PE Ratio and the Basic Science of Stock Valuation

Ratio analysis is a commonly used method of stock valuation. Among the most popular ratios are the PE, EV-to-EBITDA (enterprise value-to-EBITDA), and price-to-sales ratios. Most investors tend to look at the PE ratio, and it’s the most followed metric in stock valuation.

However, the PE ratio isn’t necessarily suitable for every company and industry. A company’s having a low or high valuation multiple also doesn’t necessarily reflect undervaluation or overvaluation.

Let’s examine some of the most followed valuation metrics using real-life examples.

PE ratio

Valuing stocks is both an art and a science. Speaking to the science part of the equation, we have several ratios: PE, EV-to-EBITDA, and price-to-book value, to name a few. Using these ratios, we can analyze whether a particular stock is undervalued or overvalued.

We have to be careful about which ratio to use for a particular stock as well as our interpretation of the results. For example, a high PE ratio doesn’t necessarily make a stock overvalued. However, it’s fair to argue that these valuation multiples are a good starting point.

In terms of stock valuation, there are plenty of approaches. Read Stock Valuation: Using Fundamental Analysis in Equities to learn more about the basics. Here, we’ll mainly focus on ratio analysis.

Which ratio to use

Typically, investors look at a stock’s PE ratio when considering its valuation. In simple terms, the PE ratio is a company’s stock price divided by its EPS. We can also say that a PE ratio tells us how much money investors are willing to pay for a company for every dollar of its earnings.

In considering PE, we can look at a company’s trailing PE ratio or its forward PE ratio. However, since the markets are forward-looking, it’s almost always better to look at forward PE. Generally, analysts look at the numbers for the next 12 months.

Pitfalls with PE ratio

One of the biggest pitfalls of the PE ratio is that we can’t value a company that’s currently making losses. Tesla (TSLA) is a perfect example. The company hasn’t posted an annual profit in its history, but it still has a higher market cap than Ford (F) and General Motors (GM). Also, for companies in capital-intensive industries, financial leverage can affect PE. Another thing to consider is that the PE ratio doesn’t account for a company’s growth rate. Here, the PEG (PE-to-growth) ratio can come to our rescue.

PEG ratio

The PEG ratio standardizes the PE ratio for growth. Generally, high-growth companies have higher PE ratios, while markets give lower multiples to companies that are growing more slowly. The general rule of thumb is that a PEG ratio of less than one shows undervaluation. However, like other rules of thumb, it has its limitations. Read Must-Know: What Is PEG Ratio and How Is It Used? for more analysis.

EV-to-EBITDA versus PE ratio

The EV-to-EBITDA ratio is preferable for capital-intensive industries such as the metals and mining industry. On that note, it’s worth noting that EBITDA is a non-GAAP (generally accepted accounting principles) measure. Some companies also report an adjusted EBITDA number.

Berkshire Hathaway (BRK.B) Chair Warren Buffett isn’t a big fan of EBITDA. However, in some asset-heavy and cyclical industries, it’s generally better to look at the EV-to-EBITDA ratio. Since industrial companies have high operating and financial leverage, their net income might be very volatile, which would affect their PE ratio. In theory, the EV-to-EBITDA ratio is capital-structure neutral. This basically means that it’s not influenced by a company’s debt levels.

Price-to-sales ratio

Just like a net loss makes it impossible to use the PE ratio, there are some companies (mostly in their early phases) that are even making losses on the EBITDA level. For these companies, it’s prudent to consider the price-to-sales ratio.

A good example here would be the cannabis sector. Most cannabis companies are currently seeing losses. However, they’re reporting strong top line growth. For companies such as these ones, it’s better to look at the price-to-sales ratio.

Cannabis sector

Let’s look at an example. Analysts expect Aurora Cannabis (ACB) to post negative EBITDA in 2019 and 2020. One approach could be to look at the company’s 2021 EV-to-EBITDA ratio. However, another approach could be to look at its price-to-sales or EV-to-sales ratio. ACB is valued at a 2020 price-to-sales ratio of 7.2x. Aphria (APHA) has a 2020 price-to-sales ratio of 2.2x. It’s prudent not to come to the simplistic conclusion that a lower price-to-sales ratio indicates undervaluation. The analogy holds true for all other ratios as well.

Clinical-stage medical companies

Meanwhile, some companies, especially clinical-stage medical companies, might not even report any revenue, making even the price-to-sales ratio redundant—let alone PE or EV-to-EBITDA. For instance, Zynerba Pharmaceuticals (ZYNE) is expected to post meaningful revenue only in 2021. For these companies, the investment decision is based on the probability of success of the product. Not surprisingly, such companies are very volatile amid news related to product trials.

Price-to-book ratio

We could also consider the price-to-book ratio. However, in practice, we use it mainly for banking stocks. Banks have to frequently mark their assets to market, which gives this metric credibility. In other industries, the norm is to report assets at their book values unless there is an impairment. Furthermore, the price-to-book ratio makes little sense for companies in the technology space, as they have few tangible assets in their books. Read A Look at the Top Five US Banks’ Valuations for more insights.

Look beyond PE—but be prudent

We can use several multiples other than the PE ratio to value stocks. However, it’s never advisable to arrive at a simplistic conclusion based on one valuation metric. It’s always better to drill deeper via time-series and cross-sectional analyses. It’s also best to look beyond typical one-year forward multiples.

The art of valuation lies in predicting what the markets are pricing in and what they might be ignoring. A stock may have a low or high valuation multiple for some fundamental reason. This concept requires a detailed analysis in itself, and we’ll explore it in a future story.