Relative Valuation
The relative valuation methods allow us to determine the value of an investment by
comparing it to similar entities.
The most common relative valuation ratios include-
Price/Earnings (P/E),
Price/Book (P/B),
Price/Sales (P/S), and
Price/Cash Flow (P/CF).
To estimate value of an investment we first determine these ratios based on averages of
comparable firms.
Second, we multiply the comparable ratios with the earnings per share, book value per share,
cash flow per share, and sales per share of the subject investment to get its value.
The implied assumption is that the investment that we value should have the same multiplier
as the comparable investments.
Price Earnings Ratio Formula
P/E = Stock Price Per Share / Earnings Per Share
or
P/E = Market Capitalization / Total Net Earnings
or
Justified P/E = Dividend Pay-out Ratio / Ke – G
Investors want to buy financially sound companies that offer a good return on investment
(ROI). Among the many ratios, the P/E is part of the research process for selecting stocks,
because we can figure out whether we are paying a fair price. Similar companies within the
same industry are grouped together for comparison, regardless of the varying stock
prices. Moreover, it’s quick and easy to use when we’re trying to value a company using
earnings. When a high or a low P/E is found, we can quickly assess what kind of stock or
company we are dealing with.
High P/E
Companies with a high Price Earnings Ratio are often considered to be growth stocks. This
indicates a positive future performance, and investors have higher expectations for future
earnings growth and are willing to pay more for them. The downside to this is that growth
stocks are often higher in volatility and this puts a lot of pressure on companies to do more to
justify their higher valuation. For this reason, investing in growth stocks will more likely be
seen as a risky investment. Stocks with high P/E ratios can also be considered overvalued.
Low P/E
Companies with a low Price Earnings Ratio are often considered to be value stocks. It means
they are undervalued because their stock price trade lower relative to its fundamentals. This
mispricing will be a great bargain and will prompt investors to buy the stock before the
market corrects it. And when it does, investors make a profit as a result of a higher stock
price. Examples of low P/E stocks can be found in mature industries that pay a steady rate
of dividends.
Justified P/E Ratio
The justified P/E ratio above is calculated independently of the standard P/E. In other words,
the two ratios should produce two different results. If the P/E is lower than the justified P/E
ratio, the company is undervalued and purchasing the stock will result in profits if the alpha is
closed
Price to Book ratio (P/B ratio)
The price to book ratio, also called the P/B or market to book ratio, is a financial valuation
tool used to evaluate whether the stock a company is over or undervalued by comparing the
price of all outstanding shares with the net assets of the company. In other words, it’s a
calculation that measures the difference between the book value and the total share price of
the company.
This comparison demonstrates the difference between the market value and book value of a
company. The market value equals the current stock price of all outstanding shares. This is
the price that the market thinks the company is worth. The book value, on the other hand,
comes from the balance sheet. It equals the net assets of the company.
The Market to Book formula is:
Market Capitalization / Net Book Value
or
Share Price / Net Book Value per Share
where,
Net Book Value = Total Assets – Total Liabilities
Price to Sales (P/S) ratio
The price to sales ratio is one of the easiest ways to understand the valuation of a company,
as it helps investors know how much they are truly paying for the company. The main
operation in any business is to generate revenue from the sale of goods and services, and the
P/S ratio provides the valuation based on the operations of the company without any
accounting adjustments.
The price-to-sales ratio (Price/Sales or P/S) is calculated by taking a company's market
capitalization (the number of outstanding shares multiplied by the share price) and divide it
by the company's total sales or revenue over the past 12 months.
The lower the P/S ratio, the more attractive the investment
Enterprise Value (EV)
Enterprise Value (EV) is the measure of a company’s total value. It looks at the entire market
value rather than just the equity value, so all ownership interests and asset claims from both
debt and equity are included. EV can be thought of as the effective cost of buying a company
or the theoretical price of a target company (before a takeover premium is considered).
The simple formula for enterprise value is:
EV = Market Capitalization + Market Value of Debt – Cash and Equivalents
The extended formula is:
EV = Common Shares + Preferred Shares + Market Value of Debt + Minority Interest
– Cash and Equivalents
Important multiples of Enterprise Value
Problem-1
Asha Ltd. reported Rs. 250 crores in Total Assets and Rs. 140 crore in debt. In the Income
Statement, it reported Rs. 560 crores in sales, the firm has 80 crore shares outstanding at Rs. 7
each. Find out P/B ratio and P/S ratio
Problem-2
International Business Machines has 1.83 billion shares outstanding trading at Rs. 125 per
share. Its Price-Book value ratio was Rs. 12.10. Its Debt-equity ration was 76%. Current
liabilities is Rs 0. How much long term debt did IBM have?
Problem-3
Ceat tyre share traded at 3.5 times of sales. It was reported a net profit margin on sales of
9.9%. What was its P/E ratio?
Problem-4
A company has an equity market value of Rs. 100 million. It reported earning of Rs. 5 million
and book value of Rs. 50 million. The firm is being used as comparable to price an IPO firm
with earning per share of Rs. 2.50 and book value per share is Rs. 30. What should be the
value of the IPO firm.
Problem-5
Problem-6
Problem-7
The following information is provided to you for the purpose of valuation.
Balance Sheet
Current Assets:
Cash 4060
Accounts Receivables 1700
Inventories 1197
Other Current Assets 383 7340
Non Current Assets
Property, Plant & Equipments 3803
Intengible Assets 2610
Other Non-Current Assets 174 6587
Total Assets 13927
Share Capital 2380
Reserves 6043
Current Liabilities
Accounts Payables 2037
Accrued Expenses 959 2996
Long-term Debts 2013
Other Long-term liabilitites 495
Total Liabilities 13927
Details of Income
Net Income 1990
Interest 41
Income Tax 264
Depreciation 1270
Calculate EV/EBITDA assuming that share price of the company is Rs 63.06