Valuation based on

comparable firms
PE , PB and PS

source: Various web sources

PE ratio

• Value investors and non-value investors alike have

long considered the price earnings ratio.

• A useful metric for evaluating the relative

attractiveness of a company's stock price compared
to the current earnings of a firm.

source: Various web sources

 Intuition behind PE ratio

• Buying the rights to the firm’s future earnings

• Be willing to pay proportionally more for a stock
with higher current earnings

source: Various web sources

 The P/E Ratio - What It Is and Why
Investors Care

• The P/E ratio is the price an investor is paying for INR 1

of a company's earnings or profit.

• In other words, if a company is reporting basic or

diluted earnings per share of INR 2 and the stock is
selling for INR 20 per share, the P/E ratio is 10 (INR 20
per share divided by INR 2 earnings per share = 10 P/E).

• Conservatism- always prefer the diluted earnings per

share when calculating the P/E ratio
source: Various web sources
 Industry and sector PE
Different industries have different P/E ratio ranges that are
considered "normal".

For example, IT companies may sell at an average P/E ratio

of 29.15

https://www.moneycontrol.com/stocks/marketinfo/pe/nse
/homebody.php?indcode=24&sortcode=0

source: Various web sources

 Industry and sector PE
Real Estate average P/E ratio of 90.80.

https://www.moneycontrol.com/stocks/marketinfo/pe/n
se/homebody.php?indcode=29&sortcode=0

There are exceptions, all things considered, these

variances between sectors and industries are perfectly
acceptable.
https://www.nseindia.com/products/content/equities/in
dices/historical_pepb.htm

source: Various web sources

 Variations of the PE ratio
Stocks with low PE ratio are perceived as having cheaper
current price, hence expected to generate higher return in
the subsequent period.
There are two variations of the PE ratio

The Trailing PE ratio uses the earnings of the last 12

months, while the Forward PE uses the expected earnings
for the next 12 months.

The Forward PE requires estimating the forward earnings

and hence, is prone to estimation errors.
•

source: Various web sources

 How to Sense When an Industry Is
Overpriced

• One potential way to know when a sector or industry is

overpriced is when the average P/E ratio of all of the
companies in that sector or industry climb far above the
historical average.

source: Various web sources

Case let
Company ABC may have reported earnings of INR 10 per
share, while company XYZ has reported earnings of INR 20
per share. Each is selling on the stock market for INR 50.
What does this mean?
• Company ABC has a P/E ratio of 5, while Company XYZ
has a P/E ratio of 2.5.
• This means company XYZ is much cheaper on a relative
basis. For every share purchased, the investor is getting
INR 20 of earnings as opposed to INR 10 in earnings from
ABC.
• All else being equal, an intelligent investor should opt to
purchase shares of XYZ.
• For the exact same price, INR 50, he is getting twice the
earning power.
source: Various web sources
 Can estimate the value of a startup’s
share
Its current earnings per share * the average PE ratio of
comparable firms

• Your startup is in IT industry

• The average PE ratio of IT companies is 29.5 ~ 30
• Your startup’s earnings per share is INR 1
• A share of your startup = INR 30 per share

PE ratio * EPS
30* 1 = 30
source: Various web sources
Case let
• Your startup is in IT industry
• The average PE ratio of IT companies is ~ 30
• Startup’s total earnings are INR 100,000
• The value of your startup = INR 3 million

PE ratio * EPS
30 * INR 100000 = INR 3,000,000

source: Various web sources

 Case let
• Inverse of PE ratio = Earnings / stock price
• That is return on investment (ROI)
Earnings INR 1
Stock price is INR 10
ROI is 10%

PE ratio of 10 = ROI is 10%

PE ratio of 20 = ROI is 5%

source: Various web sources

Case let
• VRL Logistics has earnings per share of INR 9.19
• Average PE of comparable Logistics stock is 43.8
• Estimate a value for VRL by using PE ratio

Share Price = EPS * PE of Comparable firms

9.19* 43.8 = 402.52

source: Various web sources

 The Limitations of the P/E Ratio
• Just because a stock is cheap doesn't mean you
should buy it. Many investors prefer the PEG Ratio,
instead, because it factors in the growth rate.

• Even better is the dividend-adjusted PEG

ratio because it takes the basic price-to-earnings
ratio and adjusts it for both the growth rate and the
dividend yield of the stock.

source: Various web sources

 The Limitations of the P/E Ratio
If you are tempted to buy a stock because the PE ratio
appears attractive, do your research and discover the
reasons.

• Is management honest?
• Is the business losing key customers?
• Is the weakness in the stock price or underlying financial
performance a result of forces across the entire sector,
industry, or economy, or is it caused by firm-specific bad
news?
• Is the company going into a permanent state of decline?
source: Various web sources
 The Limitations of the P/E Ratio

• When earnings are negative, not useful

• Usually, earnings are negative for most of startups

• Need to learn alternative multiples

source: Various web sources

 Other Multiples for Company
Valuation

Most often used multiples

• PB ratio

• PS ratio

source: Various web sources

Application
• Some companies (startups) may have negative
earnings

• Cannot apply PE ratio

• Using PB ratio or PS ratio

source: Various web sources

PB ratio

• Ratio of stock price per share to book value per share

• Book value per share : BPS

• BPS = Book value of equity / number of shares

outstanding

• PB ratio = Stock Price/ BPS

source: Various web sources

PB ratio
• For example, a stock with a PBV ratio of 2 means
that we pay Rs 2 for every Rs. 1 of book value. The
higher the PBV, the more expensive the stock.

• Most companies have a PBV greater than one. This

means that its market value is higher than its book
value. Why is this the case?

• There are two reasons:

source: Various web sources

 PB ratio

• First, investors will pay a premium above the book value if

the company is expected to generate enough earnings in
the future.

• These earnings justify a market value above the book

value.

source: Various web sources

PB ratio
• Second, the book value of the firm may not be up to date.
• For example, the value of an asset on a company's
balance sheet often reflects what the firm paid for the
asset.
• This is not necessarily what the asset is currently worth.
• The best example of this is property, which typically
increases in value over time.
• In this case, the true book value is higher than what the
financial statements imply.

source: Various web sources

PB ratio

• The PBV ratio is more useful for firms that hold assets of
tangible value.
•
• Manufacturing firms are a good example. They hold
property, machinery, plants, etc.

• For firms with few tangible assets, the book value is less
relevant. For example, companies that consists solely of
employees, computers, and office space, don't have a
meaningful book value.

source: Various web sources

Case let
PB ratio is useful with tangible assets

Average PB ratio of airline industry is 3

Book value per share is 10

Estimated value of equity is INR 30 per share

=PB ratio * Book Value per share

3* INR 10 = INR 30
source: Various web sources
Contd..
Average PB ratio of airline industry is 3
Book value per share is 10

If Indigo’s book value of equity INR 1 billion

The company is worth INR 3 billion

= PB ratio * Book value of equity

3* INR 1 billion
= INR 3 billion

source: Various web sources

 PS ratio

Price to sales ratio

PS ratio = Share Price / Sales per Share

Sales per share = Sales / no. of. Shares outstanding

source: Various web sources

 PS ratio
• Price to sales ratio (PSR ratio) indicates how
much investor paid for a share compared to
the sales a company generated per share.
• It measures the value placed on sales by the market.
• A higher ratio means that the market is willing to pay for
each Rupee of annual sales.
• In general, the lower the P/S, the better the value is.
• However, the value of the ratio varies across industries.
• A better benchmark is to compare with industry average.

source: Various web sources

 PS ratio
• Price to sales ratio values a stock relative to its historical
performance, market competitors or general market.

• In general, a low price to sales ratio means a

good investment because investors are paying less for
each unit of sales.

• However, price to sales sometimes provide very limited

information because it does not take into account any
expenses or debt and a company with high sales maybe
unprofitable.
source: Various web sources
 Why PS ratio is important?

• Most valuation metrics use earnings to analyze a

company’s fundamentals.

• The widely used PE ratio uses EPS, whereas the

advanced EV/EBITDA ratio uses operational earnings.

• However, earnings can be arithmetically boosted or

suppressed by changing accounting policies.

source: Various web sources

 Why PS ratio is important?

• Arbitrarily increasing the life span of an asset or a mere

change in the depreciation calculation method can alter
earnings and profits.
• In addition, methods such as deferring expenditure or
capitalisation of expenditure can help manipulate earnings or
profits.
• To avoid such anomalies, Kenneth L Fisher, a noted stock
market guru, developed a concept called price to sales ratio,
or PSR, which uses sales as a primary parameter to evaluate a
company.

source: Various web sources

 Why PS ratio is important?
• According to Fisher, investors raise expectations to unrealistic levels
for companies that have periods of strong early growth.

• When the earnings of such companies drop or they fail to live up to

investors’ lofty expectations, the stock prices fall as investors
overreact and sell.

• He believed that good companies with strong managements have

the ability to identify the problems, solve them and move forward.

• As they do, the stock prices and earnings begin to rise again.

source: Various web sources

 Why PS ratio is important?

• Based on this concept, he devised the price to sales

approach.

• While earnings fluctuate, Fisher found that sales are far

more stable.

• The sales of good companies remain more or less

constant over a period of time, are relatively difficult to
manipulate, and are less prone to accounting gimmicks.

source: Various web sources

 PS ratio suitability
The PSR is ideal for valuing companies in the investment phase and is
widely used to assess the value of cyclical stocks.

The ratio shows the number of years in which a company’s sales

equals its market capitalisation.

If the PSR of a company is 2, it implies that it will take two years for the
company’s sales to reach its market capitalisation.

The ratio can also be interpreted as the money that investors are
willing to pay for every rupee of sales generated by the company.

source: Various web sources

 PS Ratio - Shortcomings

It varies widely across industries, which makes it difficult to

compare companies in various sectors.

Besides, it does not distinguish between a leveraged and an

unleveraged company.

A firm may have a low PSR, but could be on the verge of

bankruptcy due to the high interest costs.

Another drawback is that the ratio does not give any idea about
the company’s profitability and cost structure.
source: Various web sources
 Case let
• Average PS ratio of IT industry is 1.5
• Sales per share is INR 20

Estimated value of equity is INR 30 per share

= PS ratio X sales per share
= 1.5* INR 20 = INR 30

source: Various web sources

Contd..
• Average PS ratio of IT industry is 1.5
• Sales per share = INR 20
• If your company’s sales is INR 2 million

The company is worth INR 3 million

= PS ratio * Sales per share
= 1.5 * INR 2 million
= INR 3 million

source: Various web sources

 Limitations of multiple method
• Since comparable firms are not identical
• Multiples would not match precisely
• The differences are due to
• Expected future growth rates
• Profitability
• Risk
• Cost of capital
• Accounting conventions

source: Various web sources