PE Ratio and Private company stock valuation
Definition of PE Ratio
PE ratio (PER or Price Earnings ratio) is most often used in relative valuation. PE ratio multiple methods are used when an analyst evaluates a listed company’s share price, when a venture capital firm invests in a private company, and when a non-listed company goes public.
PE ratio = Share price / EPS
PE ratio is the share price divided by EPS (Earnings Per Share). That means how many times the share price is higher than the company’s profits. Or you can interpret it as how much investors pay for the $1 profit the company generates.
In 2020, as Apple generated a net profit of $58B, and the market cap reached $2T in early 2021, Apple’s PE ratio came 40x. So you can say that Apple’s share price is valued at 40 times its net profit. Or you can interpret investors are paying $40 for Apple’s $1 profit.
Investors will pay a high price to buy the shares if they predict that a company’s profit would grow in the future. Conversely, if they estimate the profit would fall, they will sell what they own or pay a lower price to buy them.
It is intuitive and straightforward to calculate PE ratio. However, there are a couple of things to keep in mind when calculating the denominator’s EPS.
EPS = Net profit / Shares’ number
Earnings Per Share is net profit divided by the number of shares. You have to decide what net profit and what kind of shares’ number you would place at this point. Then, you should apply that criterion equally to all comparable companies.
You can choose one of the net profits at three points. The first is the one for the latest fiscal year, the Second is for the last 12 months, and the last is the expected profit for the next fiscal year. The Earnings Per Share calculated according to each point’s profit is called Current EPS, Trailing EPS, and Forwarding EPS in order. And the PE ratio calculated by each Earnings Per Share is called Current PER, Trailing PER, and Forwarding PER in order.
You can also calculate the number of shares in two ways. One is to consider only the number of shares currently issued. The other is to add the number of newly issued shares when conversion rights or stock options are exercised to the existing number of shares issued. The former EPS is Primary EPS, and the latter is Diluted EPS.
In high-growth companies, PE ratio can change significantly depending on which Earnings Per Share you use.
Forwarding EPS gets higher than Trailing EPS as the net profit of high-growth companies grows every year. So, Forwarding PER gets lower than Trailing PER under the same share price. Also, high-growth companies are more likely to issue hybrid securities with a conversion right and are more likely to issue stock options to employees. Assuming all of these options are exercised, Diluted EPS will be lower than Primary EPS as the number of common stocks increases.
Therefore, you should apply the same criteria for calculating the number of shares and selecting the time of net income when figuring the comparable companies’ PE ratio. When quoting the PE ratio from a financial information company or an internet site, you need to understand how Price Earnings ratio was calculated.
Points to note when determining the stock price level using PE ratio
Some appraisers might judge that this share price is high and that is low by looking only at the companies’ PE ratio.
However, errors can occur when evaluating the share price level only by PER without other fundamentals.
Suppose that firm A and B, which have the same business, have a PE ratio of 10 and 20, respectively. Considering only the PE ratios, you could judge that B’s share price is overvalued rather than A. But assume that A’s sales and net profit have stagnated over the past three years, while B’s growth rate is 30% and is also expected to grow by 50% next year. In this case, the judgment that A’s share price is undervalued may be wrong.
Therefore, when judging the level of share prices by Price Earnings ratio, you should also consider other fundamentals. One way to take this into account is to use PEG, which is Price Earnings ratio divided by the growth rate. PEG will be discussed in the other blog.
Private company stock valuation with PE ratio
You can do a private company stock valuation by using PE ratio. The share price is calculated by multiplying the target company’s Earnings Per Share by the listed comparable companies’ Price Earnings ratio.
A private company’s EPS x Listed comparable companies’ PER = The private company’s share price
The formula is simple to look at, but correct calculation requires elaborate work. The order is as follow:
- Find listed comparable companies that have similar business and risk to a target company.
- Calculate the PE ratio of the peer group.
- Calculate the target company’s Earnings Per Share.
- Multiply the Earnings Per Share by the calculated Price Earnings ratio of the peer group to estimate the target company’s share price.
Following these four steps, let’s estimate Dyson’s share price, a British privately held conglomerate, in the following blog.