Equity Valuation Doubt long, sales, statements, companies, following

LorrinCFA

Please explain the following statements regarding interpreting the P/E multiples and  P/CF multiples  and price to sales multiples…..
1) According to empirical research,differences in P/E ratios are significantly related to long term stock returns
2) differences to P/ CF ratio overtime are related to differnces in long term avg returns on stocks…
3) Using P/S ratio does not reflectthe differnces in cost structure and operating effiency between companies…
Thanks

genuinecfa

I’ll leave number 2 for someone else to answer, but I suspect I can help with 1 and 3:
1) Within any given industry you can calculate average P/E ratios which reflect the willingness of investors to pay for each dollar of earnings. Different industries will have different multiples depending on outlook for the industry and stability etc. and each industry can also be broken into different market caps which will also have different multiples to reflect the risk of investing in smaller companies. If a company is trading well below the industry average, it is likely a sign of undervaluation. Therefore, an investor can take a long position in the company and expect the price to increase to reflect the industry average. Obviously on the flip side, earnings may also fall which would increase the P/E ratio as well.
3)Using the P/S uses gross sales as the denominator. This means that the denominator does not include any costs associated with generating the revenue and operations, unlike the P/E ratio. Using P/S, two companies could potentially have the same valuation even though one is significantly more profitable. Think about two clothing manufacturers, one selling hand sewn clothing and another using high tech, efficient manufacturing equipment. Even though the two could have the same sales numbers, the second company will (likely) be much more profitable. If you use P/S however, the difference wouldn’t be reflected in the ratios.

bpdulog

More explanation needed…