Welcome to week two of our discussion of valuation -- code-speak for the math that helps you determine what stocks to buy and when to buy them.

Last time, we covered the discounted cash flow model, which assigns a present value to a company's projected future -- yep, you guessed it -- cash flows. This week, we're going to talk about multiples.

Multiply your returns
I'll understand if that has you thinking of twins or triplets. Fortunately, our exercise won't be as needy as three newborn babies. But it won't be as cute, either. Here's how Investopedia defines a multiple:

Another term for price/earnings ratio (P/E ratio or PE), which is a measure of the value of a company's stock determined by its current share price divided by its current annual earnings per share (EPS).

So, for example, a stock with $1 in earnings that trades for $10 a share can be said to be trading for 10 times earnings or an earnings multiple of 10. (That is, 1 x 10 = 10.)

It's all relative
Multiples matter because, as Investing Fables author Aswath Damodaran teaches, "cheap" is a relative term when it comes to stocks. Think of a mall. Let's say you find a blue dress that would look great on you. It's selling for $30 at the first store you visit. Fifteen minutes later, you arrive at a second store. Among its inventory is a similarly sized and equally cute red dress that sells for $25. Wouldn't you consider the red dress the better value?

Of course you would. The same principle applies to stocks, thanks to multiples. Consider SAP (NYSE:SAP) and Oracle (NASDAQ:ORCL), which have ignited a well-publicized rivalry in the market for business software. They're somewhat similar financially, but not entirely:

Metric* Oracle SAP


$15,203 $11,512
Gross Profit $11,724 $7,559
Gross Margin 77.1% 65.7%
Operating Profit $5,207 $3,159
Operating Margin 34.2% 27.4%
Net Profit $3,532 $2,109
Net Margin 23.2% 18.3%
Earnings per share $0.67 $2.04
3-year revenue growth 16.9% 8.1%
3-year gross profit growth 17.6% 9.3%
3-year net profit growth 13.7% 15.1%
Source: Capital IQ. Data are trailing-12-months; dollar figures in millions except per-share data; SAP data is converted from euros; and per-share data is per ADR.

Now, if you had to guess, which do you think would be the more "expensive" stock? Oracle, right? It's bigger, with better margins and better growth. Well, you're right. Oracle is slightly more expensive on a trailing-12-month basis. Here's the math:

  • Oracle P/E: $18.19 (recent stock price) / $0.67 (trailing earnings) = 27.1
  • SAP P/E: $49.27 (recent stock price) / $2.04 (trailing earnings) = 24.2

Grooving with growth
Valuing a stock using multiples isn't that difficult -- that is, after you decide on a fair multiple and growth rate. Both take some judgment. For multiples, I believe that applying the industry average is the fairest method. For growth, analyst estimates can be useful. Let's put these concepts into practice using Oracle as our guinea pig.

First, according to the industry center at Yahoo! Finance, the average multiple to earnings for application software firms such as Oracle is 23.9. Next, analysts estimate that Oracle will earn $0.97 a share for the fiscal year ending next May, and that bottom-line growth will continue at 13% annually for the next five years.

Ready to do the math? Good:

FY 2007 EPS FY 2008 EPS FY 2009 EPS FY 2010 EPS FY 2011 EPS
$0.97 $1.10 $1.24 $1.40 $1.58

Applying a 23.9 multiple to $1.58 in 2011 earnings results in a valuation of almost $38 a share. If accurate, Oracle could be good for about 16% annual returns from here. Of course, that's assuming steady growth and no decline in its multiple five years from now.

Follow the money
When it comes to valuation, the quality of the output is only as good as the numbers entered into the model. Here, analyst estimates could be woefully inaccurate. Or the industry multiple may be far too aggressive for a behemoth like Oracle. After all, many small- to mid-cap firms are grouped into the same category, including Bitstream (NASDAQ:BITS), Compuware (NASDAQ:CPWR), ILOG (NASDAQ:ILOG), Novell (NASDAQ:NOVL), and Progress Software (NASDAQ:PRGS).

Remember these flaws when picking stocks. Great investors rarely substitute math for judgment about the underlying quality of the business they're evaluating.

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Fool contributor Tim Beyers actually believes Oracle is cheap, which is why he owns shares. Get a peek at everything he's invested in by checking his Fool profile. The Motley Fool's disclosure policy is sharply undervalued.