We explain how you should use price multiples, and their limitations
20-Mar-2023 •Asif Ali and Mithilesh Bhaumik
Is the stock priced right? This is a question that has kept investors awake for generations. Over the years, various valuation techniques have emerged, but none simpler than the price multiple approach.
Price multiples are primarily used to look at a stock's market price in conjunction with its fundamentals, i.e., earnings, revenue, sales, etc. This allows investors to know if a stock's price is a reflection of its performance or if it's just hype inflating the prices.
How to calculate price multiples
While there are a plethora of price multiples, the basic principle governing them is the same.
You take the share price of any business and divide it by a metric representing its performance. Note that the metric must be a per-share metric, i.e., whatever the metric, it should be divided by the total number of outstanding shares of the company.
Price multiple = Share price / per-share metric
For example, Company A, a manufacturing company, trades at Rs 800. It has 10,00,000 outstanding shares and recorded a profit after tax of Rs 8 crore in the last 12 months. Thus, its per-share earning metric or earnings-per-share (EPS) is Rs 80. So, its price-to-earnings (P/E), a commonly used price multiple, is 10.
Similarly, an investor might use other performance metrics, such as book value, sales, etc., to evaluate other price metrics for Company A.
How to use price multiples
Let's consider another manufacturing company (operating in the same business as company A), Company B. Company B also has 10,00,000 outstanding shares, but it is trading at Rs 1,400. You want to invest in the manufacturing sector and, of course, do not want to purchase an overpriced stock. And if you just consider the stock's price, Company B is more expensive than Company A.
But suppose Company B booked a profit after tax of Rs 20 crore in the last 12 months. That means, it has an EPS of Rs 200, and its P/E is 7.
Thus, when viewed in terms of both stock price and earnings, Company B is cheaper than Company A.
Drawback of price multiples
The simplicity of price multiples is a double-edged sword. While it is an easy approach to valuation, it disregards a company's intrinsic value. In addition, there's no set benchmark. What might be a low P/E for one industry might be a high P/E in a different industry. It also does not account for a company's growth potential. All these factors combined often lead to misinterpretation.
Hence, investors should use P/E in combination with other factors. You should indeed consider valuation before investing in a company. Your investing philosophy should not be solely based on price multiples.
Suggested read:
Don't invest solely based on P/E
What is diluted EPS?
Coal India initiates offer for sale
Why businesses must adapt to technological changes
Bill Ackman's guide to investing
Wealth Insight's June issue is out!
How to identify economic moats
Why you should not invest based on hype
