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We previously mentioned that stock prices are affected by fundamental growth in companies, inflation in the long run and, there’s the component of appraisal. In today’s article, we’ll take a look at a widely used tool, multiples, which kind of express the latter.
What are them?
A multiple is a ratio, which is calculated upon dividing the market capitalization of a company by a specific financial the company has. It could be revenue, earnings, gross profit, etc. Multiples can help an investor infer the appraisal the financial community has for a single business.
The reason for this is that every time a person buys a stock, he/she is theoretically contemplating everything of the business as well as the price at which is currently trading. Therefore, a buy is a sign of ‘approval’ of these kinds of things. And, if more and more people constantly approve the conditions at which a stock is trading, the price will be bid higher, resulting in a higher multiple. The conclusion an investor could take out of this is that the financial community’s appraisal for this stock is appreciating (which could be based on fundamental changes or not).
The key element that takes account and influences a company’s multiple is its expected future cash flows. If a business is expected to grow earnings at much higher rates than competition for the coming future, it makes sense for it to trade at a higher Price to Earnings Multiple than its peers. One has to acknowledge this to try to detect the expected growth (by the market) for each company to not fall for overpriced stocks.
There are actually a lot of multiples that could be used, here are the three most common:
P/S: Price to Sales (Market Cap / Revenue)
P/FCF: Price to Free Cash Flow (Market Cap / Free Cash Flow)
P/E: Price to Earnings (Market Cap / Earnings)
All multiples are quite straight forward since the only thing changing is the denominator, and it is always an item from the financial statement. One thing to keep in mind of is that the numerator can be either Price (refers to Market cap) or Enterprise Value.
EV stands for Enterprise Value, which is equal to the Market Capitalization of the company minus Debt plus its Cash. ( EV = Mkt Cap + Debt - Cash)
Some people claim EV is a more accurate measure of the company’s value since, if acquired, it would be the actual price to pay. I mean, you’d have to pay its debt and 1 dollar paid for 1 dollar of cash cancels itself.
Are they useful?
Answering this question is always personal, but I believe there are no non-useful things in the due diligence process. Everything should add its own value and make an investor form a better opinion. The more things considered and contemplated, the better the result should be.
In the case of Multiples, among its utility you can find:
Inference of the financial community’s appraisal
Expected future growth
Pricing of the actual business
Guidance on comparison with its peers
In extremes, multiples can be very telling and help you make a better decision on buying/selling/holding or not doing anything.
Hope you enjoyed this article!
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