Equity Investments
Relative Valuation Measures
Relative Valuation Measures
Using Price Multiples for Valuation
The price multiple approach—relative valuation
Common price multiples based on comparables:
Price to earnings
Price to cash flow
Price to sales
Price to book value
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Relative Valuation Measures
Using Price Multiples for Valuation
Advantages of the price multiple approach
Widely used
Readily available
Easy to calculate
Can be used for cross-sectional analysis or time series analysis
Associated with equity returns
Multiples can be historical or
forward looking
(e.g., P0/E0 vs. P0/E1)
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Relative Valuation Measures
P/E Based on Fundamentals
Begin with the constant growth value:
D1
P0 =
k–g
Divide both sides of the equation by next year’s projected
earnings (E1) to get P/E:
D1 Dividend payout ratio
P0
= E 1 = (leading) price to earnings ratio
E1 k – g
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Relative Valuation Measures
P/E Based on Fundamentals
P0 D1 / E1
=
E1 k–g
Other things equal, the fundamental P/E ratio (price) is higher if
firm has:
Higher dividend payout ratio The same factors that
affect a stock’s price
Higher growth rate affect the stock’s P/E
Lower required return ratio.
Note that increasing the payout ratio will reduce
the retention rate: g = ROE × (1 – payout ratio) 4
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Relative Valuation Measures
P/E Based on Fundamentals: Example
You expect a firm to pay out 30% of its earnings as dividends.
Earnings and dividends are expected to grow at a constant rate
of 6%. If you require a 13% return on the stock, what is the
stock’s expected P/E ratio?
P0 D1 / E1 0.30
= = = 4.3 ×
E1 k–g 0.13 – 0.06
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Relative Valuation Measures
Interpretation of P/E
Company Industry Average
Dividend payout ratio 25% 16%
Sales growth 7.5% 3.9%
Total debt to equity 113% 68%
Which of these factors support the company having a higher P/E than
the industry?
Higher payout ratio → higher P/E
Higher sales growth → higher dividend growth → higher P/E
Higher debt → higher risk → higher required return → lower P/E
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Relative Valuation Measures
Price Multiples
P/E = stock price / earnings per share
P/S = stock price / sales per share
P/B = stock price / book value per share
P/CF = stock price / cash flow per share, where
cash flow = operating cash flow or free cash flow
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Relative Valuation Measures
Using Price Multiple Comparables
Based on the law of one price: two comparable assets
should sell for the same multiple
P/E, P/S, P/B, or P/CF ratio lower than industry average or
comparable stock suggests stock is undervalued
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Relative Valuation Measures
Price Multiples: Example
20X3 20X2 20X1
Total shareholders’ equity $55,600,000 $54,100,000 $52,600,000
Net revenues $77,300,000 $73,600,000 $70,800,000
Net income $3,200,000 $1,100,000 $400,000
Cash flow from operations $17,900,000 $15,200,000 $12,200,000
Stock price $11.40 $14.40 $12.05
Shares outstanding 4,476,000 3,994,000 3,823,000
1. Calculate P/E, P/CF, P/S, and P/BV for the company.
First state E, CF, S, and BV on a per-share basis.
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Relative Valuation Measures
Price Multiples: Solution
20X3 20X2 20X1
Equity per share $12.42 $13.55 $13.76
Net revenues per share $17.27 $18.43 $18.52
Net income per share $0.71 $0.28 $0.10
CFO per share $4.00 $3.81 $3.19
Stock price $11.40 $14.40 $12.05
Shares outstanding 4,476,000 3,994,000 3,823,000
Next, calculate ratios to share price.
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Relative Valuation Measures
Price Multiples: Solution
Industry Average 20X3 20X2 20X1
Price / book value 3.6 0.9 1.1 0.9
Price / sales 1.4 0.7 0.8 0.7
Price / earnings 8.6 16.1 51.4 120.5
Price / cash flow 4.6 2.9 3.8 3.8
Stock price $11.40 $14.40 $12.05
2. Compare to 20X3 industry averages and determine whether the
firm is undervalued or overvalued.
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Relative Valuation Measures
Price Multiples: Solution
Industry Average 20X3
Price / book value 3.6 0.9 Undervalued
Price / sales 1.4 0.7 Undervalued
Price / earnings 8.6 16.1 Overvalued
Price / cash flow 4.6 2.9 Undervalued
Stock price $11.40
The P/E ratio suggests an analyst should examine reasons why the
company’s earnings might be depressed (e.g., high depreciation,
taxes, interest expense).
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Relative Valuation Measures
Enterprise Value Multiple
enterprise value (EV)
EBITDA
EV = market value of common stock
+ market value of debt – cash and short-term investments
EV represents total market value of firm
EBITDA represents total earnings to both debt and equity
Useful when:
Firms have different capital structures
Earnings are negative, can’t use P/E ratio
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Relative Valuation Measures
EV / EBITDA Multiple: Example
Stock price $40.00
Shares outstanding 200,000
Market value of long-term debt $600,000
BV of long-term debt $900,000
BV of total debt and liabilities $2,100,000
Cash and marketable securities $250,000
EBITDA $1,000,000
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Relative Valuation Measures
EV / EBITDA Multiple: Solution
Step 1: Determine the market value of short-term debt and liabilities.
Assume book value = market value for short-term items
Market value of short-term debt estimated as:
BV of total debt – BV of long-term debt =
$2,100,000 – $900,000 = $1,200,000
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Relative Valuation Measures
EV / EBITDA Multiple: Solution
Step 2: Market value of total debt = market value of long-term
debt + short-term debt
= $600,000 + $1,200,000 = $1,800,000
Step 3: Market value of equity = stock price × number of shares
= $40 × 200,000 = $8,000,000
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Relative Valuation Measures
EV / EBITDA Multiple: Solution
Step 4: EV = debt + equity – cash
= $1,800,000 + $8,000,000 – $250,000
= $9,550,000
Step 5: EV / EBITDA
= $9,550,000 / $1,000,000 = 9.6 ×
Step 6: Compare to competitor or industry average; low
values indicate underpriced
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Relative Valuation Measures
Asset-Based Models
Equity equals market or fair value of assets minus liabilities.
Analysts usually adjust asset book values to market values.
Asset-based valuation models provide a floor value.
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Relative Valuation Measures
Asset-Based Models: Example
A firm has 2,000 shares outstanding. The market value of net
fixed assets is 120% of book value.
Cash $10,000 Accounts payable $5,000
Accounts receivable 20,000 Notes payable 30,000
Inventories 50,000 Term loans 45,000
Net fixed assets 120,000 Common equity 120,000
Total assets $200,000 Liabilities + equity $200,000
Assuming market value equals book value for liabilities and
short-term assets, calculate the net assets per share.
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Relative Valuation Measures
Asset-Based Models: Solution
Market value of assets:
10,000 + 20,000 + 50,000 + 1.2(120,000) = $224,000
Market value of liabilities:
5,000 + 30,000 + 45,000 = $80,000
Adjusted equity value:
224,000 – 80,000 = $144,000
Adjusted equity value per share:
144,000 / 2,000 = $72
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Relative Valuation Measures
Present Value Models
Advantages
Theoretically sound
Widely accepted
Disadvantages
Inputs must be estimated
Valuation can be very sensitive to input values
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Relative Valuation Measures
Multiplier Models
Advantages
Widely used, associated with stock returns
Easily calculated and readily available
Good for identifying attractive companies
Useful for time series analysis or cross-sectional analysis
Disadvantages
Differences in accounting methods, comparisons
Multiples for cyclical companies highly variable
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Relative Valuation Measures
Asset-Based Models
Advantages
Can provide floor values
Useful for firm with mostly tangible short-term assets or if
firm is to be liquidated
Disadvantages
Ongoing firm value may be greater than asset value
Fair values of assets can be difficult to estimate, especially
with primarily intangible assets, inflation
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Relative Valuation Measures
Choice of Valuation Model
The model should be chosen based on available inputs.
The model should be chosen based on the intended use
of the valuation.
More complexity is not necessarily better.
Consider values using more than one method.
Consider uncertainty about input values.
Consider uncertainty about model appropriateness.
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