The three stocks selected for the computation of the price to earnings ratios are Microsoft Corporation, Facebook Inc., and Apple Inc. The benchmark was the equity index S&P 500. The P/E ratio helps the investors to assess the value of a firm. It is one of the most widely used multiples. There is a direct relationship between market expectation and the price multiple hence company’s future performance can be determined. The price multiple is an important tool to the investors since it determines the company’s future earnings. For instance, a promising future earning of a company is indicated by a higher current earnings multiple (Bajkowski, 2000).
The formula for assessing the P/E is: Price/Earnings= Stock price / Earnings per share
For Microsoft, the 2017 fiscal year gives the following P/E computation:
Trailing P/E = 87.18/3.46 = 25.20
Leading P/E = 87.18/3.67 = 23.75
For Facebook Inc., the 2017 fiscal year gives the following P/E computation:
Trailing P/E = 159.39/6.16 = 25.88
Leading P/E = 159.39/8.43 = 18.91
For Apple, the 2017 fiscal year gives the following P/E computation:
Trailing P/E = 164.94/9.62 = 17.15
Leading P/E = 164.94/11.39 = 14.48
Using the trailing P/E, Facebook is seen to be overly valued due to the high P/E ratio; Microsoft is overvalued while Apple is the undervalued stock. Using thee Leading P/E, Microsoft is the overly valued stock; Facebook and Apple have P/E ratios less than the benchmark P/E thus undervalued.
| Company | Trailing P/E | Leading P/E | Compare |
| Microsoft Corp | 25.20 | 23.75 | -17% |
| Apple Inc. | 17.15 | 14.48 | +22% |
| Facebook Inc. | 25.88 | 18.91 | -19% |
| Benchmark P/E | 20.88 |
Computation of price to earnings ratio using forecasted fundamentals
Usually, the Trailing EPS and Leading EPS are based on previous records contrary to forward EPS that is based on the forecasted fundamentals (Lebdaoui & Wild, 2016).
The formula used is: payout ratio (1+growth rate)/ (return-growth)
For Microsoft: 1.29(1.14)/ (0.11-0.14) = -6.33
For Apple: 0.25(1.17)/ (0.09-0.17) = -0.54
For Facebook: 0(0)/ (0.07-0) = 0
The forecasted fundamentals are not a good measure to determine the stock valuation due to the companies being of High growth rate.
RECOMMENDATION TO INVESTORS
Analysis of the three companies shows that the investor should invest in Microsoft due to its high P/E ratio in both leading and trailing that indicates future profitability.
Computation for the price to book ratio (P/B)
This ratio is used to assess how well management can create more value from a given set of assets. The ratios are computed as follows:
P/B= stock price/ the value of book per share
The value of book per share= (Assets-Liabilities)/ outstanding shares
For Microsoft, the 2017 fiscal year gives the following P/B computation:
P/B = 87.18/11.39 = 7.65
For Facebook, the 2017 fiscal year gives the following P/B computation:
P/B = 159.39/31.03 = 5.14
For Apple, the 2017 fiscal year gives the following P/B computation:
P/B = 164.94/26.42 = 6.24
All the ratios are high and thus indicate that all three stocks are overvalued. However, computing the P/B using the forecasted fundamentals shows a different picture:
P/B Forecasted= (return on equity-growth rate)/ (rate of return-growth rate)
For Microsoft, the 2017 fiscal year gives the following forecasted P/B computation:
P/B = (29%-14%)/ (11%-14%) = -5.66
For Facebook, the 2017 fiscal year gives the following forecasted P/B computation:
P/B = (21%-0%)/ (7%-0%) = 3.24
For Apple, the 2017 fiscal year gives the following forecasted P/B computation:
P/B = (36%-17%)/ (9%-17%) = -2.36
In light of the second computation, only Facebook shows a high P/B in both cases while Apple and Microsoft are undervalued with negative P/B ratios.
Recommendation to investors
The investors should consider the company with a promising future return on their investments thus should give priority to Facebook
Recommendation when comparing P/E TO P/B
The P/E ratio is more popular in use as the P/B can be manipulated due to different accounting standards. Thus, if the investor is comparing the companies using both ratios, then Microsoft would be the best choice to invest.
Absolute valuation models
These are valuation models used to compare the worth of the different competitors.
Dividend discount model
This model is based on the fact that the future cash flows an investor expects to receive from his stocks are be future cash dividends (Chaplinsky, 2008)
The DDM formula is given as:
The stock value = Dividend per share÷ (discount rate-dividend growth rate)
For Microsoft, the DDM is:
DDM = 1.62/ (11%-14%)
= -58.91
For Apple, the DDM is:
DDM = 2.42/ (9%-17%)
= -30.36
For Facebook, the DDM is:
DDM = 0/ (7%-0)
= 0
Free cash flow to firm model
The FCFF is the cash that is available to the investors after the company pays out its expense. The formula used is:
FCFF = Cash Flow Operations + Interest Expenses * (1 – Tax Rate) – Capital Expenditure
For Microsoft, the FCFF is:
39,507+2,637*(1-0.3)-8,696 = 32654.8
For Apple, the FCFF is:
63,598+2,532*(1-0.3)-12,339 = 53,031.40
For Facebook, the FCFF is:
24,216+0+6,733= 30,949
Free cash flow to equity
The model valuates the amount of cash available to the shareholders after accounting for all liabilities.
The formula is given by:
FCFE = (Net Income + New Debt) – (Net Capital Expenditure + Change in Net Working Capital +Debt Repayment)
For Microsoft, the 2017 fiscal year gives the following FCFE:
FCFE= 25,489-8,696-14,404+3,637
=6,026
For Apple, the 2017 fiscal year gives the following:
FCFE = 48351-12339-28463+33600
= 41,149
For Facebook, the 2017 fiscal year gives the following
FCFE = 15,934-(-6,733)-1,887+0
=20,780
Analysis of the results for the models
The models give different values depending on the financial indicators used. Concerning the DDM, Microsoft and Apple are seen to have negative DDMs while Facebook has zero as it does not pay out dividends. This observation shows that DDM may not be a reliable measure for valuing fast-growing companies.
Considering FCFE and FCFF, Apple has the highest FCFF and FCFE hence the company has a high inflow of cash.
Reasons for different intrinsic values
The intrinsic value for the FCFF and FCFE are different because the free cash flow to the firm values the equity stake and other claimholders in the business (bondholders, preferred stockholder, etc.). The FCFE takes into account only the equity stake in the firm.
References
Bajkowski, J. (2000). Evaluating using Price to Earnings Relatives. American Association of Individual Investors.
Chaplinsky, S. (2008). The Dividend Discount Model. Darden Business Publishing.
Lebdaoui, H., & Wild, J. (2016). Islamic Banking and Financial Development. Review of Middle
