Question

John Jones, CFA, is head of the research department at Peninsular Research. Peninsular has a client who has inquired about the valuation method best suited for comparing companies in an industry with the following characteristics:
• Principal competitors within the industry are located in the United States, France, Japan, and Brazil.

• The industry is currently operating at a cyclical low, with many companies reporting losses. Jones recommends that the client consider the following valuation ratios:

1. P/E.

2. P/B.

3. EV/S.

Determine which one of the three valuation ratios is most appropriate for comparing companies in this industry. Support your answer with one reason that makes that ratio superior to either of the other two ratios in this case.

Answer 1

The

P/E ratio is the price of stock vs its earnings

P/B ratio is the ratio of price vs the book value of stock

Both these ratios are used to compare the price with either earnings or the book value to understand if the stock is undervalued or overvalued w.r.t the denominator. Generally lower P/E or P/B ratios indicate that the stock is not running at low price and thus undervalued. This makes then a good buy for now.

EV/S is the ratio of enterprise value to its Sales ratio. Enterprise value is net value of the firm obtained after adding the market capitalization and Debt and deducing cash from the sum. Thus

EV/S = (MV+D-C)/S

Where MV= Market Value

D= Debt

C= Cash or cash equivalents

S= Sales

EV/S as a metric gives an idea of how much it takes to purchase a company's sales. Thus lower EV/S is a signal that the stock is now undervalued w.r.t its sales and thus a good buy.

In this scenario, we are comparing firms in the same industry. Also all firms are experiencing a cyclical low. When we are comparing the companies in same sector, the earnings potential of all will be similar. Thus P/E ratio makes the best ratio to compare their prices and understand their relative performance. The problem with P/B ratio is that the book values of firms do not reflect their current situation to be a good indicator to compare them. P/B ratio is generally used by Banks for valuation purposes.

EV/S also is not the best indicator to compare their relative performance and can be used more for analyzing any company in solo and less for comparison the relative performance

Thus P/E is the best option to use in this case.