READING 9

RELATIVE/MARKET BASED EQUITY VALUATION

04 September 2021 - 0800HRS – 0930HRS

WHAT DO YOU SEE? P/S =13X
Los a. Distinguish between the method of comparables and the method based on forecasted fundamentals as
approaches to using price multiples in valuation, and explain economic rationales for each approach.

 The method of comparables values a stock based on the average price multiple of the stock of similar
companies.

 The method of forecasted fundamentals values a stock based on the ratio of its value from a discounted
cash flow (DCF) model to some fundamental variable (e.g., earnings per share).
Los b. Calculate and interpret a justified price multiple.
Los c. Describe rationales for and possible drawbacks to using alternative price multiples and dividend yield in
valuation.
Los d. Calculate and interpret alternative price multiples and dividend yield.

 A justified price multiple is what the multiple should be if the stock is fairly valued. If the actual multiple is
greater than the justified price multiple, the stock is overvalued; if the actual multiple is less than the justified
multiple, the stock is undervalued (all else equal).

Price /Earnings Ratio

Reasons for..

 Earnings power, as measured by earnings per share (EPS), is the primary determinant of investment value.
 The P/E ratio is popular in the investment community.
 Empirical research shows that P/E differences are significantly related to long-run average stock returns.
Reasons Against.

 Earnings can be negative, which produces a meaningless P/E ratio.

 The volatile, transitory portion of earnings makes the interpretation of P/Es difficult for analysts.
 Management discretion within allowed accounting practices can distort reported earnings, and thereby lessen
the comparability of P/Es across firms.

Trailing and Leading P/E.

Trailing P/E uses earnings over the most recent 12 months in the denominator.
Leading P/E ratio (a.k.a. forward or prospective P/E) uses next year’s expected earnings, which is defined as
either expected earnings per share (EPS) for the next four quarters, or expected EPS for the next fiscal year.
P/B Ratio

Reasons for..

 Book value is a cumulative amount that is usually positive, even when the firm reports a loss and EPS is negative. Thus, a
P/B can typically be used when P/E cannot.

 Book value is more stable than EPS, so it may be more useful than P/E when EPS is particularly high, low, or volatile.

 Book value is an appropriate measure of net asset value for firms that primarily hold liquid assets. Examples include
finance, investment, insurance, and banking firms.

 P/B can be useful in valuing companies that are expected to go out of business.

 Empirical research shows that P/Bs help explain differences in long-run average stock returns.
P/B Ratio

Reasons Against..
 P/Bs do not reflect the value of intangible economic assets, such as human capital.

 P/Bs can be misleading when there are significant differences in the asset size of the firms under consideration because in
some cases the firm’s business model dictates the size of its asset base.

 Different accounting conventions can obscure the true investment in the firm made by shareholders, which reduces the
comparability of P/Bs across firms and countries.

 Inflation and technological change can cause the book and market values of assets to differ significantly, so book value is
not an accurate measure of the value of shareholders’ investment. This makes it more difficult to compare P/Bs across
firms.
 We often make adjustments to book value to create more useful comparisons of P/B ratios across different
stocks.

 A common adjustment is to use tangible book value, which is equal to book value of equity less intangible
assets.
P/S Ratio

Reasons for..

 P/S is meaningful even for distressed firms, since sales revenue is always positive. This is not the case for
P/E and P/B ratios, which can be negative.

 Sales revenue is not as easy to manipulate or distort as EPS and book value, which are significantly
affected by accounting conventions.

 P/S ratios are not as volatile as P/E multiples.

 P/S ratios are particularly appropriate for valuing stocks in mature or cyclical industries and start-up
companies with no record of earnings. It is also often used to value investment management companies and
partnerships.

 Like P/E and P/B ratios, empirical research finds that differences in P/S are significantly related to
differences in long-run average stock returns.
P/S Ratio

Reasons against..

 High growth in sales does not necessarily indicate high operating profits as measured by earnings and cash
flow.

 P/S ratios do not capture differences in cost structures across companies.

 While less subject to distortion, revenue recognition practices can still distort sales forecasts. For example,
analysts should look for company practices that speed up revenue recognition. An example is sales on a bill-
and-hold basis, which involves selling products and delivering them at a later date. This practice accelerates
sales into an earlier reporting period and distorts the P/S ratio.
P/CF Ratio

Reasons for..

 Cash flow is harder for managers to manipulate than earnings.

 Price to cash flow is more stable than price to earnings.

 Reliance on cash flow rather than earnings handles the problem of differences in the quality of reported
earnings, which is a problem for P/E.

 Empirical evidence indicates that differences in price to cash flow are significantly related to differences in
long-run average stock returns.
P/CF Ratio

Reasons against.

 Items affecting actual cash flow from operations are ignored when the EPS plus noncash charges estimate is
used. For example, noncash revenue and net changes in working capital are ignored.

 From a theoretical perspective, free cash flow to equity (FCFE) is preferable to operating cash flow.
However, FCFE is more volatile than operating cash flow, so it is not necessarily more informative.
Dividend Yield

The dividend yield (D/P) is the ratio of the common dividend to the market price. It is most often used for
valuing indexes.

Reasons for…

 Dividend yield contributes to total investment return.

 Dividends are not as risky as the capital appreciation component of total return.

Reasons against…

 The focus on dividend yield is incomplete because it ignores capital appreciation.

 The dividend displacement of earnings concept argues that dividends paid now displace future earnings,
which implies a trade-off between current and future cash flows.
Los e. Calculate and interpret underlying earnings, explain methods of normalizing earnings per share (EPS),
and calculate normalized EPS.

 Estimating market price is easy

 Underlying earnings (a.k.a. persistent, continuing, or core earnings),– not easy to estimate.

 Analysts generally use diluted EPS, so that the effect of any dilutive securities is taken into account.

 Earnings contain a transitory portion that is due to cyclicality. While viewed as currently transitory, business
cycles are expected to repeat over the long term.

 The countercyclical tendency to have high P/Es due to lower EPS at the bottom of the cycle and low P/Es
due to high EPS at the top of the cycle is known as the Molodovsky effect.
Normalized Earnings

 Analysts adjust P/Es for cyclicality by estimating normalized (or normal) earnings per share, which is an
estimate of EPS in the middle of the business cycle. The following two methods are used to normalize
earnings:

1. Under the method of historical average EPS, the normalized EPS is estimated as the average EPS over
some recent period.

2. Under the method of average return on equity, normalized EPS is estimated as the average return on
equity (ROE) multiplied by the current book value per share (BVPS).

The method of historical average EPS ignores size effects, so the method of average ROE is preferred.
Los f. Explain and justify the use of earnings yield (E/P).

 Negative earnings render P/E ratios meaningless.

 It is common to use normalized EPS and/or restate the ratio as the earnings yield (E/P) because price is
never negative.

 A high E/P suggests a cheap security, and a low E/P suggests an expensive security, so securities can be
ranked from cheap to expensive based on E/P ratios.
Los g. Describe fundamental factors that influence alternative price multiples and dividend yield.

Los h. Calculate and interpret the justified price-to-earnings ratio (P/E), price-to-book ratio (P/B), and price-to-
sales ratio (P/S) for a stock, based on forecasted fundamentals.

Justified P/E Multiple

 The justified P/E price multiple is a P/E ratio with the “P” in the numerator equal to the fundamental value
derived from a valuation model.

 The best way to analyse the fundamental factors that affect the P/E ratio is to use the single-stage Gordon
growth model:
We can conclude that

 The fundamental factors that affect P/E are expected growth rate
and required return (which is related to risk).

 The justified P/E ratio is: Positively related to the growth rate of
expected cash flows, whether defined as dividends or free cash
flows, all else equal.

 Inversely related to the stock’s required rate of return, all else

equal.
Justified P/B Multiple

Using the sustainable growth relation of g = ROE × b and observing that E1 = B0 × ROE, we can also derive
the justified P/B from the Gordon growth model as:

We can draw two useful conclusions from this formula concerning the fundamentals that influence the P/B ratio:

 P/B increases as ROE increases, all else equal.

 The larger the spread between ROE and r, all else equal, the higher the P/B ratio.

 This makes sense if you remember that ROE is the return on the firm’s investment projects and r is the
required return. The larger the spread, all else equal, the more value the firm is creating through its
investment activities and the higher its market value as represented by V0.
Justified P/S Multiple

Since net profit margin (PM0) is equal to E0/S0, we can also restate the Gordon growth model as:

Net profit margin (E0/S0) thus influences P/S directly as well as indirectly through its effect on the
sustainable growth rate, g:
This means that the P/S ratio will increase, all else equal, if:

 Profit margin increases.

 Earnings growth rate increases.

We can also do a little algebra and solve for P/S as a function of trailing P/E, which might be an easier formula to
remember.
Justified P/CF Multiple

 The justified price to cash flow based on fundamentals can be calculated by finding the value of the
stock using a DCF model and dividing the result by the chosen measure of cash flow.
 For example, equity value using the single-stage FCFE model is;

P/CF will increase, all else equal, if:

 Required return decreases.

 Growth rate increases.
Justified EV/EBITDA Multiple

The justified EV/EBITDA based on fundamentals is simply the enterprise value based on a forecast of
fundamentals divided by EBITDA forecast based on fundamentals. The ratio is:

 Positively related to the growth rate in FCFF and EBITDA.

 Negatively related to the firm’s overall risk level and weighted average cost of capital (WACC).

Justified Dividend Yield

The dividend yield relative to fundamentals may be expressed in terms of the Gordon growth model as:

Dividend yield is:

 Positively related to the required rate of return.

 Negatively related to the forecasted growth rate in dividends. This implies that choosing high dividend yield
stocks reflects a value rather than a growth investment strategy.
Los i. Calculate and interpret a predicted P/E, given a cross-sectional regression on fundamentals, and explain
limitations to the cross-sectional regression methodology.

 A predicted P/E can be estimated from linear regression of historical P/Es on its fundamental variables,
including expected growth and risk.

Limitations

 The predictive power of the estimated P/E regression for a different time period and/or sample of stocks is
uncertain.

 The relationships between P/E and the fundamental variables examined may change over time.

 Multicollinearity is often a problem in these time series regressions, which makes it difficult to interpret
individual regression coefficients
Los j. Evaluate a stock by the method of comparables and explain the importance of fundamentals in using the
method of comparables.

Example = P/E of our stock is less than the benchmark.

There are (at least) three possible explanations for this:

 The stock is undervalued.

 The stock is properly valued, but the stock has a lower expected growth rate than the benchmark, which leads
to a lower P/E.
 The stock is properly valued, but it has a higher required rate of return (higher risk) than the benchmark, which
leads to a lower P/E.

….Remember that justified P/E is positively related to growth rates and negatively related to required rate of return and
risk…

..make sure that the stock is comparable to the benchmark; it should have similar expected growth and similar
risk…
Los k. Calculate and interpret the P/E-to-growth ratio (PEG) and explain its use in relative valuation.

The relationship between earnings growth and P/E is captured by the P/E-to-growth

(PEG) ratio:

 The PEG is interpreted as P/E per unit of expected growth.

 Remember that the growth rate is one of the fundamental factors that affect P/E (P/E is directly related to the
growth rate).

The PEG ratio, in effect, “standardizes” the P/E ratio for stocks with different expected growth rates. The implied
valuation rule is that stocks with lower PEGs are more attractive than stocks with higher PEGs, assuming that
risk is similar.
There are a number of drawbacks to using the PEG ratio:

 The relationship between P/E and g is not linear, which makes comparisons difficult.

 The PEG ratio still doesn’t account for risk.

 The PEG ratio doesn’t reflect the duration of the high-growth period for a multistage valuation model,
especially if the analyst uses a short-term high-growth forecast.
Los l. Calculate and explain the use of price multiples in determining terminal value in a multistage discounted
cash flow (DCF) model.

 A terminal value that is projected as of the end of the investment horizon should reflect the earnings growth
that a firm can sustain over the long run, beyond that point in time.

a) Based on fundamentals

 The terminal price multiple based on fundamentals is the product of the justified price multiple and an
estimate of the fundamental value.

terminal value in year n = (justified leading P/E ratio) × (forecasted earnings in year n + 1)
terminal value in year n = (justified trailing P/E ratio) × (forecasted earnings in year n)

b) based on comparables

terminal value in year n = (benchmark leading P/E ratio) × (forecasted earnings in year n + 1)
terminal value in year n = (benchmark trailing P/E ratio) × (forecasted earnings in year n)
Los m. Explain alternative definitions of cash flow used in price and enterprise value (EV) multiples and describe
limitations of each definition.

P/CF

 earnings-plus-noncash-charges (CF);
 ignores some items that affect cash flow, such as noncash revenue and changes in net working capital

 adjusted cash flow (adjusted CFO);

 care should be taken when comparing firms reporting under different standards

 free cash flow to equity (FCFE);

 it is more volatile than straight cash flow.

 earnings before interest, taxes, depreciation, and amortization (EBITDA).

Los n. Calculate and interpret EV multiples and evaluate the use of EV/EBITDA

 Because EBITDA is a flow to both equity and debt, it should be related to a numerator that measures
total company value.

Enterprise value (EV) is total company value:

 EV = market value of common stock + market value of preferred equity + market value of debt +
minority interest – cash and investments

 The rationale for subtracting cash and investments is that an acquirer’s net price paid for an
acquisition target would be lowered by the amount of the target’s liquid assets.

 Thus, EV/EBITDA indicates the value of the overall company, not equity.

 EV/EBITDA is the ratio of enterprise value to EBITDA:

EV/EBITDA is useful in a number of situations:

 The ratio may be more useful than P/E when comparing firms with different degrees of financial
leverage.
 EBITDA is useful for valuing capital-intensive businesses with high levels of depreciation and
amortization.
 EBITDA is usually positive even when EPS is not.

Drawbacks,

 If working capital is growing, EBITDA will overstate CFO. Further, the measure ignores how different
revenue recognition policies affect CFO.

 Because FCFF captures the amount of capital expenditures, it is more strongly linked with valuation
theory than EBITDA. EBITDA will be an adequate measure if capital expenses equal depreciation
expenses.
EXAMPLE

An analyst gathered the following data for Boulevard Industries [all amounts in Swiss francs (Sf)]:

Recent share price Sf 22.50

Shares outstanding 40 million
Market value of debt Sf 137 million
Cash and marketable securities Sf 62.3 million
Investments Sf 327 million
Net income Sf 137.5 million
Interest expense Sf 6.9 million
Depreciation and amortization Sf 10.4 million
Taxes Sf 95.9 million

Based on this information, calculate the EV/EBITDA ratio for Boulevard Industries.
Los o. Explain sources of differences in cross-border valuation comparisons.

 Differences in accounting methods,

 Cultures,
 Risk,
 growth opportunities

 P/Es for individual firms in the same industry vary widely internationally and country market P/Es can vary
significantly
Los p. Describe momentum indicators and their use in valuation.

 Momentum indicators relate either the market price or a fundamental variable like EPS to the time series
of historical or expected value.

 Common momentum indicators include earnings surprise, standardized unexpected earnings, and relative
strength.

 Unexpected earnings or earnings surprise is the difference between reported earnings and expected
earnings.

 The economic rationale for examining earnings surprises is that positive surprises may lead to persistent
positive abnormal returns.
Los q. Explain the use of the arithmetic mean, the harmonic mean, the weighted harmonic mean, and the
median to describe the central tendency of a group of multiples.

 The price-to-earnings multiple for a stock index is not equal to the mean or weighted mean of the P/Es of the
portfolio stocks.

 The portfolio or index P/E is best calculated as the weighted harmonic mean P/E. With the P/Es denoted by
X and the weights as w, we have:

Consider two stocks: one priced at $10 with earnings of $1 per share (P/E = 10) and one priced at $16 with
earnings of $2 (P/E = 8).
 Arithmetic mean = (8 + 10) / 2 = 9

 Weighted mean = (10 / 26) × 10 + (16 / 26) × 8 = 8.76

 The harmonic mean puts more weight on smaller values.

 When there are extreme (high or low) outliers, the arithmetic mean will be the most affected.
 For an equal weighted portfolio or index, the harmonic mean and weighted harmonic mean will be
equal.
1. Sabrina Valentine, CFA, has gathered 2. Which of the following investment strategies is most
the following data for Carolina Steel, Inc. consistent with choosing high
(CSI): dividend yield stocks?
A. Growth.
Recent share price $29.25 B. Momentum.
Shares outstanding 30 million C. Value.
Market value of debt $115 million
Cash and marketable securities $47.6 million
Investments $247 million
Net income $119.4 million
Interest expense $5.8 million
Depreciation $6.9 million
Amortization $2.3 million
Taxes $85.9 million

The EV/EBITDA ratio for CSI is closest to:

A. 3.44.
B. 4.26.
C. 4.78.