Damodaran On Relval

Equity Instruments & Markets: Part II
B40.3331
Relative Valuation
Aswath Damodaran
Aswath Damodaran 1
Why relative valuation?
“If you think I’m crazy, you should see the guy who lives across the hall”
Jerry Seinfeld talking about Kramer in a Seinfeld episode
“ A little inaccuracy sometimes saves tons of explanation”

H.H. Munro
Aswath Damodaran 2
What is relative valuation?
n In relative valuation, the value of an asset is compared to the values

assessed by the market for similar or comparable assets.
n To do relative valuation then,
• we need to identify comparable assets and obtain market values for these
assets
• convert these market values into standardized values, since the absolute
prices cannot be compared This process of standardizing creates price
multiples.
• compare the standardized value or multiple for the asset being analyzed to
the standardized values for comparable asset, controlling for any
differences between the firms that might affect the multiple, to judge
whether the asset is under or over valued
Aswath Damodaran 3
Standardizing Value
n Prices can be standardized using a common variable such as earnings,

cashflows, book value or revenues.
• Earnings Multiples
– Price/Earnings Ratio (PE) and variants (PEG and Relative PE)
– Value/EBIT
– Value/EBITDA
– Value/Cash Flow
• Book Value Multiples
– Price/Book Value(of Equity) (PBV)
– Value/ Book Value of Assets
– Value/Replacement Cost (Tobin’s Q)
• Revenues
– Price/Sales per Share (PS)
– Value/Sales
• Industry Specific Variable (Price/kwh, Price per ton of steel ....)
Aswath Damodaran 4
The Four Steps to Understanding Multiples
n Define the multiple

• In use, the same multiple can be defined in different ways by different
users. When comparing and using multiples, estimated by someone else, it
is critical that we understand how the multiples have been estimated
n Describe the multiple
• Too many people who use a multiple have no idea what its cross sectional
distribution is. If you do not know what the cross sectional distribution of
a multiple is, it is difficult to look at a number and pass judgment on
whether it is too high or low.
n Analyze the multiple
• It is critical that we understand the fundamentals that drive each multiple,
and the nature of the relationship between the multiple and each variable.
n Apply the multiple
• Defining the comparable universe and controlling for differences is far
more difficult in practice than it is in theory.
Aswath Damodaran 5
Definitional Tests
n Is the multiple consistently defined?

• Proposition 1: Both the value (the numerator) and the standardizing
variable ( the denominator) should be to the same claimholders in the
firm. In other words, the value of equity should be divided by equity
earnings or equity book value, and firm value should be divided by
firm earnings or book value.
n Is the multiple uniformally estimated?
• The variables used in defining the multiple should be estimated uniformly
across assets in the “comparable firm” list.
• If earnings-based multiples are used, the accounting rules to measure
earnings should be applied consistently across assets. The same rule
applies with book-value based multiples.
Aswath Damodaran 6
Descriptive Tests
n What is the average and standard deviation for this multiple, across the
universe (market)?
n What is the median for this multiple?
• The median for this multiple is often a more reliable comparison point.
n How large are the outliers to the distribution, and how do we deal with
the outliers?
• Throwing out the outliers may seem like an obvious solution, but if the
outliers all lie on one side of the distribution (they usually are large
positive numbers), this can lead to a biased estimate.
n Are there cases where the multiple cannot be estimated? Will ignoring
these cases lead to a biased estimate of the multiple?
n How has this multiple changed over time?
Aswath Damodaran 7
Analytical Tests
n What are the fundamentals that determine and drive these multiples?
• Proposition 2: Embedded in every multiple are all of the variables that
drive every discounted cash flow valuation - growth, risk and cash flow
patterns.
• In fact, using a simple discounted cash flow model and basic algebra
should yield the fundamentals that drive a multiple
n How do changes in these fundamentals change the multiple?
• The relationship between a fundamental (like growth) and a multiple
(such as PE) is seldom linear. For example, if firm A has twice the growth
rate of firm B, it will generally not trade at twice its PE ratio
• Proposition 3: It is impossible to properly compare firms on a
multiple, if we do not know the nature of the relationship between
fundamentals and the multiple.
Aswath Damodaran 8
Application Tests
n Given the firm that we are valuing, what is a “comparable” firm?

• While traditional analysis is built on the premise that firms in the same
sector are comparable firms, valuation theory would suggest that a
comparable firm is one which is similar to the one being analyzed in terms
of fundamentals.
• Proposition 4: There is no reason why a firm cannot be compared
with another firm in a very different business, if the two firms have
the same risk, growth and cash flow characteristics.
n Given the comparable firms, how do we adjust for differences across
firms on the fundamentals?
• Proposition 5: It is impossible to find an exactly identical firm to the
one you are valuing.
Aswath Damodaran 9
Price Earnings Ratio: Definition
PE = Market Price per Share / Earnings per Share

n There are a number of variants on the basic PE ratio in use. They are
based upon how the price and the earnings are defined.
n Price: is usually the current price
is sometimes the average price for the year
n EPS: earnings per share in most recent financial year
earnings per share in trailing 12 months (Trailing PE)
forecasted earnings per share next year (Forward PE)
forecasted earnings per share in future year
Aswath Damodaran 10
PE Ratio: Descriptive Statistics
Distribution of PE Ratios - September 2001
1200
1000
800
Number of firms
Current PE
600 Trailing PE
Forward PE
400
200
0
0-4 4-6 6-8 8 - 10 10 - 15 15-20 20-25 25-30 30-35 35-40 40 - 45 45- 50 50 -75 75 - > 100
100
PE ratio
Aswath Damodaran 11
PE: Deciphering the Distribution
Current PE Trailing PE Forward PE

Mean 30.93 30.33 21.13
Standard Error 2.70 2.74 0.73
Median 15.27 15.20 13.71
Mode 10 0 14
Standard Deviation 157.30 150.65 38.22
Kurtosis 795.82 1615.73 224.85
Skewness 26.28 36.04 12.97
Range 5370.00 7090.50 864.91
Maximum 5370.00 7090.50 865.00
Count 3387 3021 2737
Aswath Damodaran 12
PE Ratio: Understanding the Fundamentals
n To understand the fundamentals, start with a basic equity discounted

cash flow model.
n With the dividend discount model,
DPS1
P0 =
r − gn
n Dividing both sides by the earnings per share,

P0 Payout Ratio *(1 + g n )
= PE =
EPS 0 r - gn
n If this had been a FCFE Model,

FCFE 1
P0 =
r − gn
P0 (FCFE/Earnings)*(1 + g n )
= PE =
EPS0 r-g n
Aswath Damodaran 13
PE Ratio and Fundamentals
n Proposition: Other things held equal, higher growth firms will

have higher PE ratios than lower growth firms.
n Proposition: Other things held equal, higher risk firms will have
lower PE ratios than lower risk firms
n Proposition: Other things held equal, firms with lower
reinvestment needs will have higher PE ratios than firms with
higher reinvestment rates.
n Of course, other things are difficult to hold equal since high growth
firms, tend to have risk and high reinvestment rats.
Aswath Damodaran 14
Using the Fundamental Model to Estimate PE For a
High Growth Firm
n The price-earnings ratio for a high growth firm can also be related to
fundamentals. In the special case of the two-stage dividend discount
model, this relationship can be made explicit fairly simply:
 ( 1 +g)n 
) *1 −
EPS0 * P a y o u t R a t i o * ( 1g +
 ( 1 +r) n  EPS 0 *Payout Ration * ( 1 +g)n * ( 1 +g n )
P0 = +
r-g (r - gn )(1+r)n
• For a firm that does not pay what it can afford to in dividends, substitute
FCFE/Earnings for the payout ratio.
n Dividing both sides by the earnings per share:
 (1+ g )n 
Payout Ratio *(1 + g )*  1 − 
P0  (1+ r) n  Payout Ratio n * ( 1 + g )n *(1 + gn )
= +
EPS 0 r -g (r - g n )(1+ r) n
Aswath Damodaran 15
Expanding the Model
n In this model, the PE ratio for a high growth firm is a function of

growth, risk and payout, exactly the same variables that it was a
function of for the stable growth firm.
n The only difference is that these inputs have to be estimated for two
phases - the high growth phase and the stable growth phase.
n Expanding to more than two phases, say the three stage model, will
mean that risk, growth and cash flow patterns in each stage.
Aswath Damodaran 16
A Simple Example
n Assume that you have been asked to estimate the PE ratio for a firm
which has the following characteristics:
Variable High Growth Phase Stable Growth Phase
Expected Growth Rate 25% 8%
Payout Ratio 20% 50%
Beta 1.00 1.00
n Riskfree rate = T.Bond Rate = 6%
n Required rate of return = 6% + 1(5.5%)= 11.5%
 (1.25)5 
0 . 2 * (1.25) *  1− 5

 (1.115)  5
0.5 * (1.25) *(1.08)
PE = + = 28.75
(.115 - .25) (.115-.08) (1.115) 5
Aswath Damodaran 17
PE and Growth: Firm grows at x% for 5 years, 8%
thereafter
PE Ratios and Expected Growth: Interest Rate Scenarios
180
160
140
120
100 r=4%
PE Ratio
r=6%
r=8%
80 r=10%
60
40
20
0
5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
Expected Growth Rate
Aswath Damodaran 18
PE Ratios and Length of High Growth: 25% growth
for n years; 8% thereafter
PE Ratios and Length of High Growth Period
60
50
40
g=25%
PE Ratio
g=20%
30
g=15%
g=10%
20
10
0
0 1 2 3 4 5 6 7 8 9 10
Length of High Growth Period
Aswath Damodaran 19
PE and Risk: Effects of Changing Betas on PE
Ratio:
Firm with x% growth for 5 years; 8% thereafter
PE Ratios and Beta: Growth Scenarios
50
45
40
35
30
g=25%
PE Ratio
g=20%
25
g=15%
g=8%
20
15
10
0
0.75 1.00 1.25 1.50 1.75 2.00
Beta
Aswath Damodaran 20
PE and Payout
PE Ratios and Payour Ratios: Growth Scenarios
35
30
25
20 g=25%
g=20%
PE
g=15%
15 g=10%
10
0
0% 20% 40% 60% 80% 100%
Payout Ratio
Aswath Damodaran 21
PE: Emerging Markets
35
30
25
20
15
10
0
Mexico Malaysia Singapore Taiwan Hong Kong Venezuela Brazil Argentina Chile
Aswath Damodaran 22
Comparisons across countries
n In July 2000, a market strategist is making the argument that Brazil

and Venezuela are cheap relative to Chile, because they have much
lower PE ratios. Would you agree?
o Yes
o No
n What are some of the factors that may cause one market’s PE ratios to
be lower than another market’s PE?
Aswath Damodaran 23
A Comparison across countries: June 2000
Country PE Dividend Yield 2-yr rate 10-yr rate 10yr - 2yr

UK 22.02 2.59% 5.93% 5.85% -0.08%
Germany 26.33 1.88% 5.06% 5.32% 0.26%
France 29.04 1.34% 5.11% 5.48% 0.37%
Switzerland 19.6 1.42% 3.62% 3.83% 0.21%
Belgium 14.74 2.66% 5.15% 5.70% 0.55%
Italy 28.23 1.76% 5.27% 5.70% 0.43%
Sweden 32.39 1.11% 4.67% 5.26% 0.59%
Netherlands 21.1 2.07% 5.10% 5.47% 0.37%
Australia 21.69 3.12% 6.29% 6.25% -0.04%
Japan 52.25 0.71% 0.58% 1.85% 1.27%
US 25.14 1.10% 6.05% 5.85% -0.20%
Canada 26.14 0.99% 5.70% 5.77% 0.07%
Aswath Damodaran 24
Correlations and Regression of PE Ratios
n Correlations
• Correlation between PE ratio and long term interest rates = -0.733
• Correlation between PE ratio and yield spread = 0.706
n Regression Results
PE Ratio = 42.62 - 3.61 (10’yr rate) + 8.47 (10-yr - 2 yr rate) R2 = 59%
Input the interest rates as percent. For instance, the predicted PE ratio for
Japan with this regression would be:
PE: Japan = 42.62 - 3.61 (1.85) + 8.47 (1.27) = 46.70
At an actual PE ratio of 52.25, Japanese stocks are slightly overvalued.
Aswath Damodaran 25
Predicted PE Ratios
Country Actual PE Predicted PE Under or Over Valued

UK 22.02 20.83 5.71%
Germany 26.33 25.62 2.76%
France 29.04 25.98 11.80%
Switzerland 19.6 30.58 -35.90%
Belgium 14.74 26.71 -44.81%
Italy 28.23 25.69 9.89%
Sweden 32.39 28.63 13.12%
Netherlands 21.1 26.01 -18.88%
Australia 21.69 19.73 9.96%
Japan 52.25 46.70 11.89%
United States 25.14 19.81 26.88%
Canada 26.14 22.39 16.75%
Aswath Damodaran 26
An Example with Emerging Markets: June 2000
Country PE Ratio Interest GDP Real Country

Rates Growth Risk
Argentina 14 18.00% 2.50% 45
Brazil 21 14.00% 4.80% 35
Chile 25 9.50% 5.50% 15
Hong Kong 20 8.00% 6.00% 15
India 17 11.48% 4.20% 25
Indonesia 15 21.00% 4.00% 50
Malaysia 14 5.67% 3.00% 40
Mexico 19 11.50% 5.50% 30
Pakistan 14 19.00% 3.00% 45
Peru 15 18.00% 4.90% 50
Phillipines 15 17.00% 3.80% 45
Singapore 24 6.50% 5.20% 5
South Korea 21 10.00% 4.80% 25
Thailand 21 12.75% 5.50% 25
Turkey 12 25.00% 2.00% 35
Venezuela 20 15.00% 3.50% 45
Aswath Damodaran 27
Regression Results
n The regression of PE ratios on these variables provides the following –

PE = 16.16 - 7.94 Interest Rates
+ 154.40 Growth in GDP
- 0.1116 Country Risk
R Squared = 73%
Aswath Damodaran 28
Predicted PE Ratios
Country PE Ratio Interest GDP Real Country Predicted PE

Rates Growth Risk
Argentina 14 18.00% 2.50% 45 13.57
Brazil 21 14.00% 4.80% 35 18.55
Chile 25 9.50% 5.50% 15 22.22
Hong Kong 20 8.00% 6.00% 15 23.11
India 17 11.48% 4.20% 25 18.94
Indonesia 15 21.00% 4.00% 50 15.09
Malaysia 14 5.67% 3.00% 40 15.87
Mexico 19 11.50% 5.50% 30 20.39
Pakistan 14 19.00% 3.00% 45 14.26
Peru 15 18.00% 4.90% 50 16.71
Phillipines 15 17.00% 3.80% 45 15.65
Singapore 24 6.50% 5.20% 5 23.11
South Korea 21 10.00% 4.80% 25 19.98
Thailand 21 12.75% 5.50% 25 20.85
Turkey 12 25.00% 2.00% 35 13.35
Venezuela 20 15.00% 3.50% 45 15.35
Aswath Damodaran 29
Comparisons of PE across time: PE Ratio for the
S&P 500
PE Ratio: 1960-2000
35.00
30.00
25.00
20.00
15.00
10.00
5.00
0.00
60
62
64
66
68
70
72
74
76
78
80
82
84
86
88
90
92
94
96
98
00
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
Aswath Damodaran 30
Is low (high) PE cheap (expensive)?
n A market strategist argues that stocks are over priced because the PE
ratio today is too high relative to the average PE ratio across time. Do
you agree?
q Yes
q No
n If you do not agree, what factors might explain the higer PE ratio
today?
Aswath Damodaran 31
E/P Ratios , T.Bond Rates and Term Structure
16.00%
14.00%
12.00%
10.00%
8.00%
Earnings Yield
T.Bond Rate
Bond-Bill
6.00%
4.00%
2.00%
0.00%
60
62
64
66
68
70
72
74
76
78
80
82
84
86
88
90
92
94
96
98
00
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
-2.00%
Aswath Damodaran 32
Regression Results
n There is a strong positive relationship between E/P ratios and T.Bond

rates, as evidenced by the correlation of 0.685 between the two
variables.,
n In addition, there is evidence that the term structure also affects the PE
ratio.
n In the following regression, using 1960-2000 data, we regress E/P
ratios against the level of T.Bond rates and a term structure variable
(T.Bond - T.Bill rate)
E/P = 1 .88% + 0.776 T.Bond Rate - 0.407 (T.Bond Rate-T.Bill Rate)
(2.84) (6.08) (-2.37)
R squared = 50%
Aswath Damodaran 33
Estimate the E/P Ratio Today
n T. Bond Rate =
n T.Bond Rate - T.Bill Rate =
n Expected E/P Ratio =
n Expected PE Ratio =
Aswath Damodaran 34
Comparing PE ratios across firms
Company Name Trailing PE Expected Growth Standard Dev

Coca-Cola Bottling 29.18 9.50% 20.58%
Molson Inc. Ltd. 'A' 43.65 15.50% 21.88%
Anheuser-Busch 24.31 11.00% 22.92%
Corby Distilleries Ltd. 16.24 7.50% 23.66%
Chalone Wine Group Ltd. 21.76 14.00% 24.08%
Andres Wines Ltd. 'A' 8.96 3.50% 24.70%
Todhunter Int'l 8.94 3.00% 25.74%
Brown-Forman 'B' 10.07 11.50% 29.43%
Coors (Adolph) 'B' 23.02 10.00% 29.52%
PepsiCo, Inc. 33.00 10.50% 31.35%
Coca-Cola 44.33 19.00% 35.51%
Boston Beer 'A' 10.59 17.13% 39.58%
Whitman Corp. 25.19 11.50% 44.26%
Mondavi (Robert) 'A' 16.47 14.00% 45.84%
Coca-Cola Enterprises 37.14 27.00% 51.34%
Hansen Natural Corp 9.70 17.00% 62.45%

Aswath Damodaran 35
A Question
You are reading an equity research report on this sector, and the analyst
claims that Andres Wine and Hansen Natural are under valued because
they have low PE ratios. Would you agree?
o Yes
o No
n Why or why not?
Aswath Damodaran 36
Comparing PE Ratios across a Sector
Company Name PE Growth

PT Indosat ADR 7.8 0.06
Telebras ADR 8.9 0.075
Telecom Corporation of New Zealand ADR 11.2 0.11
Telecom Argentina Stet - France Telecom SA ADR B 12.5 0.08
Hellenic Telecommunication Organization SA ADR 12.8 0.12
Telecomunicaciones de Chile ADR 16.6 0.08
Swisscom AG ADR 18.3 0.11
Asia Satellite Telecom Holdings ADR 19.6 0.16
Portugal Telecom SA ADR 20.8 0.13
Telefonos de Mexico ADR L 21.1 0.14
Matav RT ADR 21.5 0.22
Telstra ADR 21.7 0.12
Gilat Communications 22.7 0.31
Deutsche Telekom AG ADR 24.6 0.11
British Telecommunications PLC ADR 25.7 0.07
Tele Danmark AS ADR 27 0.09
Telekomunikasi Indonesia ADR 28.4 0.32
Cable & Wireless PLC ADR 29.8 0.14
APT Satellite Holdings ADR 31 0.33
Telefonica SA ADR 32.5 0.18
Royal KPN NV ADR 35.7 0.13
Telecom Italia SPA ADR 42.2 0.14
Nippon Telegraph & Telephone ADR 44.3 0.2
France Telecom SA ADR 45.2 0.19
Korea Telecom ADR 71.3 0.44
Aswath Damodaran 37
PE, Growth and Risk
Dependent variable is: PE
R squared = 66.2% R squared (adjusted) = 63.1%
Variable Coefficient SE t-ratio prob

Constant 13.1151 3.471 3.78 0.0010
Growth rate 121.223 19.27 6.29 ≤ 0.0001
Emerging Market -13.8531 3.606 -3.84 0.0009
Emerging Market is a dummy: 1 if emerging market
0 if not
Aswath Damodaran 38
Is Telebras under valued?
n Predicted PE = 13.12 + 121.22 (.075) - 13.85 (1) = 8.35

n At an actual price to earnings ratio of 8.9, Telebras is slightly
overvalued.
Aswath Damodaran 39
Using comparable firms- Pros and Cons
n The most common approach to estimating the PE ratio for a firm is

• to choose a group of comparable firms,
• to calculate the average PE ratio for this group and
• to subjectively adjust this average for differences between the firm being
valued and the comparable firms.
n Problems with this approach.
• The definition of a 'comparable' firm is essentially a subjective one.
• The use of other firms in the industry as the control group is often not a
solution because firms within the same industry can have very different
business mixes and risk and growth profiles.
• There is also plenty of potential for bias.
• Even when a legitimate group of comparable firms can be constructed,
differences will continue to persist in fundamentals between the firm
being valued and this group.
Aswath Damodaran 40
Using the entire crosssection: A regression approach
n In contrast to the 'comparable firm' approach, the information in the

entire cross-section of firms can be used to predict PE ratios.
n The simplest way of summarizing this information is with a multiple
regression, with the PE ratio as the dependent variable, and proxies for
risk, growth and payout forming the independent variables.
Aswath Damodaran 41
PE versus Growth
120
100
80
60
40
20
-20
-20 0 20 40 60 80 100
Expected Growth in EPS: next 5 years
Aswath Damodaran 42
PE Ratio: Standard Regression
Model Summary
Adjusted R Std. Error of

Model R R Square Square the Estimate
1 .478a .229 .227 803.9541
a. Predictors: (Constant), Expected Growth in EPS: next 5 y,
PAYOUT1, Beta
Coefficients a,b
Standar
Unstandardized dized
Coefficients Coefficients
Model B Std. Error Beta t Sig.
1 (Constant) 13.090 1.164 11.242 .000
Beta -3.392 .908 -.089 -3.737 .000
PAYOUT1 4.938 1.190 .098 4.150 .000
Expected Growth
.880 .040 .527 22.115 .000
in EPS: next 5 y
a. Dependent Variable: Current PE
b. Weighted Least Squares Regression - Weighted by Market Cap
Aswath Damodaran 43
Second Thoughts?
n Based on this regression, estimate the PE ratio for a firm with no

growth, no payout and no risk.
n Is there a problem with your prediction?
Aswath Damodaran 44
PE Regression- No Intercept
Model Summary

a
1 .912b .832 .832 833.0224
a. For regression through the origin (the no-intercept
model), R Square measures the proportion of the
variability in the dependent variable about the origin
explained by regression. This CANNOT be compared to R
Square for models which include an intercept.
b. Predictors: Expected Growth in EPS: next 5 y, PAYOUT1,
Beta
Coefficients a,b,c
Standar
1 Beta 4.389 .609 .188 7.212 .000
PAYOUT1 13.299 .962 .189 13.823 .000
Expected Growth
1.014 .039 .608 25.786 .000
in EPS: next 5 y
a. Dependent Variable: Current PE
b. Linear Regression through the Origin
c. Weighted Least Squares Regression - Weighted by Market Cap
Aswath Damodaran 45
Problems with the regression methodology
n The basic regression assumes a linear relationship between PE ratios

and the financial proxies, and that might not be appropriate.
n The basic relationship between PE ratios and financial variables itself
might not be stable, and if it shifts from year to year, the predictions
from the model may not be reliable.
n The independent variables are correlated with each other. For example,
high growth firms tend to have high risk. This multi-collinearity makes
the coefficients of the regressions unreliable and may explain the large
changes in these coefficients from period to period.
Aswath Damodaran 46
The Multicollinearity Problem
Correlations
Expected
Growth in EPS:
Current PE next 5 y Beta Payout Ratio
Current PE Pearson Correlation 1.000 .342** .130** .009
Sig. (2-tailed) . .000 .000 .594
N 3303 2085 3027 3290
Expected Growth Pearson Correlation .342** 1.000 .397** -.078**
in EPS: next 5 y Sig. (2-tailed) .000 . .000 .000
N 2085 2675 2393 2143
Beta Pearson Correlation .130** .397** 1.000 -.213**
Sig. (2-tailed) .000 .000 . .000
N 3027 2393 4534 3114
Payout Ratio Pearson Correlation .009 -.078** -.213** 1.000
Sig. (2-tailed) .594 .000 .000 .
N 3290 2143 3114 3388
**. Correlation is significant at the 0.01 level (2-tailed).
Aswath Damodaran 47
Using the PE ratio regression
n Assume that you were given the following information for Dell. The
firm has an expected growth rate of 10%, a beta of 1.40 and pays no
dividends. Based upon the regression, estimate the predicted PE ratio
for Dell.
Predicted PE =
(Work with absolute values in regression - 10 for 10% etc.)
n Dell is actually trading at 18 times earnings. What does the predicted

PE tell you?
Aswath Damodaran 48
Investment Strategies that compare PE to the
expected growth rate
n If we assume that all firms within a sector have similar growth rates
and risk, a strategy of picking the lowest PE ratio stock in each sector
will yield undervalued stocks.
n Portfolio managers and analysts sometimes compare PE ratios to the
expected growth rate to identify under and overvalued stocks.
• In the simplest form of this approach, firms with PE ratios less than their
expected growth rate are viewed as undervalued.
• In its more general form, the ratio of PE ratio to growth is used as a
measure of relative value.
Aswath Damodaran 49
Problems with comparing PE ratios to expected
growth
n In its simple form, there is no basis for believing that a firm is

undervalued just because it has a PE ratio less than expected growth.
n This relationship may be consistent with a fairly valued or even an
overvalued firm, if interest rates are high, or if a firm is high risk.
n As interest rate decrease (increase), fewer (more) stocks will emerge as
undervalued using this approach.
Aswath Damodaran 50
PE Ratio versus Growth - The Effect of Interest
rates:
Average Risk firm with 25% growth for 5 years; 8% thereafter
Figure 14.2: PE Ratios and T.Bond Rates
45
40
35
30
25
20
15
10
0
5% 6% 7% 8% 9% 10%
T.Bond Rate
Aswath Damodaran 51
PE Ratios Less Than The Expected Growth Rate
n In September 2001,
• 33% of firms had PE ratios lower than the expected 5-year growth rate
• 67% of firms had PE ratios higher than the expected 5-year growth rate
n In comparison,
• 38.1% of firms had PE ratios less than the expected 5-year growth rate in
September 1991
• 65.3% of firm had PE ratios less than the expected 5-year growth rate in
1981.
Aswath Damodaran 52
PEG Ratio: Definition
n The PEG ratio is the ratio of price earnings to expected growth in

earnings per share.
PEG = PE / Expected Growth Rate in Earnings
n Definitional tests:
• Is the growth rate used to compute the PEG ratio
– on the same base? (base year EPS)
– over the same period?(2 years, 5 years)
– from the same source? (analyst projections, consensus estimates..)
• Is the earnings used to compute the PE ratio consistent with the growth
rate estimate?
– No double counting: If the estimate of growth in earnings per share is from the
current year, it would be a mistake to use forward EPS in computing PE
– If looking at foreign stocks or ADRs, is the earnings used for the PE ratio
consistent with the growth rate estimate? (US analysts use the ADR EPS)
Aswath Damodaran 53
PEG Ratio: Distribution
400
300
200
100
Std. Dev = 1.05

Mean = 1.55
0 N = 2084.00
Price/ Expected Growth RAte
Aswath Damodaran 54
PEG Ratios: The Beverage Sector
Company Name Trailing PE Growth Std Dev PEG

Coca-Cola Bottling 29.18 9.50% 20.58% 3.07
Molson Inc. Ltd. 'A' 43.65 15.50% 21.88% 2.82
Anheuser-Busch 24.31 11.00% 22.92% 2.21
Corby Distilleries Ltd. 16.24 7.50% 23.66% 2.16
Chalone Wine Group Ltd. 21.76 14.00% 24.08% 1.55
Andres Wines Ltd. 'A' 8.96 3.50% 24.70% 2.56
Todhunter Int'l 8.94 3.00% 25.74% 2.98
Brown-Forman 'B' 10.07 11.50% 29.43% 0.88
Coors (Adolph) 'B' 23.02 10.00% 29.52% 2.30
PepsiCo, Inc. 33.00 10.50% 31.35% 3.14
Coca-Cola 44.33 19.00% 35.51% 2.33
Boston Beer 'A' 10.59 17.13% 39.58% 0.62
Whitman Corp. 25.19 11.50% 44.26% 2.19
Mondavi (Robert) 'A' 16.47 14.00% 45.84% 1.18
Coca-Cola Enterprises 37.14 27.00% 51.34% 1.38
Hansen Natural Corp 9.70 17.00% 62.45% 0.57
Average
Aswath Damodaran 22.66 0.13 0.33 2.00 55
PEG Ratio: Reading the Numbers
n The average PEG ratio for the beverage sector is 2.00. The lowest
PEG ratio in the group belongs to Hansen Natural, which has a PEG
ratio of 0.57. Using this measure of value, Hansen Natural is
o the most under valued stock in the group
o the most over valued stock in the group
n What other explanation could there be for Hansen’s low PEG ratio?
Aswath Damodaran 56
PEG Ratio: Analysis
n To understand the fundamentals that determine PEG ratios, let us

return again to a 2-stage equity discounted cash flow model
 ( 1 +g)n 
) *1 −
EPS0 * P a y o u t R a t i o * ( 1g +
 ( 1 +r) n  EPS 0 *Payout Ration * ( 1 +g)n * ( 1 +g n )
P0 = +
r-g (r - gn )(1+r)n
n Dividing both sides of the equation by the earnings gives us the

equation for the PE ratio. Dividing it again by the expected growth ‘g’
 ( 1 +g)n 
Payout Ratio*(1+ g) * 1 −
 (1 + r) n  Payout Ratio n * ( 1 +g)n * ( 1 +g n )
PEG = +
g(r - g) g(r - gn )(1 + r)n
Aswath Damodaran 57
PEG Ratios and Fundamentals
n Risk and payout, which affect PE ratios, continue to affect PEG ratios
as well.
• Implication: When comparing PEG ratios across companies, we are
making implicit or explicit assumptions about these variables.
n Dividing PE by expected growth does not neutralize the effects of
expected growth, since the relationship between growth and value is
not linear and fairly complex (even in a 2-stage model)
Aswath Damodaran 58
A Simple Example
n Assume that you have been asked to estimate the PEG ratio for a firm
Variable High Growth Phase Stable Growth Phase
Expected Growth Rate 25% 8%
Beta 1.00 1.00
n Riskfree rate = T.Bond Rate = 6%
n Required rate of return = 6% + 1(5.5%)= 11.5%
n The PEG ratio for this firm can be estimated as follows:
 (1.25) 5 
0.2 * (1.25) * 1 −
 (1.115) 5  0.5 * (1.25)5 *(1.08)
PEG = + = .115 or 1.15
.25(.115 - .25) .25(.115-.08) (1.115)5
Aswath Damodaran 59
PEG Ratios and Risk
PEG Ratios and Beta: Different Growth Rates
2.5
g =25%
PEG Ratio
g=20%
1.5
g=15%
g=8%
0.5
0
0.75 1.00 1.25 1.50 1.75 2.00
Beta
Aswath Damodaran 60
PEG Ratios and Quality of Growth
PEG Ratios and Retention Ratios
1.4
1.2
0.8
PEG Ratio
PEG
0.6
0.4
0.2
0
1 0.8 0.6 0.4 0.2 0
Retention Ratio
Aswath Damodaran 61
PE Ratios and Expected Growth
PEG Ratios, Expected Growth and Interest Rates
2.50
2.00
1.50
r=6%
PEG Ratio
r=8%
r=10%
1.00
0.50
0.00
5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
Expected Growth Rate
Aswath Damodaran 62
PEG Ratios and Fundamentals: Propositions
n Proposition 1: High risk companies will trade at much lower PEG

ratios than low risk companies with the same expected growth rate.
• Corollary 1: The company that looks most under valued on a PEG ratio
basis in a sector may be the riskiest firm in the sector
n Proposition 2: Companies that can attain growth more efficiently by
investing less in better return projects will have higher PEG ratios than
companies that grow at the same rate less efficiently.
• Corollary 2: Companies that look cheap on a PEG ratio basis may be
companies with high reinvestment rates and poor project returns.
n Proposition 3: Companies with very low or very high growth rates will
tend to have higher PEG ratios than firms with average growth rates.
This bias is worse for low growth stocks.
• Corollary 3: PEG ratios do not neutralize the growth effect.
Aswath Damodaran 63
PE, PEG Ratios and Risk
45 2.5
40
2
35
30
1.5
25
PE
PEG Ratio
20
1
15
10
0.5
0 0
Lowest 2 3 4 Highest
Aswath Damodaran 64
PEG Ratio: Returning to the Beverage Sector
Company Name Trailing PE Growth Std Dev PEG

Coca-Cola Bottling 29.18 9.50% 20.58% 3.07
Molson Inc. Ltd. 'A' 43.65 15.50% 21.88% 2.82
Anheuser-Busch 24.31 11.00% 22.92% 2.21
Corby Distilleries Ltd. 16.24 7.50% 23.66% 2.16
Chalone Wine Group Ltd. 21.76 14.00% 24.08% 1.55
Andres Wines Ltd. 'A' 8.96 3.50% 24.70% 2.56
Todhunter Int'l 8.94 3.00% 25.74% 2.98
Brown-Forman 'B' 10.07 11.50% 29.43% 0.88
Coors (Adolph) 'B' 23.02 10.00% 29.52% 2.30
PepsiCo, Inc. 33.00 10.50% 31.35% 3.14
Coca-Cola 44.33 19.00% 35.51% 2.33
Boston Beer 'A' 10.59 17.13% 39.58% 0.62
Whitman Corp. 25.19 11.50% 44.26% 2.19
Mondavi (Robert) 'A' 16.47 14.00% 45.84% 1.18
Coca-Cola Enterprises 37.14 27.00% 51.34% 1.38
Hansen Natural Corp 9.70 17.00% 62.45% 0.57
Average
Aswath Damodaran 22.66 0.13 0.33 2.00 65
Analyzing PE/Growth
n Given that the PEG ratio is still determined by the expected growth
rates, risk and cash flow patterns, it is necessary that we control for
differences in these variables.
n Regressing PEG against risk and a measure of the growth dispersion,
we get:
PEG = 3.61 - 2.86 (Expected Growth) - 3.75 (Std Deviation in Prices)
R Squared = 44.75%
n In other words,
• PEG ratios will be lower for high growth companies
• PEG ratios will be lower for high risk companies
n We also ran the regression using the deviation of the actual growth rate
from the industry-average growth rate as the independent variable,
with mixed results.
Aswath Damodaran 66
Estimating the PEG Ratio for Hansen
n Applying this regression to Hansen, the predicted PEG ratio for the
firm can be estimated using Hansen’s measures for the independent
variables:
• Expected Growth Rate = 17.00%
• Standard Deviation in Stock Prices = 62.45%
n Plugging in,
Expected PEG Ratio for Hansen = 3.61 - 2.86 (.17) - 3.75 (.6245)
= 0.78
n With its actual PEG ratio of 0.57, Hansen looks undervalued,
notwithstanding its high risk.
Aswath Damodaran 67
Extending the Comparables
n This analysis, which is restricted to firms in the software sector, can be

expanded to include all firms in the firm, as long as we control for
differences in risk, growth and payout.
n To look at the cross sectional relationship, we first plotted PEG ratios
against expected growth rates.
Aswath Damodaran 68
PEG versus Growth
-1
-20 0 20 40 60 80 100
Expected Growth in EPS: next 5 years
Aswath Damodaran 69
Analyzing the Relationship
n The relationship in not linear. In fact, the smallest firms seem to have
the highest PEG ratios and PEG ratios become relatively stable at
higher growth rates.
n To make the relationship more linear, we converted the expected
growth rates in ln(expected growth rate). The relationship between
PEG ratios and ln(expected growth rate) was then plotted.
Aswath Damodaran 70
PEG versus ln(Expected Growth)
-1
-1 0 1 2 3 4 5
Ln(Expected Growth)
Aswath Damodaran 71
Market PEG Ratio Regression
Model Summary

1 .587a .344 .343 56.7746
a. Predictors: (Constant), LNGROWTH, PAYOUT1, Beta
Coefficients a,b
Standar
1 (Constant) 3.935 .112 35.175 .000
Beta -7.249E-02 .064 -.025 -1.140 .255
PAYOUT1 .575 .084 .149 6.873 .000
LNGROWTH -.867 .037 -.509 -23.522 .000
a. Dependent Variable: PEG1
Aswath Damodaran 72
Applying the PEG ratio regression
n Consider Dell again. The stock has an expected growth rate of 10%, a
beta of 1.40 and pays out no dividends. What should its PEG ratio be?
n If the stock’s actual PE ratio is 18, what does this analysis tell you
about the stock?
Aswath Damodaran 73
A Variant on PEG Ratio: The PEGY ratio
n The PEG ratio is biased against low growth firms because the
relationship between value and growth is non-linear. One variant that
has been devised to consolidate the growth rate and the expected
dividend yield:
PEGY = PE / (Expected Growth Rate + Dividend Yield)
n As an example, Con Ed has a PE ratio of 16, an expected growth rate
of 5% in earnings and a dividend yield of 4.5%.
• PEG = 16/ 5 = 3.2
• PEGY = 16/(5+4.5) = 1.7
Aswath Damodaran 74
Relative PE: Definition
n The relative PE ratio of a firm is the ratio of the PE of the firm to the
PE of the market.
Relative PE = PE of Firm / PE of Market
n While the PE can be defined in terms of current earnings, trailing
earnings or forward earnings, consistency requires that it be estimated
using the same measure of earnings for both the firm and the market.
n Relative PE ratios are usually compared over time. Thus, a firm or
sector which has historically traded at half the market PE (Relative PE
= 0.5) is considered over valued if it is trading at a relative PE of 0.7.
Aswath Damodaran 75
Relative PE: Cross Sectional Distribution
1000
800
600
400
200
Std. Dev = .77
Mean = 1.00
0 N = 3303.00
Relative PE
Aswath Damodaran 76
Relative PE: Distributional Statistics
n The average relative PE is always one.

n The median relative PE is much lower, since PE ratios are skewed
towards higher values. Thus, more companies trade at PE ratios less
than the market PE and have relative PE ratios less than one.
Aswath Damodaran 77
Relative PE: Determinants
n To analyze the determinants of the relative PE ratios, let us revisit the

discounted cash flow model we developed for the PE ratio. Using the
2-stage DDM model as our basis (replacing the payout ratio with the
FCFE/Earnings Ratio, if necessary), we get
 ( 1 +g j ) 
n
Payout Ratio j * ( 1+ g j ) * 1 − 
 
n n
( 1 +r j ) Payout Ratio j,n * ( 1+ g j ) * ( 1+ g j,n )
+ n
rj - g j (rj - g j,n )(1 + rj )
Relative PE j =
 ( 1 +g m ) n 

Payout Ratio m * ( 1 +g m ) * 1 − 
 ( 1 +rm ) 
n
Payout Ratio m,n * ( 1 +g m )n * ( 1+ gm,n )
+ n
rm - gm (rm - gm,n ) ( 1 +rm )
where Payoutj, gj, rj = Payout, growth and risk of the firm

Payoutm, gm, rm = Payout, growth and risk of the market
Aswath Damodaran 78
Relative PE: A Simple Example
n Consider the following example of a firm growing at twice the rate as

the market, while having the same growth and risk characteristics of
the market:
Firm Market
Expected growth rate 20% 10%
Length of Growth Period 5 years 5 years
Payout Ratio: first 5 yrs 30% 30%
Growth Rate after yr 5 6% 6%
Payout Ratio after yr 5 50% 50%
Beta 1.00 1.00
Riskfree Rate = 6%
Aswath Damodaran 79
Estimating Relative PE
n The relative PE ratio for this firm can be estimated in two steps. First,
we compute the PE ratio for the firm and the market separately:
 (1.20) 
5
0 . 3 * (1.20) * 1−
 (1.115) 5  0.5 * (1.20)5 * (1.06)
PE firm = + 5 = 15.79
(.115 - .20) (.115 -.06) (1.115)
 (1.10) 
5
0 . 3 * (1.10) *  1−
 (1.115)5  0.5 * (1.10) 5 *(1.06)
PE market = + 5 = 10.45
(.115 - .10) (.115-.06) (1.115)
n Relative PE Ratio = 15.79/10.45 = 1.51
Aswath Damodaran 80
Relative PE and Relative Growth
Relative PE and Relative Growth Rates: Market Growth Scenarios
3.50
3.00
2.50
2.00
Relative PE
Market g=5%
Market g=10%
Market g=15%
1.50
1.00
0.50
0.00
0% 50% 100% 150% 200% 250% 300%
Firm's Growth Rate/Market Growth Rate
Aswath Damodaran 81
Relative PE: Another Example
n In this example, consider a firm with twice the risk as the market,
while having the same growth and payout characteristics as the firm:
Firm Market
Expected growth rate 10% 10%
Length of Growth Period 5 years 5 years
Payout Ratio: first 5 yrs 30% 30%
Growth Rate after yr 5 6% 6%
Payout Ratio after yr 5 50% 50%
Beta in first 5 years 2.00 1.00
Beta after year 5 1.00 1.00
Riskfree Rate = 6%
Aswath Damodaran 82
Estimating Relative PE
n The relative PE ratio for this firm can be estimated in two steps. First,
we compute the PE ratio for the firm and the market separately:
 (1.10) 5 
0.3 * (1.10)* 1 −
 (1.17) 5  0 . 5 * (1.10)5 * (1.06)
PE firm = + = 8.33
(.17 - . 1 0 ) (.115-.06) (1.17)5
 (1.10) 
5
0 . 3 * (1.10) *  1−
 (1.115)5  0.5 * (1.10) 5 *(1.06)
PE market = + 5 = 10.45
(.115 - .10) (.115-.06) (1.115)
n Relative PE Ratio = 8.33/10.45 = 0.80
Aswath Damodaran 83
Relative PE and Relative Risk
Relative PE and Relative Risk: Stable Beta Scenarios
4.5
3.5
2.5
Beta stays at current level
Beta drops to 1 in stable phase
2
1.5
0.5
0
0.25 0.5 0.75 1 1.25 1.5 1.75 2
Aswath Damodaran 84
Relative PE: Summary of Determinants
n The relative PE ratio of a firm is determined by two variables. In

particular, it will
• increase as the firm’s growth rate relative to the market increases. The rate
of change in the relative PE will itself be a function of the market growth
rate, with much greater changes when the market growth rate is higher. In
other words, a firm or sector with a growth rate twice that of the market
will have a much higher relative PE when the market growth rate is 10%
than when it is 5%.
• decrease as the firm’s risk relative to the market increases. The extent of
the decrease depends upon how long the firm is expected to stay at this
level of relative risk. If the different is permanent, the effect is much
greater.
n Relative PE ratios seem to be unaffected by the level of rates, which
might give them a decided advantage over PE ratios.
Aswath Damodaran 85
Relative PE Ratios: The Auto Sector
Relative PE Ratios: Auto Stocks
1.20
1.00
0.80
Ford
0.60 Chrysler
GM
0.40
0.20
0.00
1993 1994 1995 1996 1997 1998 1999 2000
Aswath Damodaran 86
Using Relative PE ratios
n On a relative PE basis, all of the automobile stocks look cheap because

they are trading at their lowest relative PE ratios in five years. Why
might the relative PE ratio be lower today than it was 5 years ago?
Aswath Damodaran 87
Relative PEs: Why do they change?
n Historically, GM has traded at the highest relative PE ratio of the three

auto companies, and Chrysler has traded at the lowest. In the last two
or three years, this historical relationship has been upended with Ford
and Chrysler now trading at the higher ratios than GM. Analyst
projections for earnings growth at the three companies are about the
same. How would you explain the shift?
Aswath Damodaran 88
Relative PE Ratios: Market Analysis
Model Summary

1 .478a .229 .227 41.4196
a. Predictors: (Constant), Beta, RELPYT, RELGR
Coefficients a,b
Standar
1 (Constant) .674 .060 11.242 .000
RELGR .835 .038 .527 22.115 .000
RELPYT 4.431E-02 .011 .098 4.150 .000
Beta -.175 .047 -.089 -3.737 .000
a. Dependent Variable: RELPE
Aswath Damodaran 89
Value/Earnings and Value/Cashflow Ratios
n While Price earnings ratios look at the market value of equity relative to
earnings to equity investors, Value earnings ratios look at the market value of
the firm relative to operating earnings. Value to cash flow ratios modify the
earnings number to make it a cash flow number.
n The form of value to cash flow ratios that has the closest parallels in DCF
valuation is the value to Free Cash Flow to the Firm, which is defined as:
Value/FCFF = (Market Value of Equity + Market Value of Debt-Cash)
EBIT (1-t) - (Cap Ex - Deprecn) - Chg in WC
n Consistency Tests:
• If the numerator is net of cash (or if net debt is used, then the interest income from
the cash should not be in denominator
• The interest expenses added back to get to EBIT should correspond to the debt in
the numerator. If only long term debt is considered, only long term interest should
be added back.
Aswath Damodaran 90
Value/FCFF Distribution
800
600
400
200
Std. Dev = 21.77

Mean = 20.6
0 N = 3063.00
Enterprise Value/FCFF
Aswath Damodaran 91
Value of Firm/FCFF: Determinants
n Reverting back to a two-stage FCFF DCF model, we get:

 (1 + g)n 
FCFF (1 + g) 1 -  n ( 1 +g )
0  ( 1 +WACC)  n FCFF ( 1 +g)
V0 = + 0 n
WACC - g (WACC - g )(1 + WACC)n
n
• V0 = Value of the firm (today)

• FCFF0 = Free Cashflow to the firm in current year
• g = Expected growth rate in FCFF in extraordinary growth period (first
n years)
• WACC = Weighted average cost of capital
• gn = Expected growth rate in FCFF in stable growth period (after n
years)
Aswath Damodaran 92
Value Multiples
n Dividing both sides by the FCFF yields,

 (1 + g)n 
(1 + g) 1 -
V0  (1 + WACC)n  ( 1 +g)n ( 1 +gn )
= +
FCFF0 WACC - g (WACC - gn )(1 + WACC)n
n The value/FCFF multiples is a function of

• the cost of capital
• the expected growth
Aswath Damodaran 93
Alternatives to FCFF - EBIT and EBITDA
n Most analysts find FCFF to complex or messy to use in multiples

(partly because capital expenditures and working capital have to be
estimated). They use modified versions of the multiple with the
following alternative denominator:
• after-tax operating income or EBIT(1-t)
• pre-tax operating income or EBIT
• net operating income (NOI), a slightly modified version of operating
income, where any non-operating expenses and income is removed from
the EBIT
• EBITDA, which is earnings before interest, taxes, depreciation and
amortization.
Aswath Damodaran 94
Value/FCFF Multiples and the Alternatives
n Assume that you have computed the value of a firm, using discounted
cash flow models. Rank the following multiples in the order of
magnitude from lowest to highest?
o Value/EBIT
o Value/EBIT(1-t)
o Value/FCFF
o Value/EBITDA
n What assumption(s) would you need to make for the Value/EBIT(1-t)
ratio to be equal to the Value/FCFF multiple?
Aswath Damodaran 95
Illustration: Using Value/FCFF Approaches to value
a firm: MCI Communications
n MCI Communications had earnings before interest and taxes of $3356

million in 1994 (Its net income after taxes was $855 million).
n It had capital expenditures of $2500 million in 1994 and depreciation
of $1100 million; Working capital increased by $250 million.
n It expects free cashflows to the firm to grow 15% a year for the next
five years and 5% a year after that.
n The cost of capital is 10.50% for the next five years and 10% after
that.
n The company faces a tax rate of 36%.
 (1.15)5 
(1.15)  1-
V0 (1.105)5  (1.15) 5 (1.05)
= + 5
= 31.28
FCFF0 .105 -.15 (.10 - .05)(1.105)
Aswath Damodaran 96
Multiple Magic
n In this case of MCI there is a big difference between the FCFF and
short cut measures. For instance the following table illustrates the
appropriate multiple using short cut measures, and the amount you
would overpay by if you used the FCFF multiple.
Free Cash Flow to the Firm
= EBIT (1-t) - Net Cap Ex - Change in Working Capital
= 3356 (1 - 0.36) + 1100 - 2500 - 250 = $ 498 million
$ Value Correct Multiple
FCFF $498 31.28382355
EBIT (1-t) $2,148 7.251163362
EBIT $ 3,356 4.640744552
EBITDA $4,456 3.49513885
Aswath Damodaran 97
Reasons for Increased Use of Value/EBITDA
1. The multiple can be computed even for firms that are reporting net
losses, since earnings before interest, taxes and depreciation are
usually positive.
2. For firms in certain industries, such as cellular, which require a
substantial investment in infrastructure and long gestation periods, this
multiple seems to be more appropriate than the price/earnings ratio.
3. In leveraged buyouts, where the key factor is cash generated by the firm
prior to all discretionary expenditures, the EBITDA is the measure of
cash flows from operations that can be used to support debt payment at
least in the short term.
4. By looking at cashflows prior to capital expenditures, it may provide a
better estimate of “optimal value”, especially if the capital
expenditures are unwise or earn substandard returns.
5. By looking at the value of the firm and cashflows to the firm it allows
for comparisons across firms with different financial leverage.
Aswath Damodaran 98
Value/EBITDA Multiple
n The Classic Definition

Value Market Value of Equity + Market Value of Debt
=
EBITDA Earnings before Interest, Taxes and Depreciation
n The No-Cash Version

Enterprise Value Market Value of Equity + Market Value of Debt - Cash
=
EBITDA Earnings before Interest, Taxes and Depreciation
n When cash and marketable securities are netted out of value, none of
the income from the cash and securities should be reflected in the
denominator.
Aswath Damodaran 99
Value/EBITDA Distribution
1200
1000
800
600
400
200 Std. Dev = 8.06

Mean = 8.0
0 N = 3630.00
EV/EBITDA
Aswath Damodaran 100

The Determinants of Value/EBITDA Multiples:
Linkage to DCF Valuation
n Firm value can be written as:

FCFF1
V0 =
WACC - g
n The numerator can be written as follows:

FCFF = EBIT (1-t) - (Cex - Depr) - ∆ Working Capital
= (EBITDA - Depr) (1-t) - (Cex - Depr) - ∆ Working Capital
= EBITDA (1-t) + Depr (t) - Cex - ∆ Working Capital

From Firm Value to EBITDA Multiples
n Now the Value of the firm can be rewritten as,

EBITDA (1-t) + Depr (t) - Cex - ∆ Working Capital
Value =
WACC - g
n Dividing both sides of the equation by EBITDA,

Value (1- t) Depr (t)/EBITDA CEx/EBITDA ∆ Working Capital/EBITDA
= + - -
EBITDA WACC-g WACC - g WACC - g WACC - g

A Simple Example
n Consider a firm with the following characteristics:

• Tax Rate = 36%
• Capital Expenditures/EBITDA = 30%
• Depreciation/EBITDA = 20%
• Cost of Capital = 10%
• The firm has no working capital requirements
• The firm is in stable growth and is expected to grow 5% a year forever.

Calculating Value/EBITDA Multiple
n In this case, the Value/EBITDA multiple for this firm can be estimated
as follows:
Value ( 1 -.36) (0.2)(.36) 0.3 0
= + - - = 8.24
EBITDA .10 - . 0 5 .10 - . 0 5 .10 - .05 .10 - .05

Value/EBITDA Multiples and Taxes
VEBITDA Multiples and Tax Rates
16
14
12
10
Value/EBITDA
0
0% 10% 20% 30% 40% 50%
Tax Rate

Value/EBITDA and Net Cap Ex
Value/EBITDA and Net Cap Ex Ratios
12
10
8
Value/EBITDA
0
0% 5% 10% 15% 20% 25% 30%
Net Cap Ex/EBITDA

Value/EBITDA Multiples and Return on Capital
Value/EBITDA and Return on Capital
12
10
8
Value/EBITDA
WACC=10%
6 WACC=9%
WACC=8%
0
6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
Return on Capital

Value/EBITDA Multiple: Trucking Companies
Company Name Value EBITDA Value/EBITDA

KLLM Trans. Svcs. $ 114.32 $ 48.81 2.34
Ryder System $ 5,158.04 $ 1,838.26 2.81
Rollins Truck Leasing $ 1,368.35 $ 447.67 3.06
Cannon Express Inc. $ 83.57 $ 27.05 3.09
Hunt (J.B.) $ 982.67 $ 310.22 3.17
Yellow Corp. $ 931.47 $ 292.82 3.18
Roadway Express $ 554.96 $ 169.38 3.28
Marten Transport Ltd. $ 116.93 $ 35.62 3.28
Kenan Transport Co. $ 67.66 $ 19.44 3.48
M.S. Carriers $ 344.93 $ 97.85 3.53
Old Dominion Freight $ 170.42 $ 45.13 3.78
Trimac Ltd $ 661.18 $ 174.28 3.79
Matlack Systems $ 112.42 $ 28.94 3.88
XTRA Corp. $ 1,708.57 $ 427.30 4.00
Covenant Transport Inc $ 259.16 $ 64.35 4.03
Builders Transport $ 221.09 $ 51.44 4.30
Werner Enterprises $ 844.39 $ 196.15 4.30
Landstar Sys. $ 422.79 $ 95.20 4.44
AMERCO $ 1,632.30 $ 345.78 4.72
USA Truck $ 141.77 $ 29.93 4.74
Frozen Food Express $ 164.17 $ 34.10 4.81
Arnold Inds. $ 472.27 $ 96.88 4.87
Greyhound Lines Inc. $ 437.71 $ 89.61 4.88
USFreightways $ 983.86 $ 198.91 4.95
Golden Eagle Group Inc. $ 12.50 $ 2.33 5.37
Arkansas Best $ 578.78 $ 107.15 5.40
Airlease Ltd. $ 73.64 $ 13.48 5.46
Celadon Group $ 182.30 $ 32.72 5.57
Amer. Freightways $ 716.15 $ 120.94 5.92
Transfinancial Holdings $ 56.92 $ 8.79 6.47
Vitran Corp. 'A' $ 140.68 $ 21.51 6.54
Interpool Inc. $ 1,002.20 $ 151.18 6.63
Intrenet Inc. $ 70.23 $ 10.38 6.77
Swift Transportation $ 835.58 $ 121.34 6.89
Landair Services $ 212.95 $ 30.38 7.01
CNF Transportation $ 2,700.69 $ 366.99 7.36
Budget Group Inc $ 1,247.30 $ 166.71 7.48
Caliber System $ 2,514.99 $ 333.13 7.55
Knight Transportation Inc $ 269.01 $ 28.20 9.54
Heartland Express $ 727.50 $ 64.62 11.26
Greyhound CDA Transn Corp $ 83.25 $ 6.99 11.91
Mark VII $ 160.45 $ 12.96 12.38
Coach USA Inc $ 678.38 $ 51.76 13.11
US 1 Inds Inc. $ 5.60 $ (0.17) NA
Average 5.61

A Test on EBITDA
n Ryder System looks very cheap on a Value/EBITDA multiple basis,

relative to the rest of the sector. What explanation (other than
misvaluation) might there be for this difference?

Analyzing the Value/EBITDA Multiple
n While low value/EBITDA multiples may be a symptom of

undervaluation, a few questions need to be answered:
• Is the operating income next year expected to be significantly lower than
the EBITDA for the most recent period? (Price may have dropped)
• Does the firm have significant capital expenditures coming up? (In the
trucking business, the life of the trucking fleet would be a good indicator)
• Does the firm have a much higher cost of capital than other firms in the
sector?
• Does the firm face a much higher tax rate than other firms in the sector?

Value/EBITDA Multiples: Market
n The multiple of value to EBITDA varies widely across firms in the

market, depending upon:
• how capital intensive the firm is (high capital intensity firms will tend to
have lower value/EBITDA ratios), and how much reinvestment is needed
to keep the business going and create growth
• how high or low the cost of capital is (higher costs of capital will lead to
lower Value/EBITDA multiples)
• how high or low expected growth is in the sector (high growth sectors will
tend to have higher Value/EBITDA multiples)

US Market: Cross Sectional Regression
Model Summary

1 .526a .277 .276 426.8390
a. Predictors: (Constant), Eff Tax Rate, ROC1, Expected
Growth in EPS: next 5 y
Coefficients a,b
Standar
1 (Constant) 7.221 .617 11.707 .000
Expected Growth
.287 .016 .344 17.739 .000
in EPS: next 5 y
ROC1 11.123 .670 .319 16.610 .000
Eff Tax Rate -.110 .014 -.155 -7.917 .000
a. Dependent Variable: EV/EBITDA

Price-Book Value Ratio: Definition
n The price/book value ratio is the ratio of the market value of equity to
the book value of equity, i.e., the measure of shareholders’ equity in
the balance sheet.
n Price/Book Value = Market Value of Equity
Book Value of Equity
n Consistency Tests:
• If the market value of equity refers to the market value of equity of
common stock outstanding, the book value of common equity should be
used in the denominator.
• If there is more that one class of common stock outstanding, the market
values of all classes (even the non-traded classes) needs to be factored in.

Price to Book Value: Distribution
1000
800
600
400
200
Std. Dev = 2.36
Mean = 2.39
0 N = 4866.00
PBV Ratio

Price Book Value Ratio: Stable Growth Firm
n Going back to a simple dividend discount model,

DPS1
P0 =
r − gn
n Defining the return on equity (ROE) = EPS0 / Book Value of Equity,

the value of equity can be written as:
*(1 + gn )
BV 0 *ROE*Payout Ratio
P0 =
r - gn
P0 ROE*Payout Ratio*(1 + g n )
= PBV =
BV 0 r-g n
n If the return on equity is based upon expected earnings in the next time
period, this can be simplified to,
P0 ROE *Payout Ratio
= PBV =
BV 0 r-g n

Price Book Value Ratio: Stable Growth Firm
Another Presentation
n This formulation can be simplified even further by relating growth to

the return on equity:
g = (1 - Payout ratio) * ROE
n Substituting back into the P/BV equation,
P0 R O E - gn
= PBV =
BV 0 r - gn
n The price-book value ratio of a stable firm is determined by the

differential between the return on equity and the required rate of return
on its projects.

Price Book Value Ratio for a Stable Growth Firm:
Example
n Jenapharm was the most respected pharmaceutical manufacturer in

East Germany.
n Jenapharm was expected to have revenues of 230 million DM and
earnings before interest and taxes of 30 million DM in 1991.
n The firm had a book value of assets of 110 million DM, and a book
value of equity of 58 million DM. The interest expenses in 1991 is
expected to be 15 million DM. The corporate tax rate is 40%.
n The firm was expected to maintain sales in its niche product, a
contraceptive pill, and grow at 5% a year in the long term, primarily by
expanding into the generic drug market.
n The average beta of pharmaceutical firms traded on the Frankfurt
Stock exchange was 1.05.
n The ten-year bond rate in Germany at the time of this valuation was
7%; the risk premium for stocks over bonds is assumed to be 5.5%.
Estimating a Price/Book Ratio for Jenapharm
n Expected Net Income = (EBIT - Interest Expense)*(1-t)* 1+g) = (30 -

15) *(1-0.4)* (1.05) = 9.45 mil DM
n Return on Equity = Expected Net Income / Book Value of Equity =
9.45 / 58 = 16.29%
n Cost on Equity = 7% + 1.05 (5.5%) = 12.775%
n Price/Book Value Ratio = (ROE - g) / (r - g) = (.1629 - .05) / (.12775 -
.05) = 1.46
n Estimated MV of equity = BV of Equity * Price/BV ratio = 58 * 1.46
= $ 84.50 mil DM

Price Book Value Ratio for High Growth Firm
n The Price-book ratio for a high-growth firm can be estimated

beginning with a 2-stage discounted cash flow model:
 (1+ g)n 
EPS 0 *Payout Ratio *(1 + g )*  1 − 
 ( 1 +r) n  EPS 0 * Payout Ration * ( 1 + gn) * ( 1 + gn )
P0 = +
r -g ( r- g n )(1+ r) n
n Dividing both sides of the equation by the book value of equity:

  ( 1 +g)n  
g)* 1 −
ROE* Payout Ratio*(1+
P0   ( 1 +r) 
n
ROE n * Payout Ratio n * ( 1 +g) * ( 1 +g n ) 
n
= + 
BV0 r-g (r - gn )(1+r)n
 
 
where ROE = Return on Equity in high-growth period

ROEn = Return on Equity in stable growth period

PBV Ratio for High Growth Firm: Example
n Assume that you have been asked to estimate the PBV ratio for a firm
High Growth Phase Stable Growth Phase
Length of Period 5 years Forever after year 5
Return on Equity 25% 15%
Growth Rate .80*.25=.20 .4*.15=.06
Beta 1.25 1.00
Cost of Equity 12.875% 11.50%
The riskfree rate is 6% and the risk premium used is 5.5%.

Estimating Price/Book Value Ratio
n The price/book value ratio for this firm is:

  
1 − (1.20) 
5
0.25 * 0.2 * (1.20) *
  (1.12875) 5  0.15 * 0.6 * (1.20) * (1.06) 
5
PBV =  + = 2.66
(.12875 - .20) (.115 - .06) (1.12875) 5 
 
 

PBV and ROE: The Key
PBV and ROE: Risk Scenarios
3.5
3
Price/Book Value Ratios
2.5
Beta=0.5
2 Beta=1
Beta=1.5
1.5
0.5
0
10% 15% 20% 25% 30%
ROE

PBV/ROE: Oil Companies
Company Name Ticker Symbol PBV ROE
Crown Cent. Petr.'A' CNPA 0.29 -14.60%
Giant Industries GI 0.54 7.47%
Harken Energy Corp. HEC 0.64 -5.83%
Getty Petroleum Mktg. GPM 0.95 6.26%
Pennzoil-Quaker State PZL 0.95 3.99%
Ashland Inc. ASH 1.13 10.27%
Shell Transport SC 1.45 13.41%
USX-Marathon Group MRO 1.59 13.42%
Lakehead Pipe Line LHP 1.72 13.28%
Amerada Hess AHC 1.77 16.69%
Tosco Corp. TOS 1.95 15.44%
Occidental Petroleum OXY 2.15 16.68%
Royal Dutch Petr. RD 2.33 13.41%
Murphy Oil Corp. MUR 2.40 14.49%
Texaco Inc. TX 2.44 13.77%
Phillips Petroleum P 2.64 17.92%
Chevron Corp. CHV 3.03 15.69%
Repsol-YPF ADR REP 3.24 13.43%
Unocal Corp. UCL 3.53 10.67%
Kerr-McGee Corp. KMG 3.59 28.88%
Exxon Mobil Corp. XOM 4.22 11.20%
BP Amoco ADR BPA 4.66 14.34%
Clayton Williams Energy CWEI 5.57 31.02%
Average 2.30 12.23%
PBV versus ROE regression
n Regressing PBV ratios against ROE for oil companies yields the
following regression:
PBV = 1.04 + 10.24 (ROE) R2 = 49%
n For every 1% increase in ROE, the PBV ratio should increase by
0.1024.

Valuing Pemex
n Assume that you have been asked to value a PEMEX for the Mexican
Government; All you know is that it has earned a return on equity of
10% last year. The appropriate P/BV ratio can be estimated
P/BV Ratio (based upon regression) = 1.04 + 10.24 * 0.1 = 2.06

Looking for undervalued securities - PBV Ratios
and ROE
n Given the relationship between price-book value ratios and returns on

equity, it is not surprising to see firms which have high returns on
equity selling for well above book value and firms which have low
returns on equity selling at or below book value.
n The firms which should draw attention from investors are those which
provide mismatches of price-book value ratios and returns on equity -
low P/BV ratios and high ROE or high P/BV ratios and low ROE.

The Valuation Matrix
MV/BV
Overvalued
Low ROE High ROE
High MV/BV High MV/BV
ROE-r
Undervalued
Low ROE High ROE
Low MV/BV Low MV/BV

Large Market Cap Firms: PBV vs ROE: January 2001
12
AES
QCOM
10 CSCO PEP VZ
WAG BUD
PG
HD WMT ABT
TXN
ADP AMAT
JNJ IBM
8 NTERICY A BAX KRB
MMM
MMC INTCKMB
DNA PHA CAH
FITB BBDB.TO
SWY SBC
CVS
AVE SLR
ENE AIG AXP MWD
TYC
FDC MEL
6 SLB
EDS
C
BLS
TOC.TO TGT
BBV EMR
UTX GS
AT FNM
BA
TEF XOM AA
BP HON LU HI
JPM
WFC FRE DD
4 SNE PHG HCA
HWP
PNC
FSR
MU
STD
AEG BTY
AHODIS MOT DUK WM TX USB
CHV
DT DOW FBF
RD
ONE
CPQ HMC FON BNS.TO
BCE UNTMX
JDSU FTU
BAC
2 MC
REP ALL
SC UL
F
GM
T WCOM DCX
0
0.0 .1 .2 .3 .4 .5
ROE

Company Symbols
Company Name Ticker SymbolCompany Name Ticker SymbolCompany Name Ticker Symbol Company Name Ticker Symbol
Matsushita Elec. ADR MC British Telecom ADR BTY Merrill Lynch & Co. MER Int'l Business Mach. IBM
Compaq Computer CPQ Amer. Int'l Group AIG Fannie Mae FNM Abbott Labs. ABT
News Corp. Ltd. ADR NWS Chevron Corp. CHV Tyco Int'l Ltd. TYC Morgan S. Dean Witter MWD
AT&T Corp. T AEGON Ins. Group AEG Amer. Express AXP Amgen AMGN
Schlumberger Ltd. SLB Sprint Corp. FON Corning Inc. GLW Dell Computer DELL
Disney (Walt) DIS Boeing BA EMC Corp. EMC Amer. Home Products AHP
Koninklijke Philips NV PHG Hewlett-Packard HWP Gen'l Electric GE Procter & Gamble PG
Time Warner TWX Banco Bilbao Vis. ADR BBV Intel Corp. INTC Pfizer, Inc. PFE
Deutsche Telekom ADR DT Wells Fargo WFC Ford Motor F Schering-Plough SGP
WorldCom Inc. WCOM Ericsson ADR ERICY BellSouth Corp. BLS Merck & Co. MRK
Motorola, Inc. MOT Texas Instruments TXN Johnson & Johnson JNJ Bristol-Myers Squibb BMY
Telefonica SA ADR TEF Micron Technology MU Lucent Technologies LU Philip Morris MO
Banco Santander ADR STD Bank of America BAC PepsiCo, Inc. PEP Lilly (Eli) LLY
Sony Corp. ADR SNE Home Depot HD Cisco Systems CSCO Oracle Corp. ORCL
Exxon Mobil Corp. XOM McDonald's Corp. MCD Goldman Sachs GS
Aventis ADR AVE SBC Communications SBC Medtronic, Inc. MDT
Enron Corp. ENE Wal-Mart Stores WMT Sun Microsystems SUNW
Pharmacia Corp. PHA Du Pont DD Applied Materials AMAT
Shell Transport SC Citigroup Inc. C Schwab (Charles) SCH
Royal Dutch Petr. RD Qualcomm Inc. QCOM Microsoft Corp. MSFT
DaimlerChrysler AG DCX SmithKline Beecham SBH Nokia Corp. ADR NOK
BP Amoco ADR BPA Chase Manhattan Corp. CMB Coca-Cola KO

PBV Matrix: Telecom Companies
12
TelAzteca
10
TelNZ Vimple
8 Carlton
Teleglobe
FranceTel Cable&W
6
DeutscheTel
BritTel
TelItalia
Portugal AsiaSat
HongKong
BCE Royal
4 Hellenic
Nippon
DanmarkChinaTel
Espana Indast
Telmex
TelArgFrance
PhilTel Televisas
TelArgentina
2 TelIndo
TelPeru
APT
CallNet
Anonima GrupoCentro
0
0 10 20 30 40 50 60
ROE

U.S. Banks: Market Cap > $ 1 billion
5.00
MEL
SNV
CBH
3.75
WABC
WFC CYN
CFR WL
BBT
P
B VLY CMB
V 2.50 NBAK PNC
ZION FULT SKYF
HU FBF
ASO MRBK
TRMK WB
OV
STI CBC CBSS
BPOP
FVB BAC
FSCO RGBK
UPC PFGI FTU
SOTR
1.25 KEY
UB
BOH
BWE
0.12 0.16 0.20 0.24

ROE

Company Name Ticker Symbol Company Name Ticker Symbol Company Name Ticker Symbol
Westamerica Bancorp WABC Fulton Fin'l FULT Regions Financial RGBK
Keystone Fin'l KSTN First Va. Banks FVB Synovus Financial SNV
Colonial BncGrp. 'A' CNB City National Corp. CYN AmSouth Bancorp. ASO
One Valley Bancorp OV Hibernia Corp. `A' HIB KeyCorp KEY
National BanCorp. of Alaska,In NBAK Silicon Valley Bncsh SIVB BB&T Corp. BBT
BancWest Corp. BWE Mercantile Bankshares MRBK Wachovia Corp. WB
Hudson United Bancorp HU Compass Bancshares CBSS PNC Financial Serv. PNC
Provident Finl Group PFGI Popular Inc BPOP SunTrust Banks STI
Pacific Century Fin'l BOH First Security FSCO State Street Corp. STT
Centura Banks CBC No. Fork Bancorp NFB Mellon Financial Corp. MEL
Trustmark Corp. TRMK Natl Commerce Bancrp NCBC Morgan (J.P.) & Co JPM
Sky Finl Group Inc SKYF UnionBancal Corp UB First Union Corp. FTU
Wilmington Trust WL M&T Bank Corp. MTB FleetBoston Fin'l FBF
Valley Natl Bancp NJ VLY Zions Bancorp. ZION Bank of New York BK
Commerce Bancorp NJ CBH Union Planters UPC Chase Manhattan Corp. CMB
Cullen/Frost Bankers CFR SouthTrust Corp. SOTR Wells Fargo WFC
Summit Bancorp SUB Bank of America BAC

IBM: The Rise and Fall and Rise Again
10.00 50.00%
9.00
40.00%
8.00
30.00%
7.00
20.00%
6.00
Return on Equity
10.00%
Price to Book
5.00
0.00%
4.00
-10.00%
3.00
-20.00%
2.00
-30.00%
1.00
0.00 -40.00%
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Year
PBV ROE

PBV Ratio Regression
Model Summary

1 .686a .470 .469 167.8482
a. Predictors: (Constant), Beta, ROE1, Expected Growth in
EPS: next 5 y
Coefficients a,b
Standar
1 (Constant) 2.719 .199 13.678 .000
Expected Growth
6.325E-02 .008 .159 8.302 .000
in EPS: next 5 y
ROE1 9.656 .253 .667 38.183 .000
Beta -1.438 .183 -.150 -7.862 .000
a. Dependent Variable: PBV Ratio

PBV Ratio Regression: Brazil - September 2000
n Regressing PBV against ROE for 177 Brazilian firms (The betas are
missing for a lot of firms and meaningless for the rest, and there are no
expected growth rate estimates over the long term)
PBV = 0.77 + 3.78 (ROE) R squared = 17.3%
n To run this regression, we used
• Only firms with positive returns on equity
• Only firms with positive book values of equity

Cross Sectional Regression for Greece: May 2001
R squared = 22%
Number of firms in sample = 272
Coefficients a
Standar
1 (Constant) 2.106 .280 7.531 .000
ROE 11.631 1.535 .418 7.579 .000
a. Dependent Variable: PBV

Value/Book Value Ratio: Definition
n While the price to book ratio is a equity multiple, both the market
value and the book value can be stated in terms of the firm.
n Value/Book Value = Market Value of Equity + Market Value of Debt
Book Value of Equity + Book Value of Debt

Value/Book Ratio: Description
1400
1200
1000
800
600
400
Std. Dev = 2.63

200
Mean = 2.53
0 N = 4813.00
Value/BV of Capital

Determinants of Value/Book Ratios
n To see the determinants of the value/book ratio, consider the simple

free cash flow to the firm model:
FCFF1
V0 =
WACC - g
n Dividing both sides by the book value, we get:

V0 FCFF1 /BV
=
BV WACC - g
n If we replace, FCFF = EBIT(1-t) - (g/ROC) EBIT(1-t),we get

V0 ROC - g
=
BV WACC - g
Value/Book Ratio: An Example
n Consider a stable growth firm with the following characteristics:

• Return on Capital = 12%
• Cost of Capital = 10%
• Expected Growth = 5%
n The value/BV ratio for this firm can be estimated as follows:
Value/BV = (.12 - .05)/(.10 - .05) = 1.40
n The effects of ROC on growth will increase if the firm has a high
growth phase, but the basic determinants will remain unchanged.

Value/Book and the Return Spread
Value/BV Ratios and Return Spreads
4.50
4.00
3.50
3.00
Value/BV Ratio
2.50 WACC=8%
WACC=10%
WACC=12%
2.00
1.50
1.00
0.50
-
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
-2%
-1%
10%
ROC - WACC

Price Sales Ratio: Definition
n The price/sales ratio is the ratio of the market value of equity to the
sales.
n Price/ Sales= Market Value of Equity
Total Revenues
n Consistency Tests
• The price/sales ratio is internally inconsistent, since the market value of
equity is divided by the total revenues of the firm.

PS Ratios: The Inconsistency Test
n Assume that you are comparing price/sales ratios across firms in a

sector, and that there are differences in financial leverage across firms.
What type of firms will emerge with the lowest price/sales ratios?
o Low Leverage Firms
o Average Leverage Firms
o High Leverage Firms

Price/Sales Ratio: Cross Sectional Distribution
1400
1200
1000
800
600
400
Std. Dev = 2.55

200
Mean = 1.87
0 N = 4634.00
PS RATIO

Price/Sales Ratio: Determinants
n The price/sales ratio of a stable growth firm can be estimated

beginning with a 2-stage equity valuation model:
DPS1
P0 =
r − gn
n Dividing both sides by the sales per share:

P0 Net Profit Margin*Payout Ratio * ( 1+ g n )
= PS =
Sales 0 r-gn

Price/Sales Ratio for High Growth Firm
n When the growth rate is assumed to be high for a future period, the
dividend discount model can be written as follows:
 (1+ g)n 

EPS0 *Payout Ratio*(1 + g )* 1 − 
 ( 1 +r) n  EPS0 * Payout Ration * ( 1 + gn )* ( 1 + gn )
P0 = +
r -g ( r- g n )(1+ r) n
n Dividing both sides by the sales per share:

  ( 1 +g) n  
Net Margin * Payout Ratio*( 1 +g ) * 1 −
P0   ( 1 + r)n  Net Margin n * Payout Ratio n * ( 1 +g) n *(1 + gn ) 
= +
Sales 0  r -g (r - gn )(1 + r)n 
 
 
where Net Marginn = Net Margin in stable growth phase

Price Sales Ratios and Profit Margins
n The key determinant of price-sales ratios is the profit margin.

n A decline in profit margins has a two-fold effect.
• First, the reduction in profit margins reduces the price-sales ratio directly.
• Second, the lower profit margin can lead to lower growth and hence lower
price-sales ratios.
Expected growth rate = Retention ratio * Return on Equity
= Retention Ratio *(Net Profit / Sales) * ( Sales / BV of Equity)
= Retention Ratio * Profit Margin * Sales/BV of Equity

Price/Sales Ratio: An Example
High Growth Phase Stable Growth

Length of Period 5 years Forever after year 5
Net Margin 10% 6%
Sales/BV of Equity 2.5 2.5
Beta 1.25 1.00
Expected Growth (.1)(2.5)(.8)=20% (.06)(2.5)(.4)=.06
Riskless Rate =6%
  (1.20) 5
 
0.10 * 0.2 * (1.20) *  1 −
  (1.12875)5  0.06 * 0.60 * (1.20) * (1.06) 
5
PS =  +  = 1.06
(.12875 - .20) (.115 -.06) (1.12875)5
 
 

Effect of Margin Changes
Price/Sales Ratios and Net Margins
1.8
1.6
1.4
1.2
1
PS Ratio
0.8
0.6
0.4
0.2
0
2% 4% 6% 8% 10% 12% 14% 16%
Net Margin

PS/Margins: Greek Retailers
Company PS Net Margin

SPAKIANAKIS SA 0.25 2.88%
KOTSOVOLOS SA 0.48 1.91%
SANYO HELLAS 1.12 5.07%
IMAGE-SOV2VD SA 1.31 2.86%
GERMAN0S 1.49 6.94%
ELEKTRONIKI 1.61 6.29%
JUMBO 1.68 6.08%
PHiLIPPOS NAKAS 1.71 5.04%
GOODY'S 2.24 6.77%
HELLENIC DUTY 5.60 19.49%
AS COMPANY 7.02 8.23%
FOLLI-FOLLIE 10.82 29.08%

Regression Results: PS Ratios and Margins
n Regressing PS ratios against net margins,

PS = -.10 + 36.29 (Net Margin) R2 = 78%
n Thus, a 1% increase in the margin results in an increase of 0.36 in the
price sales ratios.
n The regression also allows us to get predicted PS ratios for these firms

Predicted PS Ratios
Symbol Company PS Predicted PS Under or Over Valued

SFA SPAKIANAKIS SA 0.25 0.94 -73.28%
KOTSV KOTSOVOLOS SA 0.48 0.59 -18.47%
SANYO SANYO HELLAS 1.12 1.74 -35.37%
IKONA IMAGE-SOV2VD SA 1.31 0.94 39.82%
GERM GERMAN0S 1.49 2.42 -38.41%
ELATH ELEKTRONIKI 1.61 2.18 -26.47%
BABY JUMBO 1.68 2.11 -20.39%
NAKAS PHXLXPPOS NAKAS 1.71 1.73 -1.38%
GOODY GOODY'S 2.24 2.36 -5.01%
HDF HELLENIC DUTY 5.60 6.97 -19.72%
ASCO AS COMPANY 7.02 2.89 143.07%
FOLLI FOLLX-FOLLXE 10.82 10.45 3.51%

Current versus Predicted Margins
n One of the limitations of the analysis we did in these last few pages is
the focus on current margins. Stocks are priced based upon expected
margins rather than current margins.
n For most firms, current margins and predicted margins are highly
correlated, making the analysis still relevant.
n For firms where current margins have little or no correlation with
expected margins, regressions of price to sales ratios against current
margins (or price to book against current return on equity) will not
provide much explanatory power.
n In these cases, it makes more sense to run the regression using either
predicted margins or some proxy for predicted margins.

A Case Study: The Internet Stocks
30
PKSI
LCOS SPYG
20
INTM MMXI
SCNT
MQST FFIV ATHM

A
CNET DCLK
d
j RAMP
INTW
P 10 CSGP CBIS NTPA
S NETO SONEPCLN
APNT CLKS
EDGRPSIX ATHY AMZN
SPLN BIDS
ALOY ACOM EGRP
BIZZ IIXL
ITRA ANET
ONEM ABTL INFO
FATB
RMII TMNT GEEK
-0 TURF PPOD BUYX ELTX
GSVI ROWE
-0.8 -0.6 -0.4 -0.2

AdjMargin

PS Ratios and Margins are not highly correlated
n Regressing PS ratios against current margins yields the following

PS = 81.36 - 7.54(Net Margin) R2 = 0.04
(0.49)
n This is not surprising. These firms are priced based upon expected
margins, rather than current margins.

Solution 1: Use proxies for survival and growth:
Amazon in early 2000
n Hypothesizing that firms with higher revenue growth and higher cash
balances should have a greater chance of surviving and becoming
profitable, we ran the following regression: (The level of revenues was
used to control for size)
PS = 30.61 - 2.77 ln(Rev) + 6.42 (Rev Growth) + 5.11 (Cash/Rev)
(0.66) (2.63) (3.49)
R squared = 31.8%
Predicted PS = 30.61 - 2.77(7.1039) + 6.42(1.9946) + 5.11 (.3069) =
30.42
Actual PS = 25.63
Stock is undervalued, relative to other internet stocks.

Solution 2: Use forward multiples
n You can always estimate price (or value) as a multiple of revenues,

earnings or book value in a future year. These multiples are called
forward multiples.
n For young and evolving firms, the values of fundamentals in future
years may provide a much better picture of the true value potential of
the firm. There are two ways in which you can use forward multiples:
• Look at value today as a multiple of revenues or earnings in the future
(say 5 years from now) for all firms in the comparable firm list. Use the
average of this multiple in conjunction with your firm’s earnings or
revenues to estimate the value of your firm today.
• Estimate value as a multiple of current revenues or earnings for more
mature firms in the group and apply this multiple to the forward earnings
or revenues to the forward earnings for your firm. This will yield the
expected value for your firm in the forward year and will have to be
discounted back to the present to get current value.

An Example of Forward Multiples: Amazon in early
2000
n Amazon.com lost $0.63 per share in 2000 but is expected to earn $ 1.50 per
share in 2005. At its current price of $ 49 per share, this would translate into a
price/future earnings per share of 32.67.
n In the first approach, this multiple of earnings can be compared to the
price/future earnings ratios of comparable firms. If you define comparable
firms to be e-tailers, Amazon looks reasonably attractive since the average
price/future earnings per share of e-tailers is 65. If, on the other hand, you
compared Amazon’s price to future earnings per share to the average price to
future earnings per share (in 2004) of specialty retailers, the picture is bleaker.
The average price to future earnings for these firms is 12, which would lead to
a conclusion that Amazon is over valued.
n In the second approach, the current price to earnings ratio for specialty
retailers, which is estimated to be 20.31 to the earnings per share of Amazon
in 2004 (which is estimated to be $1.50). This would yield a target price of
$30.46. Discounting this price back to the present using Amazon’s cost of
equity of 12.94% results in a value per share:
Value per share = Target price in five years/ (1 + Cost of equity)5
= $30.46/1.12945 = $16.58.
PS Regression
Model Summary

1 .851a .723 .723 88.1869
a. Predictors: (Constant), Beta, MARGIN, PAYOUT, Expected
Growth in EPS: next 5 y
Coefficients a,b,c
Standar
1 Expected Growth
4.392E-02 .005 .199 9.210 .000
in EPS: next 5 y
PAYOUT .807 .115 .087 7.007 .000
MARGIN 23.747 .466 .876 50.955 .000
Beta -.607 .085 -.187 -7.110 .000
a. Dependent Variable: PS RATIO
b. Linear Regression through the Origin
c. Weighted Least Squares Regression - Weighted by Market Cap

Cross Sectional Regression for Portugal in June
1999
n Using data on 74 Portuguese companies from 1999, we regressed PS

ratios against profit margins:
PS = 0.98 + 6.96 Margin
(4.34) (3.07) R2 = 45.29%

Value/Sales Ratio: Definition
n The value/sales ratio is the ratio of the market value of the firm to the
sales.
n Value/ Sales= Market Value of Equity + Market Value of Debt-Cash
Total Revenues

Value/Sales Ratio: Cross Sectional Distribution
1400
1200
1000
800
600
400
Std. Dev = 2.48

200
Mean = 2.01
0 N = 4644.00
EV/SALES

Value/Sales Ratios: Analysis of Determinants
n If pre-tax operating margins are used, the appropriate value estimate is

that of the firm. In particular, if one makes the assumption that
• Free Cash Flow to the Firm = EBIT (1 - tax rate) (1 - Reinvestment Rate)
n Then the Value of the Firm can be written as a function of the after-tax
operating margin= (EBIT (1-t)/Sales
  (1 + g )
n
 
(1 - RIRgrowth )(1 + g)* 1− n 
 (1+ WACC)  n
Value
= After - tax Oper. Margin *  +
(1- RIR stable )(1 + g) * ( 1 +g n ) 
Sales 0  WACC - g (WACC - g n ) ( 1 +WACC) n 
 
 
g = Growth rate in after-tax operating income for the first n years

gn = Growth rate in after-tax operating income after n years forever (Stable
growth rate)
RIRGrowth, Stable = Reinvestment rate in high growth and stable periods
WACC = Weighted average cost of capital

Value/Sales Ratio: An Example
n Consider, for example, the Value/Sales ratio of Coca Cola. The

company had the following characteristics:
After-tax Operating Margin =18.56% Sales/BV of Capital = 1.67
Return on Capital = 1.67* 18.56% = 31.02%
Reinvestment Rate= 65.00% in high growth; 20% in stable growth;
Expected Growth = 31.02% * 0.65 =20.16% (Stable Growth Rate=6%)
Length of High Growth Period = 10 years
Cost of Equity =12.33% E/(D+E) = 97.65%
After-tax Cost of Debt = 4.16% D/(D+E) 2.35%
Cost of Capital= 12.33% (.9765)+4.16% (.0235) = 12.13%
  (1.2016)10  
 ( 1 -.65)(1.2016)*  1− 10  
 (1.1213) 
10
Value of Firm 0
= .1856* +
( 1 -.20)(1.2016) * (1.06) 
= 6.10
Sales 0  .1213-.2016 (.1213-.06)(1.1213)10 
 
 

Value Sales Ratios and Operating Margins
Coca Cola: The Operating Margin Effect
12 250
10
200
150
Value/Sales Ratio
$ Value
Value/Sales
6
$ Value
100
50
2
0 0
6% 8% 10% 12% 14% 16% 18% 20%
Operating Margin

U.S. Specialty Retailers: V/S vs Operating Margin
2.0 LUX
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CHCS
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DABR BID
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TOO
BFCI
1.5 SCC
TWTR
CPWM
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TLB
PCCC WSM
SATH JWL PLCE CLE
PSUN
FOSL
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/ ORLYZLC
S LTD
a BBY
NSIT AZO
CWTRMIKE IPAR ANN
l ZQK GLBE
RAYS PIR
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MENS
s HLYW
SCHS MNRO
GBIZ DAP RUS
CAO
CC ITN BEBE
PGDA
0.5 ROST AEOS
URBN
MTMC PBY HMY
Z BKE
ANIC VOXX CHRS PSS
CLWY IBI
CELL JILL FNLY
GADZ WLSN
RUSH DBRN MDA
SAH
LVC SPGLA TWMC
FLWS ROSI FINL
PSRC ZANY
MHCO
GDYS RET.TO MLG
-0.0 MSEL
-0.000 0.075 0.150 0.225

Operating Margin
Brand Name Premiums in Valuation
n You have been hired to value Coca Cola for an analyst reports and
you have valued the firm at 6.10 times revenues, using the model
described in the last few pages. Another analyst is arguing that there
should be a premium added on to reflect the value of the brand name.
Do you agree?
o Yes
o No
n Explain.

The value of a brand name
n One of the critiques of traditional valuation is that is fails to consider

the value of brand names and other intangibles.
n The approaches used by analysts to value brand names are often ad-
hoc and may significantly overstate or understate their value.
n One of the benefits of having a well-known and respected brand name
is that firms can charge higher prices for the same products, leading to
higher profit margins and hence to higher price-sales ratios and firm
value. The larger the price premium that a firm can charge, the greater
is the value of the brand name.
n In general, the value of a brand name can be written as:
Value of brand name ={(V/S)b-(V/S)g }* Sales
(V/S)b = Value of Firm/Sales ratio with the benefit of the brand name
(V/S)g = Value of Firm/Sales ratio of the firm with the generic product

Illustration: Valuing a brand name: Coca Cola
Coca Cola Generic Cola Company

AT Operating Margin 18.56% 7.50%
Sales/BV of Capital 1.67 1.67
ROC 31.02% 12.53%
Reinvestment Rate 65.00% (19.35%) 65.00% (47.90%)
Expected Growth 20.16% 8.15%
Length 10 years 10 yea
Cost of Equity 12.33% 12.33%
E/(D+E) 97.65% 97.65%
AT Cost of Debt 4.16% 4.16%
D/(D+E) 2.35% 2.35%
Cost of Capital 12.13% 12.13%
Value/Sales Ratio 6.10 0.69
Value of Coca Cola’s Brand Name
n Value of Coke’s Brand Name = ( 6.10 - 0.69) ($18,868 million) =

$102 billion
n Value of Coke as a company = 6.10 ($18,546 million) = $ 115 Billion
n Approximately 88.69% of the value of the company can be traced to
brand name value

Value/Sales Ratio Regression: Market
Model Summary

1 .615a .379 .378 110.8277
a. Predictors: (Constant), Expected Growth in EPS: next 5 y,
OPMGN
Coefficients a,b
Standar
1 (Constant) .107 .090 1.196 .232
OPMGN 11.854 .340 .583 34.903 .000
Expected Growth
6.041E-02 .004 .238 14.274 .000
in EPS: next 5 y
a. Dependent Variable: EV/SALES

Choosing Between the Multiples
n As presented in this section, there are dozens of multiples that can be

potentially used to value an individual firm.
n In addition, relative valuation can be relative to a sector (or
comparable firms) or to the entire market (using the regressions, for
instance)
n Since there can be only one final estimate of value, there are three
choices at this stage:
• Use a simple average of the valuations obtained using a number of
different multiples
• Use a weighted average of the valuations obtained using a nmber of
different multiples
• Choose one of the multiples and base your valuation on that multiple

Averaging Across Multiples
n This procedure involves valuing a firm using five or six or more

multiples and then taking an average of the valuations across these
multiples.
n This is completely inappropriate since it averages good estimates with
poor ones equally.
n If some of the multiples are “sector based” and some are “market
based”, this will also average across two different ways of thinking
about relative valuation.

Weighted Averaging Across Multiples
n In this approach, the estimates obtained from using different multiples

are averaged, with weights on each based upon the precision of each
estimate. The more precise estimates are weighted more and the less
precise ones weighted less.
n The precision of each estimate can be estimated fairly simply for those
estimated based upon regressions as follows:
Precision of Estimate = 1 / Standard Error of Estimate
where the standard error of the predicted value is used in the
denominator.
n This approach is more difficult to use when some of the estimates are
subjective and some are based upon more quantitative techniques.

Picking one Multiple
n This is usually the best way to approach this issue. While a range of
values can be obtained from a number of multiples, the “best estimate”
value is obtained using one multiple.
n The multiple that is used can be chosen in one of two ways:
• Use the multiple that best fits your objective. Thus, if you want the
company to be undervalued, you pick the multiple that yields the highest
value.
• Use the multiple that has the highest R-squared in the sector when
regressed against fundamentals. Thus, if you have tried PE, PBV, PS, etc.
and run regressions of these multiples against fundamentals, use the
multiple that works best at explaining differences across firms in that
sector.
• Use the multiple that seems to make the most sense for that sector, given
how value is measured and created.

Self Serving Multiple Choice
n When a firm is valued using several multiples, some will yield really
high values and some really low ones.
n If there is a significant bias in the valuation towards high or low
values, it is tempting to pick the multiple that best reflects this bias.
Once the multiple that works best is picked, the other multiples can be
abandoned and never brought up.
n This approach, while yielding very biased and often absurd valuations,
may serve other purposes very well.
n As a user of valuations, it is always important to look at the biases of
the entity doing the valuation, and asking some questions:
• Why was this multiple chosen?
• What would the value be if a different multiple were used? (You pick the
specific multiple that you want to see tried.)

The Statistical Approach
n One of the advantages of running regressions of multiples against

fundamentals across firms in a sector is that you get R-squared values
on the regression (that provide information on how well fundamentals
explain differences across multiples in that sector).
n As a rule, it is dangerous to use multiples where valuation
fundamentals (cash flows, risk and growth) do not explain a significant
portion of the differences across firms in the sector.
n As a caveat, however, it is not necessarily true that the multiple that
has the highest R-squared provides the best estimate of value for firms
in a sector.

A More Intuitive Approach
n As a general rule of thumb, the following table provides a way of

picking a multiple for a sector
Sector Multiple Used Rationale
Cyclical Manufacturing PE, Relative PE Often with normalized earnings
High Tech, High Growth PEG Big differences in growth across
firms
High Growth/No Earnings PS, VS Assume future margins will be good
Heavy Infrastructure VEBITDA Firms in sector have losses in early
years and reported earnings can vary
depending on depreciation method
REITa P/CF Generally no cap ex investments
from equity earnings
Financial Services PBV Book value often marked to market
Retailing PS If leverage is similar across firms
VS If leverage is different

Sector or Market Multiples
n The conventional approach to using multiples is to look at the sector or

comparable firms.
n Whether sector or market based multiples make the most sense
depends upon how you think the market makes mistakes in valuation
• If you think that markets make mistakes on individual firm valuations but
that valuations tend to be right, on average, at the sector level, you will
use sector-based valuation only,
• If you think that markets make mistakes on entire sectors, but is generally
right on the overall market level, you will use only market-based
valuation
n It is usually a good idea to approach the valuation at two levels:
• At the sector level, use multiples to see if the firm is under or over valued
at the sector level
• At the market level, check to see if the under or over valuation persists
once you correct for sector under or over valuation.
A Test
n You have valued Earthlink Networks, an internet service provider,

relative to other internet companies using Price/Sales ratios and find it
to be under valued almost 50% .When you value it relative to the
market, using the market regression, you find it to be overvalued by
almost 50%. How would you reconcile the two findings?
o One of the two valuations must be wrong. A stock cannot be under and
over valued at the same time.
o It is possible that both valuations are right.
What has to be true about valuations in the sector for the second statement
to be true?

Reviewing: The Four Steps to Understanding
Multiples
n Define the multiple

• Check for consistency
• Make sure that they are estimated uniformally
n Describe the multiple
• Multiples have skewed distributions: The averages are seldom good
indicators of typical multiples
• Check for bias, if the multiple cannot be estimated
n Analyze the multiple
• Identify the companion variable that drives the multiple
• Examine the nature of the relationship
n Apply the multiple

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Equity Instruments & Markets: Part II

“ A little inaccuracy sometimes saves tons of explanation”

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

n Prices can be standardized using a common variable such as earnings,

n Define the multiple

n Is the multiple consistently defined?

n Given the firm that we are valuing, what is a “comparable” firm?

PE = Market Price per Share / Earnings per Share

Distribution of PE Ratios - September 2001

Current PE Trailing PE Forward PE

n To understand the fundamentals, start with a basic equity discounted

n Dividing both sides by the earnings per share,

n If this had been a FCFE Model,

n Proposition: Other things held equal, higher growth firms will

n In this model, the PE ratio for a high growth firm is a function of

PE Ratios and Expected Growth: Interest Rate Scenarios

PE Ratios and Length of High Growth Period

PE Ratios and Beta: Growth Scenarios

PE Ratios and Payour Ratios: Growth Scenarios

n In July 2000, a market strategist is making the argument that Brazil

Country PE Dividend Yield 2-yr rate 10-yr rate 10yr - 2yr

Country Actual PE Predicted PE Under or Over Valued

Country PE Ratio Interest GDP Real Country

n The regression of PE ratios on these variables provides the following –

Country PE Ratio Interest GDP Real Country Predicted PE

n There is a strong positive relationship between E/P ratios and T.Bond

Company Name Trailing PE Expected Growth Standard Dev

Hansen Natural Corp 9.70 17.00% 62.45%

Company Name PE Growth

Dependent variable is: PE

R squared = 66.2% R squared (adjusted) = 63.1%

Variable Coefficient SE t-ratio prob

n Predicted PE = 13.12 + 121.22 (.075) - 13.85 (1) = 8.35

n The most common approach to estimating the PE ratio for a firm is

n In contrast to the 'comparable firm' approach, the information in the

Expected Growth in EPS: next 5 years

Adjusted R Std. Error of

n Based on this regression, estimate the PE ratio for a firm with no

n Is there a problem with your prediction?

Adjusted R Std. Error of

n The basic regression assumes a linear relationship between PE ratios

n Dell is actually trading at 18 times earnings. What does the predicted

n In its simple form, there is no basis for believing that a firm is

Figure 14.2: PE Ratios and T.Bond Rates

n The PEG ratio is the ratio of price earnings to expected growth in

Std. Dev = 1.05

Price/ Expected Growth RAte

Company Name Trailing PE Growth Std Dev PEG

n To understand the fundamentals that determine PEG ratios, let us

n Dividing both sides of the equation by the earnings gives us the

PEG Ratios and Beta: Different Growth Rates

PEG Ratios and Retention Ratios

PEG Ratios, Expected Growth and Interest Rates

n Proposition 1: High risk companies will trade at much lower PEG

Company Name Trailing PE Growth Std Dev PEG

n This analysis, which is restricted to firms in the software sector, can be

Expected Growth in EPS: next 5 years

Adjusted R Std. Error of

n The average relative PE is always one.

n To analyze the determinants of the relative PE ratios, let us revisit the

where Payoutj, gj, rj = Payout, growth and risk of the firm

n Consider the following example of a firm growing at twice the rate as

n Expected Net Income = (EBIT - Interest Expense)(1-t) 1+g) = (30 -