Secrets about P/E and other multiples

I will address the easies valuation – relative valuation.


As discussed earlier on my blog, relative valuation doesn’t get into fundamental analysis, although you will be surprised that indirectly it is driven by the same fundamentals (explained later)

Various multiples used in market are-

1. p/e

2. EV/EBITDA

3. p/bv

4. p/sales

5. EV/EBIT

6. You can of-course make up your own.



Sanity check for any multiple:

Always ensure that any multiple you are dealing with is consistent. What I mean is whatever is in numerator is consistent with denominator. For example in P/E, numerator is price which is at equity level and denominator is EPS which is also at equity level. In EV/EBITDA, numerator is enterprise value which is at firm level and denominator is EBITDA, which is also at firm level. If you come up with a multiple in which numerator and denominator violates this principle, the multiple is no good. I am sure you should be able to identify the flaw to Price/EBIT multiple is someone throws at you.Try running these checks across other multiples and see if it passes.

In essence, either both numerator and denominator has to be at firm level(see my blog for further details) or at equity level.

Lots of people asked me what is Enterprise value, so not deviating into those details, I would suggest you refer to my blog for the explanation of Enterprise value and what drives it.

Price/Earnings

Sanity check: Both the numerator and denominator are at equity level so it passes our sanity check.

Numerator is price which can either be substituted by marketcap(in that case denominator will be Net income) or the stock price(denominator will be Earnings per share)

Now is EPS/Net Income for last 12 months(a.k.a ttm) or it’s a projection by analysts for next year(FY+1) or FY+2. This result in different versions of P/E – trailing P/E or forward P/E. Trailing P/E is where EPS/Net income is for last 12 months and Forward P/E is where EPS is for FY+1 or FY+2. So when some analyst says the stock is trading at 10x its 2011 earnings he/she is talking for forward P/E multiple of FY+2.

So which one is preferable : TTM P/E or forward. As long as you are comparing two stock on similar multiple, meaning either comparing both on TTM or forward, it doesn’t matter which multiple to use. They both will give you same results.

I am sure you will be anxious to see how to calculate P/E.

Lets do this exercise for Infosys and Wipro. All data I use is from in.reuters.com because I hate those pop up ads whenever I go to moneycontrol and others.

(Source: in.reuters.com)

We will be calculating forward P/E (see above what forward means)

Infosys

Price =2317

Estimated next year earning (go to estimates and look for mean EPS for 2010) =101.56

P/E=22.8

Now there are several issues like accounting for cash and other extra-ordinary items that I will address later.

Wipro

Lets do same exercise for wipro.

Price=554

EPS for 2010 mean=27.49

P/E=20.15

Ok so now we see wipro is trading at a lower multiple than Infosys. What would you intuitively think if some one tells you this. Wipro is cheap?

Think about it and I will return back with further insights and answer next week.