Introduction to Working with Stock Valuation Multiples

1. Introduction to Working with Stock Valuation Multiples • Question: Is a company expensive or cheap at its current price? • Examples of valuation multiples: • Price to earnings (P/E) • P/E divided by forecast growth (PEG) • Price to sales (P/S) • Price to book (P/B) • We’ll compare the company’s multiple with: • Its industry. • A broad-based stock index (e.g., the S&P 500) • Its own historical average (e.g., its 5-year average)

2. We’ll Use Price/Sales (P/S) for Our Analysis Today • Investors typically overreact to news: • They buy companies doing well to the point that they are overvalued (i.e., prices go too high). • They sell (drive down the prices) of troubled companies to the point that they represent an attractive value. • Unlike the normal behavior of shoppers to buy things that are “on sale”, investors seem to want to buy stocks when they are at high prices and sell stocks when they are at low prices. • A variety of “multiples” (ratios) can be used to try to get a sense of whether stocks are priced too high or are an attractive value. Examples: price/book value, price/earnings, and price/sales ratios.” • These ratios can vary a lot by industry. Price/sales ratios tend to be more comparable from firm to firm within the same industry. We’ll focus on those today.

3. Example: Calculate price to sales (P/S) for Apple • Price = market capitalization = # shares outstanding x price/share • = $478.87 BILLION • = 0.89199 BILLION shares x $536.86 /share • Revenue (trailing 12 months, abbreviated as “ttm”) • = $173.99 BILLION • P/S (ttm) = $ 478.87 BILLION / $173.99 BILLION = 2.75 • Interpretation of P/S: If you buy Apple here, you are paying $2.75 for one dollar of Apple’s sales. • Above data are from finance.yahoo.com Mar. 29, 2014.

4. Go to: finance.yahoo.com and type AAPL for Apple’s symbol in the top bar

5. Now click on “Key Statistics”

6. This is the a screenshot of Apple’s “Key Statistics” page 3/29/2014

7. Now we’ll use the Morningstar Database to obtain historical, industry, and index data. Go to: elibrary.unm.edu and Click on “M” in the “Databases by Title” section

8. Then click on Morningstar and enter a ticker. (PLEASE NOTE: UNM’s subscription allows only 4 users at a time . So when you’re done, please click on “End Session” in upper right.)

9. Suppose you enter AAPL for your ticker. You get this screen. Check out P/S. Does is agree with finance.yahoo.com and our calculation?

10. Here’s the same screenshot from 18 months ago (10/23/2012): P/S = 3.9 Check out Apple’s price then versus now. Now sales are up 16% but price is down 14%.

11. Now click on the “Valuation” tab, which shows a comparison of AAPL with: Its industry -- Morningstar’s industry classification will be different from S&P’s sector designation. The S&P 500 Its own 5 year average

12. From the last slide: data as of 3/27/2014 How much have P/S changed for S&P and Industry? (And AAPL is part of industry calc.) Data from 18 months ago (10/23/2012):

13. Some Industry Average P/S Data vs. S&P 500’s P/S of 1.7 (as of Mar. 27, 2014) • Google’s Morningstar Industry (Internet Content & Info) P/S = 7.2 • Pfizer’s Morningstar Industry (Major Drug Manufacturers) P/S = 3.3 • Bank of America’s Morningstar Industry (Bank Regional U.S.) P/S = 2.3 • Apple’s Morningstar Industry (Consumer Electronics) P/S = 1.7 • PNM’s Morningstar Industry (Utilities Regulated Electric) P/S = 1.4 • PPG’s Morningstar Industry (Specialty Chemicals) P/S = 1.6 • Chevron’s Morningstar Industry (Integrated Oil and Gas) P/S = 0.6 • Deere’s Morningstar Industry (Farm and Construction Equipment) P/S = 1.0

14. Suppose you find a company you like and want to find companies in the same industry, you can click on Morningstar’s “Industry Peers” tab:

15. Now let’s look at the historical data for P/S: Page down and you’ll see something like this. Click on the “Price/Sales” tab. You’ll see: Price/Sales each year for the past 10 years. Also, see trailing 12 months (ttm) in last column – that’s our 2.8. Is Apple currently near its high, median, or low historic P/S? The same info is also provided for the S&P 500. (NOTE: the default is the P/E tab --- here we clicked on the P/S tab.)

16. First “Rule of Thumb”: Some of our advisors have told us that “Price/Sales” of more than 4 or 5 is “too expensive”. They need a very strong argument to buy at that level. And if they own it, they are tempted to sell it at that level (“take profits”). For 2007, AAPL was 6.7! What if you’d bought it Oct 1, 2007 (this is approximate date of P/S calculation for 2007)?

17. For 2007, AAPL was 6.7! What if you’d bought it Oct 1, 2007 (this is approximate date of P/S calculation for 2007)? AAPL closed at $161.45/share on Oct 1, 2007. If you’d waited a year, on Oct 1, 2008: P/S was 2.3. You could buy AAPL for $100/sh. (NOTE: What’s the latest date on this Apple price and chart? Oct. 22, 2012. P/S = 3.9)

18. FYI – here’s the same Apple price and chart as of Oct. 7, 2013. P/S = 2.7

19. FYI – here’s the same Apple price and chart as of Friday, March 28, 2014. P/S = 2.75

20. Now let’s look at the historical data for the RATIO of P/S relative to the S&P 500 P/S: Maybe you are thinking: The stock market – MOST STOCKS -- fell dramatically in 2008! But remember: Most stocks lost money: & our objective is to beat the benchmark. Second “Rule of Thumb”: take the benchmark (S&P) value of the multiple into account. Compare “ratio of multiples”. Example for ratio of P/S for stock to P/S for S&P 500 : For 2007: AAPL was 6.7 and S&P500 was 1.5. Ratio: 6.7/1.5 = 4.5. AAPL was 4.5x S&P. For 2008: AAPL was 2.3 and S&P500 was 0.9. Ratio: 2.3/0.9 = 2.6. AAPL was 2.6x S&P. FYI (not shown above): P/S (ttm) on Oct 23, 2012 = 3.9/1.3 = 3.0. AAPL was 3.0x S&P. FYI (not shown above): P/S (ttm) on Oct 4, 2013 = 2.7/1.4 = 1.8. AAPL was 1.8x S&P. Question: What is the ratio of AAPL’s P/S to the S&P 500 P/S using most recent TTM? 1.6

21. Summary of our P/S observations for Apple: • Apple’s P/S of 2.8 is near its own 5-year historical low of 2.3 (in 2008) and below its 5-year average of 3.4 • Apple’s P/S of 2.8 is above (i.e., more expensive than) its Morningstar Industry Average of 1.7 • Apple’s P/S ratio to the S&P 500 P/S (ttm) is 1.6x S&P --- near low end compared to its 5-year range (2008 – 2012) of about 2.5x to 4.5x the S&P 500 P/S • Question #1: Now that we’ve looked at P/S: Does Apple look cheap or expensive? • Question #2: Investors and traders in the market have established Apple’s current price. If this stock looks cheap to you based on these multiples, what do you “know” that the market doesn’t? • To Do: What about the other multiples (e.g., P/E, PEG, P/B)?

22. Our analysis so far of P/S provides a starting point for further analysis. “Even a stock with a low price-to-sales ratio is no bargain if it has no sales and earnings growth prospects. If a company has poor prospects, then it should trade with a low ratio. Optimally, an investor is looking for a growth company that has stumbled due to a temporary factor.” Taken from the American Association of Individual Investors (AAII) website article: “Using Price-to-Sales Ratios to Screen for Out-of-Favor Stocks” by John Bajkowski (October 1996) <http://www.aaii.com/journal/article/using-price-to-sales-ratios-to-screen-for-out-of-favor-stocks>

23. Beware: if the company has changed dramatically, don’t include the historical numbers prior to the change. Is AAPL the same company it was 10 years ago?

24. Valuation Appendix 2 Discussion Question: Is a company expensive or cheap at its current price? Now we’ll ask: What do professional analysts think about the company’s stock at its current price? 2) What does the market tell us about the company’s stock?

25. We’ll construct the following table. Then we’ll use the data to analyze what the professional analysts and market are telling us about the stock at its current price. Then we’ll draw our conclusion. (Note: This is Appendix 2 of Assignment #6.)

26. Table (continued):  Conclusion and recommendation:

27. Again, let’s use Morningstar. Let’s use Chevron (ticker: CVX). On the main page, we can see a Fair Value Estimate, Consider Buying, Consider Selling, and Fail Value Uncertainty. This info is the opinion of Morningstar’s analysts.

28. Next, go to: http://advisor.marketscope.com/SP/msa/login.htmland type CVX in search

29. Next, go to: finance.yahoo.com and Click on “Analyst Opinion”

30. Finally, go to: finance.yahoo.com and Click on “Key Statistics”. Look at right column.