Valuation multiples - P/BV, P/E

Blendzior321:

Dear community,

I am a self-taught person, and I seek your guidance.

What is the rationale for using the P/E ratio to value companies operating within healthcare?

While I do understand why we use it for financial institutions that rely heavily on interest income, I do not see the rationale behind using it for healthcare companies.

Also: why do we use P/BV or P/TBV for banks? I found that "Book value per share is a good measure to value bank stocks. In this scenario, the so-called price-to-book (P/B) ratio is applied with a bank's stock price compared to equity book value per share. The alternative of comparing a stock's price to earnings, or price-to-earnings (P/E) ratio, may produce unreliable valuation results, as bank earnings can easily swing back and forth in large variations from one quarter to the next," and I quite don't get it.

Could someone explain it?

Thanks!

Good on you for being self-taught. Let me try to help.

1) P/E actually doesn't make too much sense for financial institutions because of leverage. It is best used for stable companies with reliable cash flow, leverage, growth, and risk that allows it to be compared to similarly stable companies. To see why, consider a standard one period DCF in per share terms:

P = FCF/(r-g) - ND

If you divide both sides by earnings

P/E = (FCF/E)/(r-g) - ND/E

So if you use P/E you are making implicit assumptions about these four items in perpetuity. Big pharma is typically stable across all of them, so its a pretty good metric.

2) P/B is typically a bullshit metric because BV doesn't actually mean anything. It's just a plug variable accountants invented to make the balance sheet balance. Since assets are valued at cost, it tells you nothing about how the company is performing now.

The exception is banks and real estate, where accounting rules have them mark BV to market. In ths case, BV is a good idea of the net value of assets the company is holding. And P/B is a measure of premium of the company over the assets it has, i.e. you believe it can squeeze even more returns out of its assets as compared to if it liquidated everything.