How can price multiples such as P/E, P/S, or P/B used to forecast future stock prices?...

How can price multiples such as P/E, P/S, or P/B used to forecast future stock prices? Keep in mind no ratio is evaluated in isolation.

Expert Solution

P/E ratio are used to forecast the share prices by comparing the stock P/E to the overall Industry P/E. This ratio is reflection of how much price, value investors are willing to pay to per unit earning of the company .A high P/E is a signal that company is expensive but it can also mean that investors are still willing to pay a high amount of premium to the company If the company is projected to maintain a high price to earning ratio, it can mean that the company is expected to continue commanding a premium to it's peers

Price to sales ratio is the ratio of overall maket capital of a compoany in relation to it's turnover.Price to sales (P/S) ratios between one and two are generally considered good, while a P/S ratio of less than one is considered excellent.P/S ratios can vary significantly between industries. An investor always wants to buy a business with lower price to sales as it will leave with a room with earning more returns.

The price to book ratio measures a company's market price in relation to its book value. It is a reflection of how much the equity investors are willing to pay for the assets of the company. A higher price to book value is an indication that investor are willing to pay higher and it is expensive.

Now putting all three ratio under one roof, If we have to evaluate a company and if we think from the perspective of an investor, A lower price to earning ratio in relation with the industry is preferred as it will leave with a scope of making a higher rate of return as the investor is buying cheap.

A lower price to sales ratio is also preferred as it will also leave with a scope of paying lesser in the near term and riding once the stock grow it's revenues.

A lower Price to book ratio is also preferred by value investors as it will also leave a high scope of earning higher returns once the relative valuation to the industry kicks in.

jeff jeffy answered 2 years ago

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