Shares of a little-known company can make you more money than Apple or Facebook. To find an undervalued security, you need to compare company multiples and identify the most promising business. Our article explains how to calculate and use multiples.
Multiples are derived financial ratios. Investors count multiples to see if a company’s stock is overvalued, undervalued, or in line with its price. If a stock is below its fair value, it is advantageous for investors to buy it at a low price in order to profit from the future appreciation. It also gives an indication of a company’s prospects: whether it has growth opportunities or is already stagnating.
How to use multipliers
1. Select the companies in which you want to invest. To calculate most multiples, the companies must have equal external conditions:
- Operate in the same industry. Because each sector has its own limitations and opportunities: For example, oil companies pay high taxes.
- Are registered in the same country. Market conditions, legislation all affect the company’s profits.
2. Next, calculate multiples or find ready-made indicators at investing.com or finviz.com aggregator sites.
3. Compare the companies’ ratios and choose the best option based on your priorities.
Where to look for information
Below we have listed the formulas for the major multiples. You can find the values for the formulas of specific companies in the financial statements. The statements can be viewed on the corporate information disclosure center website or on the official website of the company itself. Usually these sections are called “Investors,” “Statements,” and “Disclosure. Both IFRS (International Financial Reporting Standards), RAS (Russian Accounting Standards) and GAAP (Generally Accepted Accounting Principles in the USA) reports are suitable.
Why cannot you just pick the stock of the company that earns the most?
Multiples allow you to compare the prospects of companies in isolation from its scale: $10 million in profits for Alphabet and Spotify are not the same.
The multiples in this group correlate a company’s revenues with other financial metrics. The data for the calculation can be found in the income statement.
The P/E multiple shows how many years the company must have been in operation, earning the same profit, in order to recoup the share capital. The lower the value of this multiplier, the better: you have the opportunity to buy a share of a promising company at a low price.
To calculate P/E, you need to know earnings per share (EPS). EPS shows how much a company earns per share, and is calculated by dividing net income by the number of shares outstanding. The number of traded shares of the company may be viewed on the stock exchange’s website (column “Volume of Issue”) or on the official website of the corporation.
The P/E can be compared to the performance of various industries. If the figure is below 5, the company is undervalued. The average P/E for the entire Russian market is 5.6, while for the U.S. market, it is 20.9.
The P/E ratio of the telecommunications company MTS at the time of writing the article is 12.18. It means that investors are ready to pay 12 rubles for 1 ruble of the annual profit of the company. The average value of this multiplier for the industry is 14.78.
Such demand for MTS shares may be connected with high and stable dividends, which the company pays to its shareholders (the dividend yield is 9.98%).
This multiplier cannot be used if the company is loss-making. If profits are negative, use the P/S ratio.
Return on equity: how a company generates net profit from its own funds, on which the company pays no interest.
Conditional example. If a coffee shop on the outskirts of the city sells take-out coffee and earns the same as a café with an expensive coffee machine, equipment, and interior, it is a more efficient use of equity.
The ROE has to be higher than the average annual bond rate. Otherwise, it makes no sense for an investor to invest in an instrument with a small and non-guaranteed return – he can buy risk-free assets and get the same return.
Return on assets: how a company uses all of its assets, including borrowed assets, to make a profit.
You need to compare this figure with the values of other companies in the industry. In the retail industry, the indicator will be higher because of the high turnover rate: goods are sold more quickly here. And in mining, construction, and railroads the ROE will be lower because of high capital intensity.
The higher the ROE, the better.
Imagine you want to buy shares in Russian retailers that have been operating steadily even in quarantine. Magnit’s ROA over the last 12 months was 1.04%, X5 Retail Group NV (owns the Perekryostok and Pyatyorochka retail chains) was 2.32%, and Lenta has a negative ROA. Of these three companies, the best use of available resources – X5 Retail Group NV.
Financial strength and solvency multipliers
Use them to learn about a company’s ability to pay its debts and the degree of its indebtedness.
If you’re worried that the company you want to invest in might go bankrupt, calculate this multiplier. It shows how much debt is borrowed for every ruble of equity.
Financially sound companies have a multiplier of 1-1.5. More than 1.5 means that the company may lose its financial independence. But too low level of borrowed funds indicates lost opportunities: the company does not attract additional financing to produce more products or make a new project on the market.
Current Liquidity Ratio. It shows the company’s ability to pay its short-term obligations (debts that need to be repaid within a year) with current assets: cash, receivables, inventories.
A “good” indicator is 2 or more. If the multiplier is less than 1, this does not mean that the company will soon go bankrupt. It can attract external financing and cover debts.
The main thing is .
1. Multiples are financial derivatives. Investors count multiples to see if a company’s stock is overvalued, undervalued or in line with its price.
2. Compare multiples to the industry average.
3. to estimate how much you’re paying for a company’s $1/rub revenue, calculate P/E, P/S, EV/EBITDA.
4. To represent the book value of a stock, estimate the PV/B ratio.
5. How efficient the company is with its resources – ROE and ROA.
6. To find out financial strength and ability to pay debts – Current ratio and D/E.