Investment analysts are constantly looking for ways to find the true value of a firm. While the market provides a market value, a stock's price can be under or over the firm's intrinsic or real value. In order to help determine firm value, analysts use two different valuation pricing multiples. Calculating multiples allows analysts to multiply the firm's current earnings per share by the valuation multiple (denoted with an "x"). For instance, a PE ratio of 3x means means the intrinsic value of the company is three times earnings.
You can compare these ratios to those of other companies in the same industry to get a sense of how the company is valued. It's one tool you can use in determining which stocks to buy and sell.
Obtain the current share price of the firm. You can look this up on your favorite investment research site, such as Yahoo! Finance, Google or Bloomberg, or the website of an online brokerage of your choice. Assume the share price for XYZ company is $10.
Obtain the firm's most recent annual report. You can usually download this from the company website, get it from a brokerage website or request one by contacting the firm's investor relations department.
Calculate the price to earnings (PE) ratio and the price to book (PB) ratio. The PE ratio is calculated by dividing the stock price by the earnings per share. You can find earnings per share on the income statement contained within the annual report. Assume earnings per share is $2. The PE ratio is 5x ($10 divided by 2). The PB ratio is calculated by dividing share price by stockholders' equity, which can be found on the balance sheet included in the report. It's essentially an estimate of what the company would be worth if it were liquidated immediately. Assume stockholders' equity per share is $5. The PB is 2x ($10 divided by 5).
Determine value based on the PE ratio. Find the average PE ratio of other firms in the same industry, either by computing them through the same process or searching online for this figure. Assume the average is 5x. Multiply the company's price per share by the industry PE ratio. The calculation is 5 multiplied by $10 or $50. This tells you that XYZ company is undervalued and that the price should be around $50.
Determine the value based on the PB ratio. Calculate the average PB ratio for other companies in the same industry. If the average PB ratio for XYZ's industry is six, then XYZ should be trading at a price of $12 (2 multiplied by 6). This tells you that the company is also undervalued according to the PB multiplier.