Chapter Fourteen: Weigh Valuation Multiples
Revised and updated | Build Wealth with Common Stocks: Market-Beating Strategies for the Individual Investor
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Part II: Strategies
Chapter Fourteen
Weigh Valuation Multiples
A key principle in pursuing stock investing nirvana or alpha is evaluating the attractiveness of a stock's share price based on valuation multiples compared to its fundamental metrics.
As a retail investor on Main Street, identify asymmetric price-to-value opportunities without relying on typical Wall Street prerequisites by concentrating your due diligence on five key strategic fundamental areas of the business highlighted in Part II of the book. Then, add a touch of common sense.
This chapter highlights valuation multiples, including preferred ratios, that identify undervalued stocks of high-quality companies for The Model Portfolio, as determined by our proprietary valuation matrix.
The Quality and Value Strategy
Some market experts make reckless predictions about future price movements. The proverbial crystal ball—disguised as the polished appearance of technical charts, trends, and assumptions—causes chaos in the portfolios of unaware investors who try to predict the market.
The disciplined value investor never attempts to predict an exact stock price or the percentage change, whether it’s one, three, or five years from now, or even next week.
For the value-driven investor, a reasonable stock price is essential before taking partial ownership in a quality company. Safeguarding capital then becomes the top priority after purchasing the stock.
To keep investing super simple, I rely on just four multiples as indicators of potential stock mispricing: revenue, earnings, cash flow, and market sentiment. For entertainment, the chapter also examines a few other, more speculative multiples. During the epic bull market, a cash-rich US stock market with tax and interest rate benefits, along with companies offering strong shareholder yields and high management-driven capital allocation, was common. Still, finding quality operators with attractive valuations remained challenging.
A key idea in this book is that increasing annualized compounding through total return on capital and dividends improves when buying common shares with wide margins of safety. The savvy retail investor aims for a price below the overall estimate of the company's intrinsic value, as reflected in the stock's market value.
An investor trying to predict the exact stock price at any future point can save face by instead buying or selling speculative and risky options and futures. However, just like in a casino, luck plays a significant role in those house-advantaged games. Again, the disciplined stock investor on Main Street avoids interpreting the Wall Street consensus as a definitive buy or sell signal. Evaluating sentiment on a stock can be entertaining, though it’s also a genuine exploration into a contrarian’s treasure trove.
As discussed in Part I, Chapter Three, a broad calculation of the margin of safety provides a helpful way to evaluate a company's actual value using recent or trailing data, instead of relying on speculative future cash flows and other forecasts. Therefore, measure the margin of safety of a targeted holding for long-term value investing rather than short-term trading.
Is it a Sin to Hope for a Market Correction?
The thoughtful investor observes the often-glorified quarterly Wall Street game of hit or miss, mainly to find valuation opportunities in the stocks of quality companies. To paraphrase Warren Buffett, ‘the overactive investors on Wall Street are serving the patient investors on Main Street.’
The diligent investor never hopes for an economic event—macro or micro—that harms jobs and portfolios. When such an event occurs, cash is often used to purchase discounted shares of high-quality companies, which usually follow. You can't change the past, but you can control your response to it. Stay true to the core principle of value investing by focusing on a stock's valuation relative to its underlying fundamentals to achieve alpha.
Market Consensus
The market consensus reflects the collective opinion on a stock from analysts, bloggers, portfolio managers, retail investors, and internal clients. The contrarian believes the crowd is wrong about the company's long-term prospects. Although more research is needed to verify or challenge the consensus, it often acts as a counterintuitive indicator for the thoughtful investor.
Preferred Intrinsic Value Indicators
The Model Portfolio includes companies traded on major US exchanges—none are over-the-counter issues—meeting initial quality standards, such as a competitive value proposition, shareholder friendliness, management effectiveness, and acceptable levels of downside risk.
Equally important, at the time of purchase, these stocks were trading at reasonable prices consistent with the preferred valuation multiples. Tickers held in the portfolio or on the watchlist require further research to determine which companies, if any, are suitable for initial or continued partial ownership.
Think of an investment strategy that combines quality and value as the best way to generate compound total return over a long-term holding period. Here are the preferred valuation multiples used to build and monitor The Model Portfolio.
Price to Sales Ratio
The price-to-sales (P/S) ratio indicates a stock's price compared to its revenue.
The price-to-sales ratio is calculated by dividing the previous market day's closing price by the total sales per share over the trailing twelve months (TTM). Consider a multiple of two times or less as attractive—or at least below the industry average—when assessing a stock's price relative to its revenue stream.
As a former executive, I have always believed that increasing revenue can often solve a company's financial problems. When the market undervalues net revenues compared to the stock price, it creates a potential buying opportunity for a skilled operator. The price-to-sales ratio is arguably the best indicator of intrinsic value, as revenue directly impacts earnings. Although earnings can be manipulated through accounting rules and management practices, revenue is less easily influenced, making the P/S ratio a more reliable measure—especially when compared to industry peers of the target company.
The price-to-sales ratio is a key valuation metric for The Model Portfolio.
Price to Trailing Earnings Ratio
The price-to-trailing earnings (P/E) ratio is the most widely used valuation multiple by investors.
Price-to-earnings (P/E) is the closing stock price divided by the GAAP diluted earnings per share (EPS) over the trailing twelve months (TTM). As a reminder, GAAP stands for Generally Accepted Accounting Principles. As discussed in Chapter Twelve, the inverse of P/E, or earnings yield—trailing earnings per share divided by the stock price—measures the equity bond rate of the stock compared to the US Ten-Year Treasury note.
Among the four preferred multiples used in The Model Portfolio, I assign the least importance to the P/E ratio when estimating a stock's intrinsic value.
Price to Operating Cash Flow Ratio
Value investors often view favorable cash flow multiples as a key indicator of intrinsic value.
The price-to-operating cash flow (P/CF) ratio is found by dividing the current stock price by the cash flow per share for the most recent fiscal year. Using cash flow multiples provides a reliable method for evaluating a stock's intrinsic value. For the best deal, look for stocks trading at a single-digit multiple of operating cash flow, or at least below the sector or industry average.
Operating cash flow represents the cash generated from operating activities, calculated based on net income. Keep in mind that, according to accounting standards, operating cash flow can be higher, equal to, or lower than net income, depending on the adjustments made by senior management.
Investors also look at the price-to-free cash flow (P/FCF) ratio when evaluating valuation multiples. Introduced in Chapter Twelve, free cash flow is the operating cash flow minus capital expenditures. The price-to-cash flow ratio is often considered more reliable than the P/FCF ratio because the interpretation of free cash flow can be subjective. Use operating cash flow for consistency and availability. Still, cash is king—or queen—and whenever the market discounts a stock's cash flow from a high-quality operator, value investors pay close attention.
As a result of the earnings vertical, cash flow is a more dependable indicator of value linked to earnings quality than earnings per share. If P/E offers the big picture, then P/CF focuses on the details of the company's earnings quality within the context of market sentiment about its ability to turn profits into free cash flow for strategic capital allocation.
The price-to-operating-cash-flow ratio is an essential valuation metric for The Model Portfolio.
Enterprise Value to Operating Earnings Ratio
How does the company’s operating profit align with investors’ overall interest in the stock?
The enterprise-value-to-operating-earnings (EV/EBIT) ratio is calculated by adding market capitalization, debt, minority interest, and preferred shares, then subtracting total cash and cash equivalents (EV), and dividing the resulting sum by operating earnings or earnings before interest and taxes (EBIT).
Screen for stocks that appear undervalued based on the company's operating earnings. Typically, an EV/EBIT ratio below 15 suggests an attractive stock price. EV/EBIT is a helpful contrarian indicator, indicating whether the market has overbought a stock, as shown by a higher multiple, or underbought shares, as indicated by a lower multiple.
Investing centers on a company’s earnings, and the market typically prices stocks at fair value, though it often overpays. Occasionally, speculators and algorithms reacting to news, rumors, quarterly reports, or other short-term catalysts create a rare opportunity when a high-quality company's stock becomes oversold.
An investor gauges market sentiment on a stock by comparing its enterprise value to operating earnings. The value investor, paying close attention, seizes the opportunity when the stock suddenly drops, whether buying from a watchlist or increasing shares in an existing holding.
Enterprise value relative to operating earnings is a key valuation metric for The Model Portfolio.
Valuation Rating
Rate a stock you’ve researched for valuation as bullish, neutral, or bearish based on the weighting of the four preferred valuation multiples of the common shares as a whole.
Though it can be frustrating, equities in a portfolio or on a watchlist are often seen as fairly valued or overvalued by investors who prioritize long-term ownership of quality stocks at reasonable prices. Practice discipline and patience in your search for value; sometimes, a surprising bargain shows up when you least expect it.
Asleep at the Wheel
With the start of the COVID-19 pandemic in early 2020, engine maker Cummins (NYSE: CMI) was the only company on my watchlist that met or exceeded all five of The Model Portfolio’s preferred methodologies.
However, I missed the chance to buy it at a steep discount during the market correction in March 2020. I eventually forgave myself for missing this bargain and remained confident that another buying opportunity for CMI would arise in the future.
As it turned out, two years later, in May 2022, I had the chance to add CMI to The Model Portfolio at $183.33 per share, adjusted for cash dividends paid. As of this book’s update on November 6, 2025, the stock price has increased by 152.44% since inception, compared to 70.50% for the S&P 500, resulting in 8,194 basis points of market-beating alpha.
My experience with CMI reminds us that value-focused common stock investing is like searching for a needle in a haystack, requiring significant discipline and patience to succeed in the long run.
Wait for the valuation multiples of a stable company's shares to drop to levels that indicate a temporary bargain. Just as discounted prices on Nike athletic wear appear only occasionally, so do fair prices on Nike common stock. Stay alert so you don't blink and miss those great yet brief buying opportunities.
Remember to do your due diligence or consult a licensed broker or registered investment advisor before investing in CMI, NKE, or any other stocks.
Other Conventional Valuation Multiples
Three additional ratios are commonly used in stock valuation. In practice, I assign less importance to these pricing models as described in each entry.
Price-to-Book Ratio
The price-to-book ratio (P/B) shows the stock price compared to shareholders’ equity or net asset value over a trailing quarter.
Focus on stocks of companies with solid fundamentals trading at a P/B ratio below two. Finding such an appealing valuation in a quality company is rare during a secular bull market. In those times, look for P/B ratios that are below the industry average.
Some investors focus on a measure of tangible book value, where intangible assets, such as patents, intellectual property, and goodwill, are excluded from the denominator. Although accounting for intangible assets can often lead to inflated balance sheets, ensure that management restricts entry manipulation and maintains consistency from one quarter to the next.
Price to Forecasted Earnings Ratio
Despite my ongoing skepticism about forecasting and the frustration it sometimes causes among readers, the price-to-forward-earnings ratio (P/FE) remains a valuable factor to consider when evaluating a well-researched stock.
Keep in mind that, as a future indicator, placing more emphasis on P/FE can risk turning it into a speculative gamble. Use P/FE as a tiebreaker rather than a primary decision-maker.
Price-to-Earnings Growth Ratio
The price-to-earnings-growth ratio (PEG) is calculated by dividing the P/E ratio by the projected long-term EPS growth rate, as estimated by brokerage analysts based on guidance from senior executives.
The PEG ratio has gained popularity among growth and momentum investors. The value investor remains wary of the PEG's forward-looking projection method compared to historical results. Still, PEG provides a useful measure of a stock's value. Aim for a PEG ratio below two, or at least under the industry average.
Buy Something When Nobody Else Likes It
“The safest and most potentially profitable thing is to buy something when no one likes it.”1 —HOWARD MARKS
This chapter concludes with another simple yet powerful quote from Howard Marks' client memos compiled for his influential book The Most Important Thing.
Following Marks’ wisdom, I add each stock to The Model Portfolio based on initial bullish ratings in the valuation multiples. The other four aspects of my proprietary research approach—value proposition, shareholder yields, management's return, and, as discussed in Chapter Fifteen, downside risk—are also evaluated.
Regardless of the valuation multiples or methods a retail investor uses, remember that price is what you pay and value is what you get. It’s essential to note that value matters in every aspect of our financial lives, including the stock market, and it endures through each market cycle for decades to come, and perhaps forever.
The lesson stays the same: Own shares of excellent companies bought when the stock price is reasonable or at temporary bargain prices after being ignored by the crowd.
CHAPTER FOURTEEN SUMMARY
On Intrinsic Value
A core principle in seeking alpha through stock investing is assessing the appeal of a stock's price compared to the company's fundamentals using valuation multiples.
A compelling stock price is crucial for securing a fair share of ownership in a high-quality company.
When assessing valuation, concentrate on the price multiples of trailing sales, earnings, and operating cash flow, as well as the market sentiment indicator of enterprise value compared to operating earnings.
Although useful as valuation multiples, be cautious of the intangibles in price-to-book ratios and the speculative nature of future growth and earnings projections.
Buy the common shares of a targeted, high-quality, durable company when the market turns against it, creating a bargain price.
This updated chapter is copyrighted 2021 and 2025 by David J. Waldron. All rights are reserved worldwide.
Next in Build Wealth with Common Stocks | Part II Strategies | Chapter Fifteen: Assess Downside Risk
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Howard Marks, The Most Important Thing (New York: Columbia University Press, 2011), 27, original quote published in Marks’s memo to clients of Trust Company of the West: “Random Thoughts on the Identification of Investment Opportunities,” January 24, 1994.