Question

In 200 words or more, Review how the price-to-earnings ratio and enterprise value ratios are used to compare stock values.

Answer 1

We can use price earnings ratio or enterprise value ratios of peers/similar companies in the same induustry to say whether a particular stock is undervalued or overvalued or fairly valued. These ratios indicate for the same earnings what should be the fair price assuming market values other stocks correctly. Lets say the industry or peer price earnings ratio be x and earnings of the company be y then fair price of the stock should be equal to x*y. If stock price in market is less than x*y then the stock is undervalued. If stock price in market is more than x*y then the stock is overvalued. If stock price in market is equal to x*y then the stock is fairly valued. Similar analysis can be performed using enterprise ratios as well. Just replace earnings above by denominator of enterprise ratio so if enterprise ratio to be used is EV/EBITDA then instead of earnings as above use EBITDA. We will multiply EBITDA with the ratio and we will get enterprise value. Subtract net debt from enterprise value to get equity value. Divide by number of shares to get stock price. If stock price in market is less than calculated value stock is undervalued. If stock price in market is more than calculated value stock is overvalued. Otherwise the stock is fairly valued.