Types of Valuation Indicators

A price multiple is a ratio of a stock's price to a measure of value per share such as earnings, assets, sales or cash flows. To tie up a company's performance with its market valuation, an analyst needs to evaluate what a dollar of share price can "buy" in terms of the company's earnings, sales, cash flow or assets. For example, an analyst can estimate that each dollar invested in the company generates $1.5 of sales. Using this information, the analyst can evaluate the attractiveness of investing in the company's stock at the current market price per share.

An enterprise value multiple is also a ratio used to determine the value of a company. It relates the enterprise value of a company to a measure of value (e.g., EBITDA).

Momentum indicators relate either price or a fundamental (such as earnings) to the time series of their own past values, or in some cases to their expected value.

All price multiples can be applied to equity valuation in two different ways: the method of comparables and the method based on forecasted fundamentals.

The Method of Comparables

Price multiples are price scaled by a measure of value, which provides the basis for the method of comparables. The method involves the comparison of a company's actual price multiple to some benchmark value to evaluate if an asset is relatively fairly priced, relatively undervalued, or relatively overvalued. The economic rationale is the law of one price - similar assets should sell at approximately equal prices. That is, if two companies are identical in all respects, their shares should be quoted at the same price in an efficient market.

Some of the most widely used benchmarks involve the multiple of a closely matched individual stock, the average or median value of the multiple for the stock's company or industry peer group.

The method is the most popular application of price multiples. It allows investors to determine the stock's relative valuation as compared to the benchmark. For example, many analysts point out that even after the technology market crash of 2000-2001, some technology stock still remain overvalued on the basis of P/E multiple compared to the normal historical valuations.

By its nature the method of comparables allows analysts to value investments only on a relative basis, i.e., only in comparison to the benchmark value of multiple. It cannot be used for absolute valuation of stocks, since the benchmark itself may as well depart from its fair value. Although Sun Microsystems seems to be undervalued comparing to other storage hardware companies, an analyst would needs some more information to recommend purchase of its stocks, since the entire storage industry may currently be overvalued and primed for decline.

The Method Based on Forecasted Fundamentals

This method is based on the assumption that fundamentals - characteristics of a business related to profitability or financial strength, such as current level of assets, sales and earnings - drive cash flows. The price multiple of an asset should be related to the prospective cash flows from holding it.

To perform this analysis, an analyst should first calculate the present value of the complete stream of forecasted future cash flows. Any DCF model can be used for this purpose. Then the analyst should divide the present value of cash flows by a selected fundamental value, such as earnings per share or sales per share to obtain a price multiple justified by fundamentals.

A justified price multiple is an analyst's estimated fair or appropriate price multiple. This multiple will likely represent a combination of comparables to other traded securities as well as forecasted company fundamentals.

• Method of comparables: Justified P/E = average P/E of firms in biotech industry.
• Forecasted fundamentals: Justified P/E = value from DCF model.

If the justified price multiple differs from the actual multiple, then the analyst is signaling that the security may be currently over or undervalued. Consequently, the analyst's support and justification for this multiple will be closely scrutinized as it suggests that the market is not currently incorporating all of the information as the analyst deems appropriate.