George Calhoun - Price and Value: A Guide to Equity Market Valuation Metrics

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Every Fall, in my introductory course on Quantitative Finance, I begin with the basic metrics that are a starting point for thinking about whether a stock is valued correctly: the Price-to-Earnings (P/E) ratio and its variants. The topic is pedagogically fruitful, combining a seeming simplicity in construction just ratios, no complex math with intriguing difficulties in interpretation and an abundance of counterintuitive and thought-provoking applications.

The students soon realize that these metrics do not always give clear answers. But they do raise interesting questions. Korean stocks typically carry a lower P/E that is, they are less expensive, or more undervalued than American stocks. Why?Morgan Stanleytrades at a premium toGoldman Sachs. Why? Why does a dollar of earnings atCostcocreate 50% more stock market value than a dollar ofWalmartsearnings? Why arePepsisearnings usually priced more cheaply thanCokes? What should we make of the exorbitant P/E ratio (ten times the market average) thatAmazoncarries?Questions like these are the seeds of the broader curriculum, highlighting the complexities of the financial markets.

A few years later, as the students are completing their degrees, ready to enter the working world of Finance, armed with extensive math and computer science skills, and having taken a wide range of courses related to Quantitative Finance in all its dimensions, somehow we seem to have circled back to that same starting point: the question ofvaluationand the markets perspective on it.The students vocabulary has expanded; they now speak of factor models and smart beta; they converse easily about momentum and mean reversion; they use portfolio optimization techniques to balance risk and return; they know how to scrutinize the market microstructure to analyze liquidity and volatility; they have learned how to hedge different types of market risk with complex derivatives. But underlying these advanced concepts and techniques, there is still the basic mystery:How does the market determine the correct price for the assets that it trades? How does it ascribe value to a complex and dynamic business enterprise?And this always brings us back, at some point, to the basic valuation metrics.

Ratios like the P/E are by far the most common type of valuation tool used by practitioners. For investors, the ratios link fundamental corporate performance (e.g., sales, profit) with share prices, to quickly diagnose potentially undervalued or overvalued companies. Financial analysts use them to calibrate, and validate, more sophisticated models based on calculating future discounted cash flows (DCFs) or to help price mergers and acquisitions or to characterize different market regimes (e.g., for detecting bubbles). But many market professionals view the use of these ratios as mere shortcuts even somehow a kind of cheating, not quite the real thing in terms of enterprise valuation. Business education reinforces this perspective. DCF models are taught and rehearsed in every finance course in the universe, elaborated in weighty textbooks; valuation ratios are relegated to a quick chapter or two, if presented at all. Sometimes the P/E can seem almost too self-evident to require formal instruction.

The subject deserves a systematic treatment. The mystery, and the potency, of a simple ratio like the P/E stems from its incongruous nature. It is a direct and explicitapples-to-oranges comparison.The two halves of the ratio are derived from different sources, based on different conceptual frameworks. The numerator comes from the market, reflecting its emotions, its peculiar weather, and its purported wisdom of the crowd; the denominator is an objective measure of residual cash flows, groomed and adjusted according to standardized rules of accounting, and has nothing to do with the market. This hybrid signal is both ambiguous and unstable (or nonstationary as the statisticians say). That is, the significance of the P/E its momentarily correct interpretation changes from time to time and from company to company. This does not impair its usefulness, but it does challenge the user to approach the matter carefully, alert to its complexities, and to handle the results with caution.

This book is intended to shed light on the use of market ratios for enterprise valuation, to assess the quantity and quality of the information they contain, and to highlight the questions they raise. I have tried to adopt a consistent critical perspective which is often missing from other presentations. Many investment advisers present their chosen formula as