Relative Valuation

Three essential steps in relative valuation:

1. finding comparable assets that are priced by the market
2. scaling the market prices to a common variable to generate standardized prices that are comparable
3. adjusting for differences across assets when comparing their standardized values

Multiples:

• Earnings Multiple: Price/Earnings ratio, alternatively, EBIT and EBITDA can also be used to replace Earnings.

  Variations in Price - current price; average price over the last six months or a year

  Variations in Earnings - EPS from the most recent financial year (current P/E); the last four quarters of earnings (trailing P/E); expected EPS in the next financial year (forward P/E). EPS can be computed based on primary shares outstanding or fully diluted shares or include or exclude extraordinary items.

  One of the problems with using the current P/E to compare firms in a group is that different firms can have different fiscal year ends.

• Book Value: Stock Price/Book Value of equity (net worth)
• The ratio of the market value of the firm to replacement cost is called Tobin's Q
• Revenue Multiples: price/sales ratio
• Enterprise value-to-sales ratio: The numerator becomes the market value of the operating assets of the firm.

Enterprise Value is the sum of the market values of debt and equity, net of cash.

• Companies that use aggressive assumptions in measuring earnings will look cheaper on earning multiples than firms that adopt conservative accounting practices
• Every multiple is a function of three variables - risk, growth, and cash-flow-generating potential
• The PEG ratio, which is the ratio of the P/E to the expected growth rate in earnings of a a firm, is widely used to analyze high-growth firms.

Steps to use Multiples...

• ...to ensure that the multiple is defined consistently and that it is measured uniformly across the firms being compared
• ...to be aware of the cross-sectional distribution of the multiple, not only across firms in the sector being analyzed but also across the entire market
• ...to analyze the multiple and understand not only what fundamentals determine the multiple but also how changes in these fundamentals translate into changes in the multiple
• ...to find the right firms to use for comparison and controlling for differences that may persist across these firms

Fundamentals determining Equity Multiples:

P/E - Expected growth, Payout ratio, Equity risk

PEG - Expected growth, Payout ratio, Equity risk

Price/FCFE - Expected growth, risk

Price/BV of equity - Expected growth, Payout ratio, Equity risk, Return on equity

Price/sales - Expected growth, Payout ratio, Equity risk, net margin

(companion variable for each multiple is italicized)