In Chapter 2, I discussed the valuation methods based on the assets of companies. In Chapter 5, I focused on the valuation method based on the free cash flow and the earnings of the companies that have predictable earnings power. In this chapter, I want to explain business evaluation, in general, and how different evaluation methods can or cannot be applied to businesses across different industries and in different situations.
This chapter offers a broad explanation of valuation methods and their applications. Although I have previously mentioned that some industries should be avoided by investors who seek to invest in only good companies, some of these industries will be remarked on in this chapter. So, please don't confuse the comments in this chapter with the investing philosophy of buying only good companies.
Valuation approaches can be divided into three categories: (1) valuation ratios, (2) intrinsic values, and (3) rate of return. I will discuss each of them in detail in this chapter.
Valuation ratio approach is the most commonly used method of valuation. Among all the valuation ratios, P/E is the most popularly used ratio. Then there are price/sales, price/book, price/free-cash-flow, EV/EBIT, EV/EBITDA, and many others.
The P/E ratio can be viewed as the number of years it takes for the company to earn back the price that investors paid for the stock. For example, if a company earns $2 per share ...