated revenue for 2010 is $46.95 billion, which would be a 4% increase from 2009. Earnings per share is estimated at 7.27, which would be a 6.5% decrease from 2009, and represents a 6% net margin. From these numbers and empirical data, I estimate a 2010 EBIT of $4.46 billion (9.5% operating margin).
Now, I just use my 8.8 to multiply to $4.6 billion to get a market cap of $40.5 billion.
Finally, we need to divide that by the shares outstanding to get the target share price. Lockheed currently has 381.9 million shares outstanding, but it typically buys back 2-5% annually. I’m going to split the difference on this and assume that the number of shares will decrease by 2.5% this year, leaving a year-end number of 379.18 million.
Dividing $40.5 billion by 378.18 million gives me a target share price of about $107. Interestingly, this is close to the discounted free cash flow rate of $109. So, in both cases, I used my best guess and determined that the stock looked undervalued. Using my 20% minimum “margin of safety”, I would consider buying Lockheed at share prices of $85 and below.
Obviously, you can easily plug in the sale price or the book-price and, using the appropriate currency rates, make an estimate based on many of the same factors. This type of stock valuation makes more sense for most people, and accounts for market-based factors such as different types of inventory for different industries. However, one should be careful and consider how the future may differ from the past when predicting a “repeat target”. Use your head and try to avoid using multiples that are much higher than historical market averages.
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