Lately, I have been a big fan of investing in low fee mutual funds and ETFs. It takes a lot less work and research to invest in funds than stocks. That doesn’t mean I don’t have any individual stocks though. There are many methods to value a stock, and a comparison to similar companies is an important part of the investor’s toolbox.
Investment professionals use complex models to value a stock, and many of them include multiple analysis. Multiples are different ratios calculated from a company’s financial statements that can help show financial trends, strengths, and weaknesses.
The most popular multiples are:
- P/E ratio, or price / earnings ratio (share price / earnings per share)
- Price/book ratio (share price / book value per share)
- Dividend yield (dividend per share / share price)
- Price / sales (share price / sales per share)
Multiple Analysis Example
To conduct a very simple multiple analysis, we will compare one company to a peer in the same category. In this example, we will find the target share price of telecom giant AT&T (NYSE:T). To find the value, we will do a P/E ratio comparison with Verizon (NYSE:VZ).
The current share price for AT&T as of this writing is $33.76. The earnings per share for the most recent quarter is $0.77. That gives AT&T a P/E ratio of 43.80. Verizon’s share price is $41.97 as of this writing and the most recent earnings per share is $1.07. The P/E for Verizon today is 39.13.
Because the P/E for AT&T is higher than its peer, if you believe the share price of Verizon intrinsically represents its true value, the share price of AT&T is too high and expected to decrease. Using Verizon’s P/E ratio and AT&T’s earnings per share, we believe that the share price should be 39.13 x 0.77 = $30.13.
However, just comparing to one company, while simple for this example, is not the best method to conduct a peer analysis. Rather, we should look at a bucket of stocks in the company’s industry. AT&T industry peers include Verizon, Sprint Nextel, and CenturyLink . To include a global comparison, it may be worth adding companies like America Movil and Deutsche Telekom. To calculate a more representative P/E comparison, we should take the average P/E of those companies, possibly giving extra weight to the US based rivals.
Advantages of Multiple Analysis in Pricing a Stock
Having done many stock analysis projects in the past, I can vouch that this is the easiest method to use to value a stock. It only takes a few minutes and helps give a perspective on how the company is priced compared to the industry.
It is a simple calculation to conduct. If you do a multiple analysis on a company using the four methods above compared to industry peers, you can get an even better picture of how the stock compares.
Weaknesses of Multiple Analysis in Pricing a Stock
With simplicity comes shortfalls. Because we are only taking a few metrics into account, we may be missing something very important in the company’s operation. For example, a price/sales comparison could give the company a great valuation, but we might not see that net income is very low due to high overhead costs.
This method of valuation also assumes that the peer group has a good valuation. It is possible that the entire industry is overvalued (think dot com bubble) or undervalued. If that is the case, we are anchoring the stock price to other companies that are incorrect.
This valuation is also only good for a very short period. Stock prices change constantly throughout the day and the calculations generally use very recent metrics. They are not forward looking and do not price in economic factors.
At the end of the day, finding the intrinsic value of an investment is very difficult. If you were right all the time, you could make millions on Wall Street as a fund manager. But we are not all right all the time. Not even Warren Buffet is always right. But some people are right more often than others. Most of those people use many tools to find the value of a stock. Multiple analysis is an important tool and one that should not be overlooked, but it should not be used exclusively.
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What methods have you used to value a stock? Do you like multiple analysis? Please share why in the comments.
Originally published November 13, 2008. Updated January 21, 2013. Image by Manu_H / flickr.