Relative Valuation

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RELATIVE VALUATION

FI 640

Dr. Alok Nemani

RELATIVE VALUATION

▪ In relative valuation, the value of an asset is compared to the

values assessed by the market for similar assets.

▪ Can’t catch market trends. Assumes market is on average

efficient.

CONDUCTING RELATIVE VALUATION

▪ Identify similar assets and obtain market values for these

assets.

▪ Convert these market values into standardized values or

multiples, since the absolute prices cannot be compared.

▪ Multiples for both the assets should be estimated in a

consistent manner (such as accounting rules, periods, ratio

definition etc.)

▪ Compare the multiple for the asset being analyzed to the

multiple for the comparable asset, controlling for any

differences between the firms that might affect the multiple

(example: size, growth rate, profitability etc.).

FINDING THE RIGHT MULTIPLE

➢What is the right value of a multiple?

I. Compare the current multiple of the company to its

own historical multiple.

▪ Measured at a comparable point in the business cycle

and macroeconomic environment

II. Compare current multiples to those of other

companies, a sector or a market.

▪ Adjust the multiple for differences in growth, profitability,

lifecycle, dividends, risk profile etc.

▪ Compare the current spread between them to a historical

spread.

PE RATIO

▪ Price-to-earnings (PE ratio): stock price divided by EPS

❑ Price: usually the current stock price

❑ EPS is earnings per share

❑ EPS can be of different types.

• Most recent EPS

• Trailing PE: last 12-month EPS

• Forward PE: next 12-month EPS

PE RATIO

▪ All else equal, high PE ratio firms are overvalued compared to low

PE stocks. But,

▪ All else is seldom equal.

❑ Firms with high growth, high ROE, low risk (stable earnings), high

dividends typically command high PE ratio.

❑ Determine expected PE ratio using comparable asset and multiply it by

correct EPS to get expected intrinsic value.

▪ Getting the right PE ratio:

❑ Examine past (3-5 year) ratios : Highest PE ratio may be used for best

case, average for base case, lowest for worst case. Assign probability

based on market condition i.e., GDP growth, inflation, interest rates.

❑ Adjust for historic spreads

❑ Regress firm’s PE ratio on industry or competitor PE ratio to predict the

PE ratio.

PEG RATIO

▪ PE ratio is higher for high growth firms.

▪ To reconcile high P/E valuation for high growth firms, the

PEG ratio was developed.

▪ It is the ratio of price multiple to the EPS growth rate.

▪ 𝑃𝐸𝐺 = ൗ𝑃/𝐸 𝑔, g is expected earnings growth rate

▪ Allows identification of overvalued stocks by adjusting for

growth.

IS PEG SUPERIOR TO P/E?

▪ PEG is more appropriate for high growth firms.

▪ P/E is more appropriate for stable companies.

▪ The main issue is the quality of the growth estimate.

▪ We know that analysts have consistently over-estimated

EPS growth.

▪ PEG is not better or worse than P/E. It is just a different

valuation measure.

EV-TO-EBITDA RATIO

▪ Economic value to EBITDA

▪ EV (economic value) = market value of equity + market value of

debt (take book value of market value not available) - cash.

▪ EBITDA: earnings before interest, taxes, and depreciation

▪ Intuition is similar to PE. Firms with high growth, high ROE, low

risk (stable earnings) typically command high multiple.

▪ Firms with high debt (not distressed) commands higher multiple

due to low cost of capital.

▪ EV/EBITDA analysis provides firm value.

▪ EV/EBITDA is preferred for capital intensive and high leverage

businesses.

PRICE-TO-BOOK RATIO

▪ Price/Book Value = Market Value of Equity / Book Value of Equity

❑ Market value of equity = share price * # shares outstanding

❑ Book value of equity = shareholders’ equity in the balance sheet

▪ High ROE firms typically trade at a higher multiple.

▪ Good for capital intensive businesses.

❑ Examples: Energy companies, Financial services and banks, Transportation companies, manufacturing companies.

▪ Can be used for cyclical businesses.

▪ Should not be used for firms with volatile capital structure or firms with negative equity.

PRICE-TO-SALES RATIO

❑ Price/ Sales= Market Value of Equity/Total Revenues

❑ Price = PS ratio * sales

❑ Sales are generally less subject to distortion or manipulation

than EPS or book value.

❑ Sales are positive when EPS is negative.

❑ Because sales are more stable than EPS, PS is generally more

stable than PE.

❑ PS is appropriate for valuing the equities of growth companies

yet to turn profitable, firms with temporary setback and when

sales is the most important metric.

❑ Since it does not account for capex or debt, should be used for

companies for which debt ratios or capex is stable.

CHOOSING THE RIGHT METHODOLOGY

▪ How to determine the right value given there are numerous

multiples?

▪ First approach:

❑ Use simple average of stock price calculated using different multiples.

❑ Use weighted average of stock price calculated using different multiples.

▪ A better approach:

❑ Determine the right multiple for your company and use it for valuation.

❑ Right multiple depends on business dynamics (industry), value drivers

CHOOSING MULTIPLES

4-13

Sector Right Multiple

Cyclical

Manufacturing - for stable & low leverage

Manufacturing - for high leverage

High Tech, Normal growth

High Tech, High growth

Heavy Infrastructure

Financial services

Retail - for stable & low leverage

Retail - for high leverage

CHOOSING MULTIPLES

4-14

Sector Right Multiple

Cyclical PB

Manufacturing - for stable & low leverage PE, PB, EV/EBITDA

Manufacturing - for high leverage EV/EBITDA, PB

High Tech, Normal growth PE

High Tech, High growth PEG

Heavy Infrastructure EV/EBITDA, PB

Financial services Price to Book

Retail - for stable & low leverage PE, PS

Retail - for high leverage EV to sales

NICE THOUGHTS

▪ The P/E ratio is only a reflection of what most investors expect to

happen at a point in time, and that is neither here nor there in terms

of what actually will happen.” Peter Bernstein

▪ “Just because something is cheap does not mean it is not going to

go down.” Warren Buffett

▪ “There is nothing at all conservative, in my opinion, about

speculating as to just how high a multiplier a greedy and capricious

public will put on earnings.” Warren Buffett

THANK YOU

Slide 1: Relative valuation
Slide 2: Relative valuation
Slide 3: Conducting Relative valuation
Slide 4: Finding the right multiple
Slide 5: PE ratio
Slide 6: PE ratio
Slide 7: PEG ratio
Slide 8: IS PEG Superior to P/E?
Slide 9: EV-to-EBITDA ratio
Slide 10: Price-to-book ratio
Slide 11: Price-to-sales ratio
Slide 12: Choosing the right methodology
Slide 13: Choosing Multiples
Slide 14: Choosing Multiples
Slide 15: Nice thoughts
Slide 16