### Analyzing Price Ratios: Value Investing

In the Financial Statement Analysis Module the sub branch “Analyzing Price Ratios” is organized around four sub-sections:

Price to Earnings
Price to Sales
Price to Book
Price to Cash

Recently, the company Facebook went public and the initial public offering (IPO) price was set at \$38.  This was a controversial price, in that many investors thought that it did not represent good value given Facebook’s fundamentals.  However, if the IPO was set at \$10 then few investors would have had this concern.  Given a company’s fundamentals, there will be some price at which investors would consider it to be fairly valued.  However, what this price is at any point in time can fluctuate a lot.  In fact, in the first two months of trading, the stock price of Facebook has fluctuated from a high of \$45 to a low of \$22.28.

This raises the question: how do you assess whether a stock’s fundamentals represent good value?

The analysis of business ratios allows an investor to assess the relative strength of a company’s fundamentals.  However, this provides no insight into the question.  A stock with strong fundamentals may not be good value while a stock with relative weak fundamentals may provide excellent value to investors.  The major objective of price ratio analysis is to answer this type of question.

Price Ratios and Value Investors

Value investing was popularized by Benjamin Graham with the concept of “margin of safety” and the advantages of this approach have been demonstrated by Warren Buffet.  In this topic you will learn how to construct the primary set of price ratios used by value investors to identify what stocks they assess to be value stocks, i.e. stocks with strong fundamentals that can be acquired relatively cheaply.

Price to Earnings (P/E) Ratio

Arguably the most popular of all ratios and certainly the most frequently cited is the P/E Ratio.  Why this is the case is because it represents the number of years to recover the stock price with future zero growth earnings.  That is, if current earnings persist without a change then the P/E ratio measures the number of years required to recover the current stock price.  As a result, cross sectional variation among P/E ratios is related to growth expectations.  This relationship is reinforced from the observation that average P/E ratios vary for the market as a whole with the business cycle and thus P/E ratios are popular because they are considered to be a leading indicator of future economic activity.  This multiple can also be used to identify the relative value of similar stocks at a point in time by comparing P/E ratios across stocks.

The definition of a P/E ratio is as follows:

P/E Ratio = Stock Price / Earnings per Share (EPS)

In practice there are different types of P/E ratios commonly used in practice which vary depending upon the answer to the following question:

Which earnings should be used in the P/E ratio?

The financial statements provide measures of earnings for some completed accounting period.  In addition, financial analysts provide forecasts of future earnings.  These forecasts are usually provide for the current year, next year and annualized five year forecasts.  As time moves forward the current year forecast becomes more accurate because it contains the information provided in 10-Q accounting reports including additional guidance provided by management.

The FTS ratio module covers each of these cases.  For example, consider Coca Cola (KO):

Suppose the spot price at the time of this example is \$77.55 and the consensus for current year earnings per share is \$4.0636 then the price earnings ratio for KO is 19.0838.  In other words, if KO’s earnings did not grow then it would take just over 19 years to recover the \$77.55 stock price.

It is immediately clear from the above example that the “zero growth” assumption in a price earnings ratio is a critical assumption for understanding differences among P/E ratios.

Role of Growth Forecasts

A popular refinement of the P/E ratio designed to highlight the importance of growth assumptions to Price/Earnings ratio is the Price/Earnings to Growth Ratio (PEG) Ratio.

PEG Ratio = P/E Ratio divided by Forecast Growth

Here Forecast Growth is often defined as the expected Growth over the next 5-years.

Again, this ratio is interpreted relative to a similar stock or set of stocks in an industry.  All other things being equal, the stock with a lower PEG ratio is ranked higher than a similar stock with a higher PEG ratio.

What is the PEG ratio?

Recall that the P/E ratio is measured in terms of years to recover the stock price with zero growth earnings.  Thus the PEG ratio is Years scaled by % Growth or years per % of growth.  For example, if years equal 10 and % growth equals 10 then the PEG ratio is 1 year per % of growth to recover the current stock price.  Similarly, if the PEG ratio is 0.5 versus 2 the former (0.5) recovers the stock price in quicker time per % of growth than does the latter (2).

We illustrate these ideas next for a small set of well known stocks with similar business models.

Earnings Yield

How Can You Interpret P/E Ratios when Earnings are Zero or Negative?

This question identifies the problem with the P/E ratio which is that it is undefined when earnings are zero and rankings break down when earnings pass through zero.  Relative valuation consists of ranking stocks by price ratios and the earnings yield is designed to overcome these problems with the P/E ratio.  The reciprocal is called the Earnings Yield or Earnings to Price Ratio.

Earnings Yield = Earnings to Price Ratio = Earnings divided by Price

Because price is greater than zero this scaling variable overcomes the previous problems and preserves rankings as earnings pass through zero.  The following example illustrates this property:

Example: P/E Ratios versus E/P Ratios

Suppose you are interested in ranking the following set of similar stocks in terms of relative over or undervalued on the basis of earnings and stock prices.  Assume the EPS for this set of stocks is -.20, -.10, 0, 0.10 and 0.20 and that the stock price for each stock is \$1.

EPS     Price    P/E Ratio         Ranking           E/P Ratio         Ranking
1          -0.2        1            -5                     2                     -0.2                   5
2          -0.1        1           -10                    1                     -0.1                   4
3          0.0         1        Infinity               5                      0.0                   3
4          0.1         1            10                    4                      0.1                   2
5          0.2         1              5                    3                      0.2                   1

You can see that hat the ranking is meaningless for the P/E Ratios but meaningful for the E/P Ratios.  So when faced with positive and negative earnings the E/P Ratio is preferred for relative valuation.

The FSA Price Earnings Ratio Calculator

The first three columns of the calculator provide forward looking estimates of the P/E ratio.  The first column is computed from the 5-year earnings growth forecast, column 2 from the next year’s earnings growth forecast and column 3 from the current year earnings growth forecast.  These measures attempt to refine the leading indicator properties of the P/E ratio by basing the measure upon consensus earnings’ forecasts.

Price to Sales Ratio

Price/Sales Ratio is a measure of the number of years to recover the stock price with zero sales growth.

Price to sales ratio = Stock price by Sales Revenue per share.

One rationale for working with the price to sales ratio is that Sales Revenue is the top line of the income statement and thus potential less subject to manipulation.  However, even though this top line item is usually subject to less potential manipulation care must still be taken to read item 7 in the 10-K, specifically the “Management’s Discussion and Analysis (MD&A) and Forward Looking Statements, and Critical Accounting Policy” section.   This section often provides a discussion of the stock’s revenue recognition criteria.  Specific issues to look out for are:

Under the merchant model of revenue recognition revenue is booked as the price a customer pays for the good or service whereas under the agent model only the net proceeds from the price is booked as revenue.  This distinction becomes blurred with many dot com business models.  For example, a web site company may actually keep only a small percentage of the price paid by a customer.  For example, just prior to their initial public offering of Groupon stock, Groupon changed their revenue recognition criteria from a gross (i.e., merchant) reporting to a net (i.e., agent) reporting basis in response to some criticism of their accounting practices prior to going public.  Many web based companies including Google adopt a mixed approach to revenue recognition and as a result it is always important to read the MD&A section of a 10-K to review a company’s revenue recognition criteria.

Another method for managing revenue is what is referred to as “Contra deals or barter.” This method involves booking revenue ahead of when the sale actually occurs. For example, a dot-com may exchange advertising space on its website for advertising space on another to build brand recognition and use up excess advertising capacity without using cash. GAAP requires recording barter transactions at fair value, but does not specify how to determine fair value. Many dot-coms have treated such barter advertising deals as a sale, thereby accelerating revenue as well as expenses.

The above and other cases are discussed by Mary-Jo Rebelo in “The Effect of the Dot-Com Decline on Independent Accountants” (The CPA Journal, May 2003).

On the positive side, Sales Revenue is relatively more stable and more predictable than net income.  The price to sales ratio can be computed relative to reported sales as well as forecast sales revenue.  In the FTS calculator the two standard analyst sales forecasts are used which are current and next year’s sales.  Finally, because sales revenue is always positive the price to sales ratio avoids the problems associated with the P/E ratio when earnings pass from positive to negative.

Working from top line sales towards the bottom line provides additional insight into the drivers of the price ratios.  In order to gain insight into these drivers additional price ratios are provided in the calculator as follows:

Price to Gross Margin = Price / Gross Margin per share
Gross Margin to Price = Gross Margin per share / Price
Price to Net Operating Profit after Tax (NOPAT) = Price / NOPAT per share
NOPAT to price = NOPAT / Price

The inverse of each of these ratios is provided because both Gross Margin and NOPAT can be close to zero or negative and for the same reasons as the earnings to price ratio scaling by the positive number price preserves rankings.

The last set of ratios in this calculator relate to Enterprise Value as opposed to stock price.  Enterprise Value is often used by value investors who are assessing stock investing from a long holding period perspective.  From this perspective the prevailing view is that one is buying a business as opposed to buying a share.  As a result, Enterprise Value is used in the place of Price.  This leads naturally to a modification of the traditional Earnings Yield (Earnings to Price Ratio) which adopts a shareholder focus.  The variation is to use Earnings Before Interest and Taxes in place of Earnings per share (EPS).  This variation was popularized by Joel Greenblatt as part of his “Magic Formula,” who uses EBIT to enterprise value ratio in place of EPS divided by stock price.

Enterprise Value

An important distinction often made by value investors such as Warren Buffet, is to view stock investing in terms of buying the business as opposed to buying a share in the business.

Enterprise value is defined as follows:

Enterprise Value = Market capitalization + Total Debt - Cash and Cash equivalents - Short term Security Investment + Non-Controlling Interest

Market capitalization = Spot price times shares outstanding (i.e., issued shares – treasury stock))

The use of enterprise value reflects the cost of acquiring the business as opposed a share in the business.  The following enterprise value ratios are then computed:

Gross Margin to Enterprise Value  = Gross Margin / Enterprise Value

Earnings Before Interest and Taxes (EBIT) to Enterprise Value = EBIT / Enterprise Value

Net Operating Profit after Tax (NOPAT) to Enterprise Value = NOPAT / Enterprise Value

The use of EBIT to Enterprise value estimates the pretax operating income relative to the cost of acquiring the business.  This provides a strong performance metric for evaluating return from acquiring a business.

Price to Book Ratio

Price/Book Ratio is a measure of the  number of years to recover the stock price with zero growth in book value per share.  The book value per share is a measure of the capital that shareholders have invested in the company.  It is defined as:

Price to Book = Stock price divided by Shareholders’ equity per share
Book to Price or Book to Market = Shareholders’ equity per share divided by stock price

The book to market ratio was popularized in Fama and French’s 3-factor model designed to describe stock returns from the observed history of realized returns from US publicly listed stocks.  Empirically this model was demonstrated to perform better than the popular Capital Asset Pricing Model (CAPM) for explaining realized return behavior.

In academic studies stocks with a high book-to-market ratio have been customarily referred to as value stocks as opposed to growth stocks.  That is growth stocks are judged to be stocks with a low book to market (i.e., high price to book ratio) because for these stocks investors expect management to create more value from the set of resources under their control.  A growth stock can also arise from accounting measurement issues because human capital is not measured in the balance sheet.  As a result, a stock like IBM will have a low book to market because human talent is an important driver of returns for IBM.  However, over a large sample of stocks value stocks have traditionally generated higher realized returns than growth stocks and in the Fama and French model this is argued to be a risk premium.

Price to Cash Ratios

Price/Cash Flow Ratio is a measure of the number of years to recover the stock price with zero growth in the cash generated per share.  One of the main ideas behind the price to cash flow ratios is the assumption that cash flows are more persistent and less open to manipulation than are accrual based income measures.  In the Earnings’ Quality cash flow statement calculator accrual income was compared to cash flows from operating and investing activities.  In the price to cash flow ratios these ideas are extended by providing a comparison with P/E ratios.

There are three major price to cash flow ratios which are defined as follows:

Price/Cash Flows from Operations per share = Price / (Cash Flow from Operations / (Issued Shares less Treasury Stock))

Price/Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) per share = Price / (EBITDA / (Issued Shares less Treasury Stock))

Price/Free Cash Flow (FCFF) per share = Price / ((Cash Flow from Operating Activities less Capital Expenditure plus after tax net interest expense)/ (Issued Shares less Treasury Stock)).

The first cash flow measure comes from the Accounting Cash Flow Statement.  Cash flow from operations (CFO) is the cash the company generates from sales revenue excluding costs associated with long term investments and non-current assets.  In the indirect form of the cash flow statement it is measured by starting with Net Income and then adjusting for Depreciation, Amortization, Deferred Taxes, Changes in Working Capital and items related to Net Income that have cash implications but not accounting income implications.

EBITDA is a proxy for Cash Flows from Operations.  It adds back the two major non cash expenses to Earnings Before Interest and Taxes.  The major difference between CFO and EBITDA is how the firm chooses to finance their net working capital.  For example, it could be a source of funds, which may imply that the firm is managing short term working capital to generate cash.  This could range from delaying paying their creditors, collecting their accounts receivable more quickly, or turning over inventory more efficiently.   The reverse of these types of scenarios would in turn imply that the short run change in working capital uses cash.

Finally, free cash flow is defined as cash flow from operations minus capital expenditure (expenditure on productive capacity which usually involves non-current assets) adjusted for US GAAP which treats interest expense as part of operations.  Again the difference between Cash Flows from Operations and Free Cash Flow arises from the firm’s investment decision in terms of how it impacts capital expenditure.

Each of these measures provides insight into how the market is assessing the growth in cash flows for the same reasons as discussed in the P/E section.