The denominator for each ratio is the particular ratio’s namesake. For example, the price to earnings ratio is the entire market capitalization of the company divided by the most recent 12 months of earnings. Here is the actual Price to Earnings Ratio on 05/01/19 for Microsoft:
Microsoft’s P/E Ratio = Market Capitalization on 05/01/19 = $1,000,000,000,000 (1.0T) = 28.57
Past 12 Months of Earnings $35,000,000,000 (35.0B)
The Wall Street Journal has the trailing twelve months PE as 28.42 on 05/01/19.
The other two core valuation ratios are:
This section of the book explains these three ratios and their respective nuances. For the reader, there are two important attributes of valuation ratios that must be grasped to be a good investor.
First off, valuation ratios are market indicators and as such, investors rely heavily on their values in their respective decision models. The first section below explores this in more detail and how the reader must use some common sense when using valuation ratios in their respective decision models.
Secondly, valuation ratios are easily distorted due to the respective underlying elements in their equations. The second section below will explain this and how important it is for the user to ascertain the driver of value related to the respective ratio.
Finally, an illustration of how unreliable the ratios are is presented. With greater knowledge of the valuation ratios, a user can properly equate their results into their decision model on whether to buy or sell a stock investment.
Valuation Ratios are Market Indicators
The most important attribute of valuation ratios is this: valuation ratios are determined by the market, not by the company’s performance. As stated before, the numerator is an outside value and is not a function of any of the five financial sections of the company. The numerator is always the price per share or market capitalization. A user of valuation ratios understands that either the per share price or the market capitalization is used and they both mean the same. Market capitalization is merely the price per share times the number of shares in the market (shares outstanding). To assist you in understanding this relationship, look at the following table:
Company Price/SH (05/03/19) #of Shares Outstanding Market Capitalization
Microsoft $128.90 7.67 Billion $988.66 Billion
Verizon $57.54 4.14 Billion $238.22 Billion
Apple $211.75 4.70 Billion $995.23 Billion
Kroger $25.74 798 Million $20.54 Billion
Market capitalization is merely the value of all shares. Thus, when using any valuation ratio, the denominator may either be as a single share or for all shares. The key is that the denominator must match the relationship.
Most importantly, the price is determined by buyers and sellers in the market conducting transactions based on the principle of greed, i.e. getting the most out of the transaction. Since most activity, via volume, is conducted by institutional buyers (retirement plans, mutual funds, insurance companies, governmental agencies and holding companies), it is assumed that the value or current trading price is the going true worth of the stock. Why does it fluctuate throughout the day and throughout the share’s lifetime?
The answer is expectations. Most buyers are convinced that the stock will improve in value over time and that they have seen something in the financial statements, government reports, news releases and social media that the company will perform better in the future. Whereas, sellers believe otherwise.
Many of these buyers and sellers use business ratios to assist them in understanding the company’s overall performance. Thus, valuation ratios are really the resulting outcome of the other four categories of business ratios. This leads into the second attribute of valuation ratios, they are easily distorted by the financial results.
Distortion by the Underlying Elements of Valuation Ratios
The three primary valuation ratios are:
- Price to Earnings
- Price to Sales
- Price to Cash Flow
Each valuation ratio’s denominator is easily manipulated, even under Generally Accepted Accounting Principles (GAAP). This is why it is important for the user to understand each valuation ratio’s business elements. Each section below explains each ratio’s underlying elements and some tools used in accounting to manipulate the results thus affecting the outcomes.
Every publicly traded company issue financial statements. One of the financial sections is a set of ‘Notes’. Usually within the first five notes is a statement by the company that they use estimates to determine certain values on the income statement and balance sheet. Estimates are customarily determined for:
- Deferred Revenue
- Percentage of Completion
- Bad Debt
- Extraordinary Events
Historically, the estimates are reasonable and reliable. However, the fact is they are used. Often, estimates are so extreme, the value is unreliable and affects the stock price negatively. A good example is the estimate made by PG&E related to the cause of the famous ‘Camp Fire’ from November/December 2018. Here is the actual note:
(3) The Utility incurred costs, net of insurance, of $9.5 billion (before the tax impact of $2.7 billion) during the twelve months ended December 31, 2018 associated with the 2018 Camp fire. This includes accrued charges of $10.5 billion (before the tax impact of $2.9 billion) during the twelve months ended December 31, 2018 related to estimated third-party claims.
From the financial report: http://s1.q4cdn.com/880135780/files/doc_financials/2018/2018-Annual-Report-FINAL-web-ready-version-4-24-19.pdf . Go to page V at the bottom.
This force the company into Chapter 11 bankruptcy (reorganization) on January 29, 2019.
It will take almost a decade for the final costs to be determined. Thus, this single event greatly distorts earnings, even estimated earnings. Prior to the Camp Fire, PG&E’s price to earnings ratio was approximately 14 to 15 times earnings to a staggering 95 times earnings today (05/19). The dramatic change is a reflection of the uncertainty related to the stock today. It is unknown what the future will be under the reorganization and if current shareholders will be entitled to any value.
Another underlying element of value is sales. Sales are also easily manipulated. One of rules with GAAP relates to defining sales. In general, to qualify as a sale, the transaction must be both quantifiable and certain. Many industries marginalize both elements of a sale. The issue at hand is the subjective nature of both. Here are a couple of historical cases addressing either of the underlying elements.
Health South was a large publicly traded health care company in the late 90’s and early 2000’s. The CEO ordered the staff to create fake transactions (certainty element) causing earnings to inflate $1.4 Billion dollars over several years. The CEO was caught by the Securities and Exchange Commission and the company was forced into bankruptcy in 2003.
American Insurance Group booked loans as revenue (sales) thus inflating earnings. Total fraud was in excess of $3.8 Billion. The 2005 bankruptcy forced the US taxpayers to foot the bill.
Of the top three valuation ratios, this one is the easiest to manipulate. Cash flow is a difficult financial relationship for even the most sophisticated readers of financial statements to understand. It is a result of three major areas of cash uses/sources:
- Cash Flow from Operations
- Cash Flow from Investing
- Cash Flow from Financing
Each of the three major uses/sources of cash can be manipulated. For example, cash flow from operations, starts with the value from earnings. In addition, there are adjustments for changes in current assets including receivables and current liabilities. All elements of this one area of cash flow are easily manipulated. A good example is a simple line of credit draw on the last day of the accounting period. A financial draw increases cash and increases liabilities. Thus, the resulting cash flow from operations is easily manipulated higher.
With the price to cash flow ratio, if cash flow increases and the price stays the same, the ratio decreases making the stock look more appealing. Think about this for a moment, the company borrowed money and the stock price will increase in value in order to maintain a consistent price to cash flow ratio.
For the reader, it is important to understand how reliable valuation ratios truly are.
Reliability with Valuation Ratios
Valuation ratios are tied disproportionately on one single concept, consistency. All valuation ratios are a multiple of the underlying denominator. To predict a reasonable multiple of the denominator, the user of the ratio assumes the denominator is consistently calculated from one accounting period to the next.
Most sophisticated users rely on GAAP for consistencies with the calculation of the denominator value. There are historical problems with this reliance on GAAP. First off, GAAP has over 160 standards which were recently codified into a new structure. The key is that these standards are modified from time to time and new ones are added regularly. The fact that they change means that its difficult to have true consistency from one accounting period to the next.
Another valuation principle assumes that the respected valuation ratio is comparing two similar companies. The simple truth is that no two companies are alike. It is actually very difficult to find two similar companies within the same industry. For example, the average investor would think that electric utilities are similar. Afterall, they are merely taking a resource and turning this into electricity and selling the end product to the consumer. Actual results are significantly different. Duke is a large electric utility based out of North Carolina. If you go deep into their financials, you’ll discover that about one-fourth of their revenues are derived from power distribution and not from power generation. Whereas Dominion Power, its neighbor directly to the North, derives the bulk of its revenue stream from pure energy sales and gas distribution. One earns its revenue from electric energy and distribution, the other from electric energy and gas. Would their respective Price to Sales or Price to Earnings be a fair comparison?
Even their respective earnings are regulated differently. Both are governed by different governmental boards that approve of rate hikes or rate adjustments for respective energy sources. The proverbial comparison of apples to apples does not exist between these two utility companies.
A final valuation principle assumes that the value result for each ratio is a derivative of high volume of stock transactions. Without this high volume, there are not enough buyers/sellers to forecast the value of the respective company. Low volume activity is subjective and tends towards terminal value of the entity and not its future value.
Each of the articles in this section of the website explain the respective valuation ratio and the underlying principles to calculate a result. There are several examples in each chapter illustrating the respective formula’s and the subjective criteria. ACT ON KNOWLEDGE.