Leading P/E (also called the forward P/E, or prospective P/E) is a stock's current price divided by next year's expected earnings.
For companies with rising earnings, the leading P/E will be smaller than the trailing P/E.
When calculating trailing P/E, an analyst must consider the following:
1. transitory, nonrecurring components of earnings that are company specific;
2. transitory components of earnings due to cyclicality (business or industry cyclicality);
3. differences in accounting methods;
4. potential dilution of EPS.
Nonrecurring items (such as gains and losses form the sale of assets, asset writedowns, provisions for future losses, and change in accounting estimates) often appear in the income from continuing operations portion of the Income Statement. An analyst should pay particular attention to the Income Statement, its footnotes, and management discussion and analysis.
Two of several methods to calculate Business-cycle-adjusted EPS:
1. historical average EPS: the average EPS over the most recent full cycle. However, this method doesn't account for changes in the company's size.
2. average return on equity: the average return on equity (ROE) from the most recent full cycle, multiplied by current book value per share. This method reflects more accurately the effect on EPS of growth or shrinkage in the company's size.
Basic earnings per share reflects total earnings divided by the weighted-average number of shares actually outstanding during the period.
Diluted earnings per share is the division by the number of shares that would be outstanding if holders of securities such as executive stock options, equity warrants, and convertible bonds exercised their options.
Among the positive P/Es, the stock with the lowest P/E has the lowest purchase cost per currency unit of earnings. In order to include negative P/Es in the ranking, we could use earnings yield ratio (E/P).
Price to Book Value
Rationales for using P/BV:
1. Book value is a cumulative balance sheet amount, book value is generally positive even when EPS is negative.
2. Book value per share is more stable than EPS, P/BV maybe more meaningful than P/E when EPS is abnormally high or low, or is highly variable.
3. Book value per share has been viewed as more appropriate for valuing companies composed chiefly of liquid assets, such as finance, investment, insurance, and banking institutions.
4. Book value has also been used in valuation of companies that are not expected to continue as a going concern.
5. Differences in P/BVs may be related to differences in long-term average returns.
Possible drawbacks of P/BVs:
1. Other assets besides those recognized in accounting may be critical operating factors, such as human capital.
2. P/B can be misleading as a valuation indicator when significant differences exist among companies examined in terms of the level of assets used. Such differences may reflect differences in business models.
3. Accounting effects on book value may compromise book value as a measure of shareholders' investment in the company.
4. In the accounting of most countries, including the US, book value largely reflects the historical purchase costs of assets, as well as accumulated accounting depreciation expense. Inflation as well as technological change eventually drive a wedge between the book value and the market value of assets. As a result, book value per share often poorly reflects the value of shareholders' investments.
Calculation:
common shareholders' equity = shareholders' equity - total value of equity claims that are senior to common stock
book value per share = common shareholders' equity / # of common shares outstanding
Example:
Given the following information, compute price/book value.
- Book value of assets = $550,000
- Total sales = $200,000
- Net income = $20,000
- Dividend payout ratio = 30%
- Operating cash flow = $40,000
- Price per share = $100
- Shares outstanding = 1000
- Book value of liabilities = $500,000
Book value of equity = $550,000 - $500,000 = $50,000 Market value of equity = ($100)(1000) = $100,000
Price/Book = $100,000/$50,000 = 2.0X
Price/Book = $100,000/$50,000 = 2.0X
Calculating tangible book value per share involves subtracting intangible assets from common shareholders' equity. It is not so appropriate to separate patents, but might be appropriate to subtract goodwill.
P/S:
Rationales for using P/S:
1. Sales are generally less subject to distortion or manipulation.
2. Sales are positive even when EPS is negative.
3. Sales are generally more stable than EPS. P/S may be more meaningful than P/E when EPS is abnormally high/low.
4. P/S has been viewed as appropriate for valuing the stock of mature, cyclical, and zero-income companies.
5. Differences in P/S may be related to differences in long-term average returns.
Drawbacks:
1. A business may show high growth in sales even when it is not operating profitably.
2. P/S doesn't reflect a company's expenses, differences in P/S may be explained by differences in cost structure.
3. Revenue recognition practices offer the potential to distort P/S.
Bill-and-Hold involves selling products but not delivering those products until a later date.
P/CF:
Rationales for using P/CF:
1. Cash Flow is less subject to manipulation than earnings.
2. Cash flow is generally more stable than earnings.
3. Using P/CF rather than P/E address the issue of differences in accounting conservatism between companies (differences in the quality of earnings).
4. Differences in P/CF may be related to differences in long-term average returns.
Drawbacks:
1. When the EPS plus noncash charges approximation to cash flow from operations is used, items affecting actual cash flow from operations, such as noncash revenue and net changes in working capital, are ignored.
2. Theory views free cash flow to equity rather than cash flow as the appropriate variable for valuation. FCFE does have the possible drawback of being more volatile.
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