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LOS c: Discuss rationales for and possible drawbacks to using price multiples (including P/E, P/B, P/S, P/CF) and dividend yield in valuation.

Which of the following is a disadvantage of using price-to-sales (P/S) multiples in stock valuations?

A)	The use of P/S multiples can miss problems associated with cost control.

B)	It is difficult to capture the effects of changes in pricing policies using P/S ratios.

C)	P/S multiples are more volatile than price-to-earnings (P/E) multiples.

Due to the stability of using sales relative to earnings in the P/S multiple, an analyst may miss problems of troubled firms concerning its cost control. P/S multiples are actually less volatile than P/E ratios, which is an advantage in using the P/S multiple. Also, P/S ratios provide a useful framework for evaluating effects of pricing changes on firm value.

Which of the following is a disadvantage of using the price-to-book value (PBV) ratio?

A)	Book values are affected by accounting standards, which may vary across firms and countries.

B)	Book value may not mean much for manufacturing firms with significant fixed costs.

C)	Firms with negative earnings cannot be evaluated with the PBV ratios.

The disadvantages of using PBV ratios are:

Book values are affected by accounting standards, which may vary across firms and countries.

Book value may not mean much for service firms without significant fixed costs.

Book value of equity can be made negative by a series of negative earnings, which limits the usefulness of the variable.

Which of the following is NOT an advantage of using price-to-book value (PBV) multiples in stock valuation?

A)	Book value is often positive, even when earnings are negative.

B)	PBV ratios can be compared across similar firms if accounting standards are consistent.

C)	Book values are very meaningful for firms in service industries.

Book values are NOT very meaningful for firms in service industries.

A)	P/S ratios do not express differences in cost structures across companies.

B)	P/S ratios are not as volatile as price-to-earnings (P/E) multiples.

C)	sales figures are not as easy to manipulate or distort as earnings per share (EPS) and book value.

P/S ratios do not express differences in cost structures across companies. Both remaining responses are advantages of the P/S ratios, not disadvantages.

One disadvantage of using the price/sales (P/S) multiple for stock valuation is that:

A)	profit margins are not consistent across firms within an industry.

B)	P/S multiple does not provide a framework to evaluate the effects of corporate policy decisions and price changes.

C)	sales are relatively stable and might not change even though earnings and value might change significantly.

The stability of sales (relative to earnings and book value) can be a disadvantage. For example, revenues may remain stable but earnings and book values can drop significantly due to a sharp increase in expenses.

A)	P/E ratios for medical-technology firms with different specialties are not comparable.

B)	Earnings per share are not a good determinant of investment value for medical-technology companies.

C)	The company is likely to be unprofitable.

Earnings are the chief determinant of value for most companies, including med-tech. P/E is the most common valuation method and the best known by lay investors. Comparability of P/E ratios across industries is always problematic, but not as much so for within the med-tech industry. A start-up company is very likely to have negative earnings, which renders the P/E ratio useless. (Study Session 12, LOS 44.c)

Book value tends to be more stable than earnings. Therefore, Lincoln’s favorite valuation tool, the P/B ratio, is less volatile than the P/E. The P/S ratio tends to be less volatile than the P/E as well, but Bosley’s other favorite, earnings yield, is just as volatile. The method preferred by Barnes is likely to be more volatile than the P/B ratio. (Study Session 12, LOS 44.c)

Start-up companies tend to be unprofitable, and also often have negative free cash flow. Book value has some predictive power for such companies, but this is also often negative for new and unprofitable companies. The price/sales ratio, one of Bosley’s favorites, is the only metric that will work even if earnings, cash flows, and book value are negative. (Study Session 12, LOS 44.c)

A)	reports a lot of depreciation expense.

B)	has a different capital structure than most of its peers.

C)	pays a dividend, and is likely to deliver little earnings growth.

For companies that report a lot of depreciation expense or must be compared to companies with different levels of financial leverage, the EV/EBITDA ratio may be more useful than the P/E. For companies that pay a dividend and have little profit growth, both should work fine. Given Barnes’ stated preference for the P/E ratio, she is least likely to use the EV/EBITDA ratio with the dividend-paying firm. (Study Session 12, LOS 44.c)

A)	The price/sales ratio.

B)	The PEG ratio.

C)	The mean P/E of S& 500 companies.

No valuation method will work dependably across all types of stocks. The four Barnes proposed are probably as good as any. But the PEG ratio does not correct for risk – it works as a comparison tool only if the companies have similar expected risks and returns. The other justifications are reasonable. (Study Session 12, LOS 44.c)

A)	research shows that P/E differences are significantly related to long-run average stock returns.

B)	earnings volatility facilitates interpretation.

C)	earnings can be negative.

Research shows that P/E differences are significantly related to long-run average stock returns. Both remaining factors reduce the usefulness of the P/E approach.

A)	earnings can be negative.

B)	management discretion increases the reliability of the ratio.

C)	earnings power is the primary determinant of investment value.

Earnings power is the primary determinant of investment value. Both remaining factors reduce the usefulness of the P/E approach.

A firm is better valued using the discounted cash flow approach than the P/E multiples approach when:

A)	expected growth rate is very high.

B)	dividend payout is low.

C)	earnings per share are negative.

P/E multiples are not meaningful when the earnings per share are negative. While this problem can be partially offset by using normalized or average earnings per share, the problem cannot be eliminated.

An argument against using the price-to-earnings (P/E) valuation approach is that:

A)	earnings can be negative.

B)	research shows that P/E differences are significantly related to long-run average stock returns.

C)	earnings power is the primary determinant of investment value.

Negative earnings render the P/E ratio useless. Both remaining factors increase the usefulness of the P/E approach.

Analyst Ariel Cunningham likes using the price/earnings ratio for valuation purposes because studies have shown it is very effective at identifying undervalued stocks. However, she has one main problem with the statistic – it doesn’t work when a company loses money. So Cunningham is considering switching to a different core valuation metric. Given Cunningham’s rationale for using the price/earnings ratio, which option would be her best alternative?

Book value is usually positive, but not always. Cash flow is often negative. If the reason Cunningham wants to stop using the P/E ratio is that it does not work for unprofitable companies, her best option is a ratio base on sales, which are positive in all but the rarest of instances.

Bill Whelan and Chad Delft are arguing about the relative merits of valuation metrics.

Whelan: “My ratio is less volatile than most, and it works particularly well when I look at stocks in cyclical industries.”

Delft: “The problem with your ratio is that it doesn’t reflect differences in the cost structures of companies in different industries. I like to use a metric that strips out all the fluff that distorts true company performance.”

Price/book

EV/EBITDA

Price/cash flow

Price/book

Price/sales

Price/cash flow

The price/sales ratio is not very volatile, and it is of particular value when dealing with cyclical companies. The price/cash flow ratio considers the stock price relative to cash flows, ignoring the noncash gains and losses that can skew earnings. A major weakness of the price/cash flow ratio is the fact that there are different ways of calculating it, making comparisons difficult at times.

An analyst focusing mostly on financial stocks is likely to prefer valuing stocks via the:

The price/book ratio is a preferred tool for valuing financial stocks.