We have already discussed the P/E and P/B multiples in detail. Let’s briefly recall what we discussed in previous issues of the magazine:
- P/E = Price/EPS, or P/E = Company Market Cap/Net Income. P/E indicates the number of net incomes a company needs to recover the business value. In simpler terms, it is the number of years required to recoup an investment in a business.
- The P/E of growth companies (companies with revenue growth exceeding 10-15% per year) can be quite high. The P/E of value companies (with low revenue growth and dividend payments) can be low.
- Avoid buying shares of a company whose P/E significantly exceeds the industry average.
- When choosing between companies in the same industry, it is better to buy shares of the company with the lower P/E (VERY IMPORTANT! under equal conditions).
- You can invert the P/E ratio and calculate the inverse E/P, which gives the percentage of investment returns you receive as net income.
- P/B = Price/Book (Shareholders’ Equity).
- The ideal situation is when market cap equals shareholders’ equity, i.e., P=B or P/B=1. This means that the market fairly values the company’s worth.
- Avoid buying shares of a company whose P/B significantly exceeds the industry average.
- This point was not discussed, but it should be noted separately that the P/B ratio is more suitable for companies with significant tangible assets (e.g., industrial companies). P/E, on the other hand, is universal and can be applied to any company.
Benjamin Graham and Peter Lynch Methods
Now let’s talk about how Benjamin Graham and Peter Lynch suggested using the P/E and P/B ratios.
Benjamin Graham proposed the following selection criteria for stocks: the P/E of the company, calculated based on its average earnings over the last three years, should not exceed 15, and the P/B should not exceed 1.5. This is a rather strict criterion, considering the prolonged bull market we have observed in recent years.
Peter Lynch suggested the following approach: the P/E of a stock that can be bought should not exceed the expected growth rate. For example, if the profit growth for the year is 10%, then the P/E should not be higher than 10 (preferably lower).
Let’s take a specific example. Consider Lockheed Martin shares. The average P/E over the last three years is 22.15; the P/B is 47.86. Therefore, according to Graham’s criteria, the company’s shares are not suitable for investment.
The revenue growth for the last period was 11.2%; the latest P/E is 14.84. Therefore, according to Lynch’s criteria, the company’s shares are suitable for investment.
P/S Ratio
Now let’s discuss the relatively simple multiple “Price/Sales (P/S)” and how it can be used to compare companies. To understand how the P/S ratio works, we first need to define the concept of revenue.
After that, everything is quite simple: once we look at the company’s revenue in the report, we need to divide the market capitalization (number of shares * price) by the revenue amount, and we get the P/S ratio.
Let’s return to our example:
Company A has 1,000 shares, and Company B has 1,500 shares. During the past reporting period (1 year), Company A earned 1.5 million rubles in net profit (revenue is 3 million), and Company B earned 2 million rubles (revenue is 4 million).
The share price of Company A is 3,000 rubles, and that of Company B is 1,000 rubles. Then:
- P/S of Company A = (1000*3000)/3,000,000 = 1
- P/S of Company B = (1500*1000)/4,000,000 = 0.375
Thus, P/S of Company B < P/S of Company A, which means that Company B’s shares are undervalued compared to Company A’s. More generally, this rule reads as follows: choose companies with a P/S lower than the industry average P/S.
The conclusion is: if a company has a P/S lower than the industry average, but its net profit margin (net profit to revenue ratio) is not lower than the industry average, the company is undervalued and its shares can be purchased.
Which criteria to use is certainly up to the investor. My opinion is that one should never focus on just one rule, but try to assess the entire picture.
FAQ
What is the P/E ratio?
The P/E ratio measures a company’s stock price relative to its earnings, indicating how much investors are willing to pay per unit of earnings.
How is the P/S ratio calculated?
The P/S ratio is calculated by dividing a company’s market capitalization by its total revenue, helping to compare companies within the same industry.
Why is the P/B ratio important?
The P/B ratio compares a company’s market value to its book value, providing insight into whether a stock is overvalued or undervalued relative to its assets.
