It can be difficult for novice investors to make sense of the many companies listed on the stock exchange. To be successful in the stock market, one needs to pick the right stocks. And this is where valuation multiples come in. They allow an investor to compare the investment potential of companies in a similar line of business but different in size.

With the help of such multiples, investors can determine whether a company's stock is undervalued or overvalued so that they can pick the most profitable investment opportunities.

Using multiples

First, you should select several companies in the same industry group that are most appealing for investment purposes and then calculate their multiples. To do that, you will need information from the company’s financial statements, usually published on its official website.  You can also find multiples that have been already calculated on various aggregator websites. Then you can make a comparative analysis and choose the best option.

Revenue multiples

P/E = Share Price/Earnings per Share

The Price-to-earnings (P/E) multiple is the most widely used metric that reflects the ratio of the share price to earnings per share. It gives an idea of how overvalued or undervalued a company’s securities are. This multiple shows how long it will take the company to recoup the share price if its earnings stayed constant. It also makes it possible to compare various companies.  The lower the P/E value, the more attractive the company's stock is for investors.

If P/E is between 0 and 5, the company is regarded as undervalued. When the indicator is below 0, it indicates that the issuer is unprofitable. A P/E ratio under 20 is considered optimal.

The P/E multiple cannot be used if the company is unprofitable.

P/S = Price/Sales

The Price-to-Sales (P/S) multiple reflects the ratio of a company's market capitalization (value) to its annual sales (revenue). This ratio basically shows the company’s value as compared to its annual revenue. Even if a company shows losses at year-end, this multiple makes its valuation possible. It is less prone to fluctuations because revenue is a more stable metric than net earnings. This ratio helps to see how much demand there is for the issuer’s products or services.

 The metric is valid only when it is above 0. P/S less than 2 is considered normal. 

EV/EBITDA Ratio

This multiple is an alternative to the popular P/E ratio. Its focus is on the enterprise value as a whole. Debt and equity are its two main components. To calculate this ratio the following formula is used: EV/EBITDA = Enterprise Value/EBITDA

This formula also makes it possible to compare companies that use different methods of capital investments.

Balance sheet multiples

P/BV = Price/Book Value (Net Assets)

Price-to-Book-Value (P/BV) Ratio reflects the current market value of the issuer’s shares to its book value.

The multiple can be calculated as follows: the company’s market capitalization is divided by its net assets.

This metric gives us an idea of what will remain for an investor if the issuer goes bankrupt.

This multiple provides a comparative analysis of issuers that own something tangible (equipment, buildings, etc.) and it is not very suitable for comparing IT companies since they have very few tangible assets.  You should pay attention to this indicator if you want to invest in bonds. Its value should be less than 1 but greater than 0. 

Profitability multiples

ROE = Net Income/Shareholder’s Equity * 100%

Return on Equity (ROE) is a ratio that shows how efficiently the company is managing its capital, in other words – the company’s profitability. The indicator is expressed as a percentage.

It can be calculated as follows: a company’s annual return is divided by shareholder’s equity and multiplied by 100%.

Obviously, the higher the metric (ROE), the more attractive the issuer's stock is for investors. 

ROA = Net Income/Company’s Assets * 100%

Return on Assets (ROA) is an indicator that reflects the profit an issuer is able to generate from its assets.

It can be calculated as follows: the company’s net income is divided by the company’s assets and multiplied by 100%.

This is the main indicator that shows the company’s efficiency. It shows what profit was made by all assets of the company (both owned and borrowed capital).

The higher this indicator is, the more attractive the investment opportunity is for market participants.

 

Key takeaways

  1. Multiples are financial ratios that help compare the fundamentals of a business as well as its performance and find undervalued investment opportunities.
  2. You should compare multiples to the average values in the relevant sector of the economy.
  3. P/E, P/S, EV/EBITDA ratios show if the stock price is fair.
  4. If you want to know the stock’s book value, look at the P/BV multiple.
  5. ROE and ROA show how the company’s own resources are used.

 Multiples can make it easier for investors to find attractive assets. However, there is no single formula that determines if a business is a good investment opportunity or not. Each ratio can provide an assessment for certain individual aspects of a company’s performance but may not for the issuer as a whole. Therefore, investment decisions should be based on a multifaceted approach that compares several ratios, rather than a single metric. This is an important law to follow for a fundamental investor.