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Equity Instruments & Markets: Part II
B40.3331
Relative Valuation
Aswath Damodaran
Aswath Damodaran 2
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 3
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 4
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 5
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 6
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 earningsbased multiples are used, the accounting rules to measure
earnings should be applied consistently across assets. The same rule
applies with bookvalue based multiples.
Aswath Damodaran 7
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 8
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 9
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 10
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 11
PE Ratio: Descriptive Statistics
Dist ribut ion of PE Rat ios  Sept ember 2001
0
200
400
600
800
1000
1200
04 4  6 6  8 8  10 10  15 1520 2025 2530 3035 3540 40  45 45 50 50 75 75 
100
> 100
PE rat io
N
u
m
b
e
r
o
f
f
i
r
m
s
Current PE
Trailing PE
Forward PE
Aswath Damodaran 12
PE: Deciphering the Distribution
Current PE Trailing PE Forward PE
Mean 30.93 30.33 21.13
St andard Error 2.70 2.74 0.73
Median 15.27 15.20 13.71
Mode 10 0 14
St andard Deviat ion 157.30 150.65 38.22
Kurt osis 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 13
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,
n Dividing both sides by the earnings per share,
n If this had been a FCFE Model,
P
0
·
DPS
1
r − g
n
P
0
EPS
0
· PE=
Payout Ratio*(1 + g
n
)
r  g
n
P
0
·
FCFE
1
r − g
n
P
0
EPS
0
· PE =
(FCFE/Earnings)*(1 + g
n
)
rg
n
Aswath Damodaran 14
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 15
Using the Fundamental Model to Estimate PE For a
High Growth Firm
n The priceearnings ratio for a high growth firm can also be related to
fundamentals. In the special case of the twostage dividend discount
model, this relationship can be made explicit fairly simply:
• 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:
P
0
=
EPS
0
*Payout Rat i o*( 1+ g) * 1 −
( 1+g)
n
( 1+r)
n

.
`
,
r  g
+
EPS
0
*Payout Ratio
n
* ( 1 +g)
n
* ( 1 +g
n
)
(r  g
n
)(1+r)
n
P
0
EPS
0
=
Payout Ratio*(1 +g)* 1 −
(1+g)
n
(1+ r)
n

.
`
,
r  g
+
Payout Ratio
n
*( 1+g)
n
*(1 + g
n
)
(r  g
n
)(1+ r)
n
Aswath Damodaran 16
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 17
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%
PE =
0. 2 * (1.25) * 1−
(1.25)
5
(1.115)
5

.
`
,
(.115  .25)
+
0. 5 * (1.25)
5
*(1.08)
(.115.08) (1.115)
5
= 28.75
Aswath Damodaran 18
PE and Growth: Firm grows at x% for 5 years, 8%
thereafter
PE Rat ios and Expect ed Gr owt h: Int er est Rat e Scenar ios
0
20
40
60
80
100
120
140
160
180
5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
Expect ed Growt h Rat e
P
E
R
a
t
i
o
r=4%
r=6%
r=8%
r =1 0 %
Aswath Damodaran 19
PE Ratios and Length of High Growth: 25% growth
for n years; 8% thereafter
PE Rat ios and Lengt h of High Growt h Period
0
10
20
30
40
50
60
0 1 2 3 4 5 6 7 8 9 10
Lengt h of High Growt h Period
P
E
R
a
t
i
o
g=25%
g=20%
g=15%
g=10%
Aswath Damodaran 20
PE and Risk: Effects of Changing Betas on PE
Ratio:
Firm with x% growth for 5 years; 8% thereafter
PE Rat ios and Bet a: Growt h Scenarios
0
5
10
15
20
25
30
35
40
45
50
0.75 1.00 1.25 1.50 1.75 2.00
Bet a
P
E
R
a
t
i
o
g=25%
g=20%
g=15%
g=8%
Aswath Damodaran 21
PE and Payout
PE Rat ios and Payour Rat ios: Growt h Scenarios
0
5
10
15
20
25
30
35
0% 20% 40% 60% 80% 100%
Payout Rat io
P
E
g=25%
g=20%
g=15%
g=10%
Aswath Damodaran 22
PE: Emerging Markets
0
5
10
15
20
25
30
35
Mexico Malaysia Singapore Taiwan Hong Kong Venezuela Brazil Argentina Chile
Aswath Damodaran 23
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 24
A Comparison across countries: June 2000
Count ry PE Dividend Yield 2yr rat e 10yr rat e 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%
Swit zerland 19.6 1.42% 3.62% 3.83% 0.21%
Belgium 14.74 2.66% 5.15% 5.70% 0.55%
It aly 28.23 1.76% 5.27% 5.70% 0.43%
Sweden 32.39 1.11% 4.67% 5.26% 0.59%
Net herlands 21.1 2.07% 5.10% 5.47% 0.37%
Aust ralia 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 25
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 (10yr  2 yr rate) R
2
= 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 26
Predicted PE Ratios
Count ry Act ual PE Predict ed 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%
Swit zerland 19.6 30.58 35.90%
Belgium 14.74 26.71 44.81%
It aly 28.23 25.69 9.89%
Sweden 32.39 28.63 13.12%
Net herlands 21.1 26.01 18.88%
Aust ralia 21.69 19.73 9.96%
Japan 52.25 46.70 11.89%
Unit ed St at es 25.14 19.81 26.88%
Canada 26.14 22.39 16.75%
Aswath Damodaran 27
An Example with Emerging Markets: June 2000
Country PE Ratio Interest
Rates
GDP Real
Growth
Country
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 28
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 29
Predicted PE Ratios
Country PE Ratio Interest
Rates
GDP Real
Growth
Country
Risk
Predict ed PE
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 30
Comparisons of PE across time: PE Ratio for the
S&P 500
PE Rat i o: 1 9 6 0  2 0 0 0
0.00
5.00
10.00
15.00
20.00
25.00
30.00
35.00
1
9
6
0
1
9
6
2
1
9
6
4
1
9
6
6
1
9
6
8
1
9
7
0
1
9
7
2
1
9
7
4
1
9
7
6
1
9
7
8
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
Aswath Damodaran 31
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 32
E/P Ratios , T.Bond Rates and Term Structure
2.00%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
1
9
6
0
1
9
6
2
1
9
6
4
1
9
6
6
1
9
6
8
1
9
7
0
1
9
7
2
1
9
7
4
1
9
7
6
1
9
7
8
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
Earnings Yield
T.Bond Rat e
BondBill
Aswath Damodaran 33
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 19602000 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 RateT.Bill Rate)
(2.84) (6.08) (2.37)
R squared = 50%
Aswath Damodaran 34
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 35
Comparing PE ratios across firms
Company Name Trailing PE Expect ed Growt h St andard Dev
CocaCola Bot t ling 29.18 9.50% 20.58%
Molson Inc. Lt d. ' A' 43.65 15.50% 21.88%
AnheuserBusch 24.31 11.00% 22.92%
Corby Dist illeries Lt d. 16.24 7.50% 23.66%
Chalone Wine Group Lt d. 21.76 14.00% 24.08%
Andres Wines Lt d. ' A' 8.96 3.50% 24.70%
Todhunt er Int ' l 8.94 3.00% 25.74%
BrownForman ' B' 10.07 11.50% 29.43%
Coors ( Adolph) ' B' 23.02 10.00% 29.52%
PepsiCo, Inc. 33.00 10.50% 31.35%
CocaCola 44.33 19.00% 35.51%
Bost on Beer ' A' 10.59 17.13% 39.58%
Whit man Corp. 25.19 11.50% 44.26%
Mondavi ( Robert ) ' A' 16.47 14.00% 45.84%
CocaCola Ent erprises 37.14 27.00% 51.34%
Hansen Nat ural Corp 9.70 17.00% 62.45%
Aswath Damodaran 36
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 37
Comparing PE Ratios across a Sector
Company Name PE Growt h
PT Indosat ADR 7.8 0.06
Telebras ADR 8.9 0.075
Telecom Corporat ion of New Zealand ADR 11.2 0.11
Telecom Argent ina St et  France Telecom SA ADR B 12.5 0.08
Hellenic Telecommunicat ion Organizat ion SA ADR 12.8 0.12
Telecomunicaciones de Chile ADR 16.6 0.08
Swisscom AG ADR 18.3 0.11
Asia Sat ellit e Telecom Holdings ADR 19.6 0.16
Port ugal Telecom SA ADR 20.8 0.13
Telef onos de Mexico ADR L 21.1 0.14
Mat av RT ADR 21.5 0.22
Telst ra ADR 21.7 0.12
Gilat Communicat ions 22.7 0.31
Deut sche Telekom AG ADR 24.6 0.11
Brit ish Telecommunicat ions 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 Sat ellit e Holdings ADR 31 0.33
Telef onica SA ADR 32.5 0.18
Royal KPN NV ADR 35.7 0.13
Telecom It alia 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 38
PE, Growth and Risk
Dependent variable is: PE
R squared = 66.2% R squared (adjusted) = 63.1%
Variable Coefficient SE tratio 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 39
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 40
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 41
Using the entire crosssection: A regression approach
n In contrast to the 'comparable firm' approach, the information in the
entire crosssection 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 42
PE versus Growth
Expect ed Growt h in EPS: next 5 years
100 80 60 40 20 0 20
120
100
80
60
40
20
0
20
Aswath Damodaran 43
PE Ratio: Standard Regression
Model Summary
.478
a
.229 .227 803.9541
Model
1
R R Square
Adjust ed R
Square
St d. Error of
t he Est imat e
Predict ors: ( Const ant ) , Expect ed Growt h in EPS: next 5 y,
PAYOUT1, Bet a
a.
Coef f icient s
a,b
13.090 1.164 11.242 .000
3.392 .908 .089 3.737 .000
4.938 1.190 .098 4.150 .000
.880 .040 .527 22.115 .000
( Const ant )
Bet a
PAYOUT1
Expect ed Growt h
in EPS: next 5 y
Model
1
B St d. Er r or
Unst andardized
Coef f icient s
Bet a
St andar
dized
Coef f icient s
t Sig.
Dependent Variable: Current PE a.
Weight ed Least Squares Regression  Weight ed by Market Cap b.
Aswath Damodaran 44
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 45
PE Regression No Intercept
Model Summary
.912
b
.832 .832 833.0224
Model
1
R R Square
a
Adjust ed R
Square
St d. Error of
t he Est imat e
For regression t hrough t he origin ( t he noint ercept
model) , R Square measures t he proport ion of t he
variabilit y in t he dependent variable about t he origin
explained by regression. This CANNOT be compared t o R
Square f or models which include an int ercept .
a.
Predict ors: Expect ed Growt h in EPS: next 5 y, PAYOUT1,
Bet a
b.
Coef f icient s
a,b,c
4.389 .609 .188 7.212 .000
13.299 .962 .189 13.823 .000
1.014 .039 .608 25.786 .000
Bet a
PAYOUT1
Expect ed Growt h
in EPS: next 5 y
Model
1
B St d. Er r or
Unst andardized
Coef f icient s
Bet a
St andar
dized
Coef f icient s
t Sig.
Dependent Variable: Current PE a.
Linear Regression t hrough t he Origin b.
Weight ed Least Squares Regression  Weight ed by Market Cap c.
Aswath Damodaran 46
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 multicollinearity makes
the coefficients of the regressions unreliable and may explain the large
changes in these coefficients from period to period.
Aswath Damodaran 47
The Multicollinearity Problem
Correlat ions
1.000 .342* * .130* * .009
. .000 .000 .594
3303 2085 3027 3290
.342* * 1.000 .397* * .078 * *
.000 . .000 .000
2085 2675 2393 2143
.130* * .397* * 1.000 .213 * *
.000 .000 . .000
3027 2393 4534 3114
.009 .078 * * .213 * * 1.000
.594 .000 .000 .
3290 2143 3114 3388
Pearson Correlat ion
Sig. ( 2t ailed)
N
Pearson Correlat ion
Sig. ( 2t ailed)
N
Pearson Correlat ion
Sig. ( 2t ailed)
N
Pearson Correlat ion
Sig. ( 2t ailed)
N
Current PE
Expect ed Growt h
in EPS: next 5 y
Bet a
Payout Rat io
Current PE
Expect ed
Growt h in EPS:
next 5 y Bet a Payout Rat io
Correlat ion is signif icant at t he 0.01 level ( 2t ailed) .
* * .
Aswath Damodaran 48
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 49
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 50
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 51
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
0
5
10
15
20
25
30
35
40
45
5% 6% 7% 8% 9% 10%
T.Bond Rate
Aswath Damodaran 52
PE Ratios Less Than The Expected Growth Rate
n In September 2001,
• 33% of firms had PE ratios lower than the expected 5year growth rate
• 67% of firms had PE ratios higher than the expected 5year growth rate
n In comparison,
• 38.1% of firms had PE ratios less than the expected 5year growth rate in
September 1991
• 65.3% of firm had PE ratios less than the expected 5year growth rate in
1981.
Aswath Damodaran 53
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 54
PEG Ratio: Distribution
Price/ Expect ed Growt h RAt e
400
300
200
100
0
St d. Dev = 1.05
Mean = 1.55
N = 2084.00
Aswath Damodaran 55
PEG Ratios: The Beverage Sector
Company Name Trailing PE Growt h St d Dev PEG
CocaCola Bot t ling 29.18 9.50% 20.58% 3.07
Molson Inc. Lt d. ' A' 43.65 15.50% 21.88% 2.82
AnheuserBusch 24.31 11.00% 22.92% 2.21
Corby Dist illeries Lt d. 16.24 7.50% 23.66% 2.16
Chalone Wine Group Lt d. 21.76 14.00% 24.08% 1.55
Andres Wines Lt d. ' A' 8.96 3.50% 24.70% 2.56
Todhunt er Int ' l 8.94 3.00% 25.74% 2.98
BrownForman ' 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
CocaCola 44.33 19.00% 35.51% 2.33
Bost on Beer ' A' 10.59 17.13% 39.58% 0.62
Whit man Corp. 25.19 11.50% 44.26% 2.19
Mondavi ( Robert ) ' A' 16.47 14.00% 45.84% 1.18
CocaCola Ent erprises 37.14 27.00% 51.34% 1.38
Hansen Nat ural Corp 9.70 17.00% 62.45% 0.57
Average 22.66 0.13 0.33 2.00
Aswath Damodaran 56
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 57
PEG Ratio: Analysis
n To understand the fundamentals that determine PEG ratios, let us
return again to a 2stage equity discounted cash flow model
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’
P
0
=
EPS
0
*Payout Rat i o*( 1+ g) * 1 −
( 1+g)
n
( 1+r)
n

.
`
,
r  g
+
EPS
0
*Payout Ratio
n
* ( 1 +g)
n
* ( 1 +g
n
)
(r  g
n
)(1+r)
n
PEG =
Payout Ratio*(1+ g) * 1 −
( 1+g)
n
(1 + r)
n

.
`
,
g(r  g)
+
Payout Ratio
n
* ( 1+g)
n
* ( 1 +g
n
)
g(r  g
n
)(1 + r)
n
Aswath Damodaran 58
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 2stage model)
Aswath Damodaran 59
A Simple Example
n Assume that you have been asked to estimate the PEG 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%
n The PEG ratio for this firm can be estimated as follows:
PEG =
0.2 * (1.25) * 1 −
(1.25)
5
(1.115)
5

.
`
,
.25(.115  .25)
+
0.5 * (1.25)
5
*(1.08)
.25(.115.08) (1.115)
5
= .115 or 1.15
Aswath Damodaran 60
PEG Ratios and Risk
PEG Rat ios and Bet a: Dif f erent Growt h Rat es
0
0.5
1
1.5
2
2.5
3
0.75 1.00 1.25 1.50 1.75 2.00
Bet a
P
E
G
R
a
t
i
o
g =25%
g=20%
g=15%
g=8%
Aswath Damodaran 61
PEG Ratios and Quality of Growth
PEG Rat ios and Ret ent ion Rat ios
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1 0.8 0.6 0.4 0.2 0
Ret ent ion Rat io
P
E
G
R
a
t
i
o
PEG
Aswath Damodaran 62
PE Ratios and Expected Growth
PEG Rat ios, Expect ed Growt h and Int erest Rat es
0.00
0.50
1.00
1.50
2.00
2.50
5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
Expect ed Growt h Rat e
P
E
G
R
a
t
i
o
r=6%
r=8%
r =1 0 %
Aswath Damodaran 63
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 64
PE, PEG Ratios and Risk
0
5
10
15
20
25
30
35
40
45
Lowest 2 3 4 Highest
0
0.5
1
1.5
2
2.5
PE
PEG Ratio
Aswath Damodaran 65
PEG Ratio: Returning to the Beverage Sector
Company Name Trailing PE Growt h St d Dev PEG
CocaCola Bot t ling 29.18 9.50% 20.58% 3.07
Molson Inc. Lt d. ' A' 43.65 15.50% 21.88% 2.82
AnheuserBusch 24.31 11.00% 22.92% 2.21
Corby Dist illeries Lt d. 16.24 7.50% 23.66% 2.16
Chalone Wine Group Lt d. 21.76 14.00% 24.08% 1.55
Andres Wines Lt d. ' A' 8.96 3.50% 24.70% 2.56
Todhunt er Int ' l 8.94 3.00% 25.74% 2.98
BrownForman ' 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
CocaCola 44.33 19.00% 35.51% 2.33
Bost on Beer ' A' 10.59 17.13% 39.58% 0.62
Whit man Corp. 25.19 11.50% 44.26% 2.19
Mondavi ( Robert ) ' A' 16.47 14.00% 45.84% 1.18
CocaCola Ent erprises 37.14 27.00% 51.34% 1.38
Hansen Nat ural Corp 9.70 17.00% 62.45% 0.57
Average 22.66 0.13 0.33 2.00
Aswath Damodaran 66
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 industryaverage growth rate as the independent variable,
with mixed results.
Aswath Damodaran 67
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 68
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 69
PEG versus Growth
Expect ed Growt h in EPS: next 5 years
100 80 60 40 20 0 20
6
5
4
3
2
1
0
1
Aswath Damodaran 70
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 71
PEG versus ln(Expected Growth)
Ln( Expect ed Growt h)
5 4 3 2 1 0 1
6
5
4
3
2
1
0
1
Aswath Damodaran 72
Market PEG Ratio Regression
Model Summary
.587
a
.344 .343 56.7746
Model
1
R R Square
Adjust ed R
Square
St d. Error of
t he Est imat e
Predict ors: ( Const ant ) , LNGROWTH, PAYOUT1, Bet a
a.
Coef f icient s
a,b
3.935 .112 35.175 .000
7.249E02 .064 .025 1.140 .255
.575 .084 .149 6.873 .000
.867 .037 .509 23.522 .000
( Const ant )
Bet a
PAYOUT1
LNGROWTH
Model
1
B St d. Er r or
Unst andardized
Coef f icient s
Bet a
St andar
dized
Coef f icient s
t Sig.
Dependent Variable: PEG1
a.
Weight ed Least Squares Regression  Weight ed by Market Cap
b.
Aswath Damodaran 73
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 74
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 nonlinear. 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 75
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 76
Relative PE: Cross Sectional Distribution
Relat ive PE
1000
800
600
400
200
0
St d. Dev = .77
Mean = 1.00
N = 3303.00
Aswath Damodaran 77
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 78
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
2stage DDM model as our basis (replacing the payout ratio with the
FCFE/Earnings Ratio, if necessary), we get
where Payout
j
, g
j
, r
j
= Payout, growth and risk of the firm
Payout
m
, g
m
, r
m
= Payout, growth and risk of the market
Relative PE
j
=
Payout Ratio
j
*( 1+ g
j
) * 1 −
( 1 +g
j
)
n
( 1+r
j
)
n

.
`
,
r
j
 g
j
+
Payout Ratio
j,n
* ( 1+ g
j
)
n
*( 1+ g
j,n
)
(r
j
 g
j,n
)(1 + r
j
)
n
Payout Ratio
m
* ( 1+g
m
) * 1 −
( 1+g
m
)
n
( 1+r
m
)
n

.
`
,
r
m
 g
m
+
Payout Ratio
m,n
* ( 1+g
m
)
n
* ( 1+ g
m,n
)
(r
m
 g
m,n
) ( 1+r
m
)
n
Aswath Damodaran 79
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 80
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:
n Relative PE Ratio = 15.79/10.45 = 1.51
PE
firm
=
0. 3 *(1.20) * 1−
(1.20)
5
(1.115)
5

.
`
,
(.115  .20)
+
0.5 * (1.20)
5
* (1.06)
(.115 .06) (1.115)
5
= 15.79
PE
market
=
0. 3 *(1.10) * 1−
(1.10)
5
(1.115)
5

.
`
,
(.115  .10)
+
0.5 * (1.10)
5
*(1.06)
(.115.06) (1.115)
5
= 10.45
Aswath Damodaran 81
Relative PE and Relative Growth
Relat ive PE and Relat ive Growt h Rat es: Market Growt h Scenarios
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
0% 50% 100% 150% 200% 250% 300%
Firm' s Growt h Rat e/ Market Growt h Rat e
R
e
l
a
t
i
v
e
P
E
Market g=5%
Market g=10%
Market g=15%
Aswath Damodaran 82
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 83
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:
n Relative PE Ratio = 8.33/10.45 = 0.80
PE
firm
=
0. 3 * (1. 10) * 1 −
(1.10)
5
(1.17)
5

.
`
,
(.17  . 10)
+
0. 5 * (1.10)
5
* (1.06)
(.115.06) (1.17)
5
= 8.33
PE
market
=
0. 3 *(1.10) * 1−
(1.10)
5
(1.115)
5

.
`
,
(.115  .10)
+
0.5 * (1.10)
5
*(1.06)
(.115.06) (1.115)
5
= 10.45
Aswath Damodaran 84
Relative PE and Relative Risk
Relat ive PE and Relat ive Risk: St able Bet a Scenarios
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
0.25 0.5 0.75 1 1.25 1.5 1.75 2
Bet a st ays at current level
Bet a drops t o 1 in st able phase
Aswath Damodaran 85
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 86
Relative PE Ratios: The Auto Sector
Relative PE Ratios: Auto Stocks
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1993 1994 1995 1996 1997 1998 1999 2000
Ford
Chrysler
GM
Aswath Damodaran 87
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 88
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 89
Relative PE Ratios: Market Analysis
Model Summary
.478
a
.229 .227 41.4196
Model
1
R R Square
Adjust ed R
Square
St d. Error of
t he Est imat e
Predict ors: ( Const ant ) , Bet a, RELPYT, RELGR a.
Coef f icient s
a,b
.674 .060 11.242 .000
.835 .038 .527 22.115 .000
4.431E02 .011 .098 4.150 .000
.175 .047 .089 3.737 .000
( Const ant )
RELGR
RELPYT
Bet a
Model
1
B St d. Er r or
Unst andardized
Coef f icient s
Bet a
St andar
dized
Coef f icient s
t Sig.
Dependent Variable: RELPE
a.
Weight ed Least Squares Regression  Weight ed by Market Cap
b.
Aswath Damodaran 90
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 DebtCash)
EBIT (1t)  (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 91
Value/FCFF Distribution
Ent erprise Value/ FCFF
800
600
400
200
0
St d. Dev = 21.77
Mean = 20.6
N = 3063.00
Aswath Damodaran 92
Value of Firm/FCFF: Determinants
n Reverting back to a twostage FCFF DCF model, we get:
• V
0
= Value of the firm (today)
• FCFF
0
= 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
• g
n
= Expected growth rate in FCFF in stable growth period (after n
years)
V
0
=
FCFF
0
(1 + g) 1 
(1 + g)
n
( 1 +WACC)
n

.
`
,
WACC g
+
FCFF
0
( 1+g)
n
( 1+g
n
)
(WACC g
n
)(1 + WACC)
n
Aswath Damodaran 93
Value Multiples
n Dividing both sides by the FCFF yields,
n The value/FCFF multiples is a function of
• the cost of capital
• the expected growth
V
0
FCFF
0
=
(1 + g) 1 
(1 + g)
n
(1 + WACC)
n

.
`
,
WACC g
+
( 1+g)
n
( 1 +g
n
)
(WACC g
n
)(1 + WACC)
n
Aswath Damodaran 94
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:
• aftertax operating income or EBIT(1t)
• pretax operating income or EBIT
• net operating income (NOI), a slightly modified version of operating
income, where any nonoperating expenses and income is removed from
the EBIT
• EBITDA, which is earnings before interest, taxes, depreciation and
amortization.
Aswath Damodaran 95
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(1t)
o Value/FCFF
o Value/EBITDA
n What assumption(s) would you need to make for the Value/EBIT(1t)
ratio to be equal to the Value/FCFF multiple?
Aswath Damodaran 96
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%.
V
0
FCFF
0
=
(1.15) 1
(1.15)
5
(1.105)
5

.
`
,
.105 .15
+
(1.15)
5
(1.05)
(.10  .05)(1.105)
5
= 31.28
Aswath Damodaran 97
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 (1t)  Net Cap Ex  Change in Working Capital
= 3356 (1  0.36) + 1100  2500  250 = $ 498 million
$ Value Correct Multiple
FCFF $498 31.28382355
EBIT (1t) $2,148 7.251163362
EBIT $ 3,356 4.640744552
EBITDA $4,456 3.49513885
Aswath Damodaran 98
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 99
Value/EBITDA Multiple
n The Classic Definition
n The NoCash Version
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.
Value
EBITDA
·
Market Value of Equity + Market Value of Debt
Earnings before Interest, Taxes and Depreciation
Enterprise Value
EBITDA
·
Market Value of Equity + Market Value of Debt  Cash
Earnings before Interest, Taxes and Depreciation
Aswath Damodaran 100
Value/EBITDA Distribution
EV/ EBITDA
1200
1000
800
600
400
200
0
St d. Dev = 8.06
Mean = 8.0
N = 3630.00
Aswath Damodaran 101
The Determinants of Value/EBITDA Multiples:
Linkage to DCF Valuation
n Firm value can be written as:
n The numerator can be written as follows:
FCFF = EBIT (1t)  (Cex  Depr)  ∆ Working Capital
= (EBITDA  Depr) (1t)  (Cex  Depr)  ∆ Working Capital
= EBITDA (1t) + Depr (t)  Cex  ∆ Working Capital
V
0
=
FCFF
1
WACC g
Aswath Damodaran 102
From Firm Value to EBITDA Multiples
n Now the Value of the firm can be rewritten as,
n Dividing both sides of the equation by EBITDA,
Value =
EBITDA (1t) + Depr (t)  Cex  ∆ Working Capital
WACC g
Value
EBITDA
=
(1 t)
WACCg
+
Depr (t)/EBITDA
WACC g

CEx/EBITDA
WACC g

∆ Working Capital/EBITDA
WACC g
Aswath Damodaran 103
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.
Aswath Damodaran 104
Calculating Value/EBITDA Multiple
n In this case, the Value/EBITDA multiple for this firm can be estimated
as follows:
Value
EBITDA
=
( 1.36)
.10  . 05
+
(0.2)(.36)
.10  . 05

0.3
.10  .05

0
.10  .05
= 8.24
Aswath Damodaran 105
Value/EBITDA Multiples and Taxes
VEBITDA Mult iples and Tax Rat es
0
2
4
6
8
10
12
14
16
0% 10% 20% 30% 40% 50%
Tax Rat e
V
a
l
u
e
/
E
B
I
T
D
A
Aswath Damodaran 106
Value/EBITDA and Net Cap Ex
Value/ EBITDA and Net Cap Ex Rat ios
0
2
4
6
8
10
12
0% 5% 10% 15% 20% 25% 30%
Net Cap Ex/ EBITDA
V
a
l
u
e
/
E
B
I
T
D
A
Aswath Damodaran 107
Value/EBITDA Multiples and Return on Capital
Value/ EBITDA and Ret urn on Capit al
0
2
4
6
8
10
12
6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
Ret urn on Capit al
V
a
l
u
e
/
E
B
I
T
D
A
WACC=10%
WACC=9%
WACC=8%
Aswath Damodaran 108
Value/EBITDA Multiple: Trucking Companies
Company Name Value EBITDA Value/ EBITDA
KLLM Trans. Svcs. 114.32 $ 48.81 $ 2.34
Ryder Syst em 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
Mart en Transport Lt d. 116.93 $ 35.62 $ 3.28
Kenan Transport Co. 67.66 $ 19.44 $ 3.48
M.S. Car r ier s 344.93 $ 97.85 $ 3.53
Old Dominion Freight 170.42 $ 45.13 $ 3.78
Trimac Lt d 661.18 $ 174.28 $ 3.79
Mat lack Syst ems 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 Ent erprises 844.39 $ 196.15 $ 4.30
Landst ar 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
USFreight ways 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 Lt d. 73.64 $ 13.48 $ 5.46
Celadon Group 182.30 $ 32.72 $ 5.57
Amer. Freight ways 716.15 $ 120.94 $ 5.92
Transf inancial Holdings 56.92 $ 8.79 $ 6.47
Vit ran Corp. ' A' 140.68 $ 21.51 $ 6.54
Int erpool Inc. 1,002.20 $ 151.18 $ 6.63
Int renet Inc. 70.23 $ 10.38 $ 6.77
Swif t Transport at ion 835.58 $ 121.34 $ 6.89
Landair Services 212.95 $ 30.38 $ 7.01
CNF Transport at ion 2,700.69 $ 366.99 $ 7.36
Budget Group Inc 1,247.30 $ 166.71 $ 7.48
Caliber Syst em 2,514.99 $ 333.13 $ 7.55
Knight Transport at ion Inc 269.01 $ 28.20 $ 9.54
Heart land Express 727.50 $ 64.62 $ 11.26
Greyhound CDA Transn Corp 83.25 $ 6.99 $ 11.91
Mar k VII 160.45 $ 12.96 $ 12.38
Coach USA Inc 678.38 $ 51.76 $ 13.11
US 1 Inds Inc. 5.60 $ ( 0 . 1 7 ) $ NA
Average 5.61
Aswath Damodaran 109
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?
Aswath Damodaran 110
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?
Aswath Damodaran 111
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)
Aswath Damodaran 112
US Market: Cross Sectional Regression
Model Summary
.526
a
.277 .276 426.8390
Model
1
R R Square
Adjust ed R
Square
St d. Error of
t he Est imat e
Predict ors: ( Const ant ) , Ef f Tax Rat e, ROC1, Expect ed
Growt h in EPS: next 5 y
a.
Coef f icient s
a,b
7.221 .617 11.707 .000
.287 .016 .344 17.739 .000
11.123 .670 .319 16.610 .000
.110 .014 .155 7.917 .000
( Const ant )
Expect ed Growt h
in EPS: next 5 y
ROC1
Ef f Tax Rat e
Model
1
B St d. Er r or
Unst andardized
Coef f icient s
Bet a
St andar
dized
Coef f icient s
t Sig.
Dependent Variable: EV/ EBITDA a.
Weight ed Least Squares Regression  Weight ed by Market Cap
b.
Aswath Damodaran 113
PriceBook 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 nontraded classes) needs to be factored in.
Aswath Damodaran 114
Price to Book Value: Distribution
PBV Rat io
1000
800
600
400
200
0
St d. Dev = 2.36
Mean = 2.39
N = 4866.00
Aswath Damodaran 115
Price Book Value Ratio: Stable Growth Firm
n Going back to a simple dividend discount model,
n Defining the return on equity (ROE) = EPS
0
/ Book Value of Equity,
the value of equity can be written as:
n If the return on equity is based upon expected earnings in the next time
period, this can be simplified to,
P
0
·
DPS
1
r − g
n
P
0
·
BV
0
*ROE*Payout Ratio *(1 + g
n
)
r  g
n
P
0
BV
0
· PBV =
ROE*Payout Ratio*(1 + g
n
)
rg
n
P
0
BV
0
· PBV =
ROE*Payout Ratio
rg
n
Aswath Damodaran 116
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,
n The pricebook 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.
P
0
BV
0
· PBV =
ROE  g
n
r  g
n
Aswath Damodaran 117
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 tenyear 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%.
Aswath Damodaran 118
Estimating a Price/Book Ratio for Jenapharm
n Expected Net Income = (EBIT  Interest Expense)*(1t)* 1+g) = (30 
15) *(10.4)* (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
Aswath Damodaran 119
Price Book Value Ratio for High Growth Firm
n The Pricebook ratio for a highgrowth firm can be estimated
beginning with a 2stage discounted cash flow model:
n Dividing both sides of the equation by the book value of equity:
where ROE = Return on Equity in highgrowth period
ROE
n
= Return on Equity in stable growth period
P
0
=
EPS
0
*Payout Ratio *(1 +g)* 1 −
(1+ g)
n
( 1+r)
n

.
`
,
r  g
+
EPS
0
* Payout Ratio
n
* ( 1 + g )
n
* ( 1 + g
n
)
( r g
n
)(1+ r)
n
P
0
BV
0
=
ROE* Payout Ratio*(1+ g) * 1 −
( 1+g)
n
( 1+r)
n

.
`
,
r  g
+
ROE
n
* Payout Ratio
n
* ( 1 +g)
n
* ( 1 +g
n
)
(r  g
n
)(1+r)
n
]
]
]
]
]
Aswath Damodaran 120
PBV Ratio for High Growth Firm: Example
n Assume that you have been asked to estimate the PBV ratio for a firm
which has the following characteristics:
High Growth Phase Stable Growth Phase
Length of Period 5 years Forever after year 5
Return on Equity 25% 15%
Payout Ratio 20% 60%
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%.
Aswath Damodaran 121
Estimating Price/Book Value Ratio
n The price/book value ratio for this firm is:
PBV =
0.25 * 0.2 * (1.20) * 1 −
(1.20)
5
(1.12875)
5

.
`
,
(.12875  .20)
+
0.15 * 0.6 * (1.20)
5
* (1.06)
(.115  .06) (1.12875)
5
]
]
]
]
]
= 2.66
Aswath Damodaran 122
PBV and ROE: The Key
PBV and ROE: Risk Scenarios
0
0.5
1
1.5
2
2.5
3
3.5
4
10% 15% 20% 25% 30%
ROE
P
r
i
c
e
/
B
o
o
k
V
a
l
u
e
R
a
t
i
o
s
Bet a=0.5
Bet a=1
Bet a=1.5
Aswath Damodaran 123
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%
PennzoilQuaker State PZL 0.95 3.99%
Ashland Inc. ASH 1.13 10.27%
Shell Transport SC 1.45 13.41%
USXMarathon 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%
RepsolYPF ADR REP 3.24 13.43%
Unocal Corp. UCL 3.53 10.67%
KerrMcGee 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%
Aswath Damodaran 124
PBV versus ROE regression
n Regressing PBV ratios against ROE for oil companies yields the
following regression:
PBV = 1.04 + 10.24 (ROE) R
2
= 49%
n For every 1% increase in ROE, the PBV ratio should increase by
0.1024.
Aswath Damodaran 125
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
Aswath Damodaran 126
Looking for undervalued securities  PBV Ratios
and ROE
n Given the relationship between pricebook 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 pricebook value ratios and returns on equity 
low P/BV ratios and high ROE or high P/BV ratios and low ROE.
Aswath Damodaran 127
The Valuation Matrix
MV/BV
ROEr
High ROE
High MV/BV
Low ROE
Low MV/BV
Overvalued
Low ROE
High MV/BV
Undervalued
High ROE
Low MV/BV
Aswath Damodaran 128
Large Market Cap Firms: PBV vs ROE: January 2001
ROE
.5 .4 .3 .2 .1 0.0
12
10
8
6
4
2
0
XOM
C
CSCO
WMT
INTC
AIG
BP
SBC
IBM
VZ
JNJ
RD
HD
TYC
MWD
NT
DT
JPM
PG
T
WFC
BLS
TXN
BAC
FNM
SC
ERICY
TEF
PHA
SNE
BTY
PEP
ABT
DIS
AXP
HWP
WCOM
LU
AVE
QCOM
BA
AEG
GS
PHG
ENE
CHV
STD
MC
BBV
DD
F
MOT
ONE
JDSU
SLB
MMM
FRE
DCX
WAG
FBF
ADP
HMC
HON
AMAT
BUD
KMB
TOC.TO
DNA
UTX
TX
EMR
UN
KRB
FTU
TGT
CPQ
MMC
AA
GM
ALL
SWY FITB
CAH
WM DUK
TMX
EDS
A BAX
HI
AES
SLR
AHO
FSR
MEL
FDC
USB
UL
BCE
CVS
DOW
BBDB.TO
FON
MU
BNS.TO
AT
REP
PNC HCA
Aswath Damodaran 129
Company Symbols
Company Name Ticker Symbol Company Name Ticker Symbol Company Name Ticker Symbol Company Name Ticker Symbol
Mat sushit a Elec. ADR MC Brit ish Telecom ADR BTY Merrill Lynch & Co. MER Int ' l Business Mach. IBM
Compaq Comput er CPQ Amer. Int ' l Group AIG Fannie Mae FNM Abbot t Labs. ABT
News Corp. Lt d. ADR NWS Chevron Corp. CHV Tyco Int ' l Lt d. TYC Morgan S. Dean Wit t er MWD
AT&T Corp. T AEGON Ins. Group AEG Amer. Express AXP Amgen AMGN
Schlumberger Lt d. SLB Sprint Corp. FON Corning Inc. GLW Dell Comput er DELL
Disney ( Walt ) DIS Boeing BA EMC Corp. EMC Amer. Home Product s AHP
Koninklij ke Philips NV PHG Hewlet t Packard HWP Gen' l Elect ric GE Proct er & Gamble PG
Time Warner TWX Banco Bilbao Vis. ADR BBV Int el Corp. INTC Pf izer, Inc. PFE
Deut sche Telekom ADR DT Wells Fargo WFC Ford Mot or F ScheringPlough SGP
WorldCom Inc. WCOM Ericsson ADR ERICY BellSout h Corp. BLS Merck & Co. MRK
Mot orola, Inc. MOT Texas Inst rument s TXN Johnson & Johnson JNJ Brist olMyers Squibb BMY
Telef onica SA ADR TEF Micron Technology MU Lucent Technologies LU Philip Morris MO
Banco Sant ander ADR STD Bank of America BAC PepsiCo, Inc. PEP Lilly ( Eli) LLY
Sony Corp. ADR SNE Home Depot HD Cisco Syst ems CSCO Oracle Corp. ORCL
Exxon Mobil Corp. XOM McDonald' s Corp. MCD Goldman Sachs GS
Avent is ADR AVE SBC Communicat ions SBC Medt ronic, Inc. MDT
Enron Corp. ENE WalMart St ores WMT Sun Microsyst ems SUNW
Pharmacia Corp. PHA Du Pont DD Applied Mat erials AMAT
Shell Transport SC Cit igroup Inc. C Schwab ( Charles) SCH
Royal Dut ch Pet r. RD Qualcomm Inc. QCOM Microsof t Corp. MSFT
DaimlerChrysler AG DCX Smit hKline Beecham SBH Nokia Corp. ADR NOK
BP Amoco ADR BPA Chase Manhat t an Corp. CMB CocaCola KO
Aswath Damodaran 130
PBV Matrix: Telecom Companies
TelAzt eca
TelNZ Vimple
Carlt on
Cable&W
Teleglobe FranceTel
Deut scheTel
Brit Tel
TelIt alia
AsiaSat Port ugal
HongKong
Royal BCE Hellenic
ChinaTel Nippon
Danmark
Espana
Indast
Televisas Telmex
TelArgFrance PhilTel
TelArgent ina
TelIndo
TelPeru
GrupoCent ro APT CallNet
Anonima
ROE
60 50 40 30 20 10 0
12
10
8
6
4
2
0
Aswath Damodaran 131
WABC
OV
NBAK
BWE
HU
PFGI
BOH
CBC
TRMK
SKYF
WL
VLY
CBH
CFR
FULT
FVB
CYN
MRBK
CBSS
BPOP
FSCO
UB
ZION
UPC
SOTR
RGBK
SNV
ASO
KEY
BBT
WB
PNC
STI
MEL
FTU
FBF
CMB
WFC
BAC
1.25
2.50
3.75
5.00
0.12 0.16 0.20 0.24
ROE
P
B
V
U.S. Banks: Market Cap > $ 1 billion
Aswath Damodaran 132
Company Name Ticker Symbol Company Name Ticker Symbol Company Name Ticker Symbol
West america Bancorp WABC Fult on Fin' l FULT Regions Financial RGBK
Keyst one Fin' l KSTN First Va. Banks FVB Synovus Financial SNV
Colonial BncGrp. ' A' CNB Cit y Nat ional Corp. CYN AmSout h Bancorp. ASO
One Valley Bancorp OV Hibernia Corp. ` A' HIB KeyCorp KEY
Nat ional BanCorp. of Alaska,In NBAK Silicon Valley Bncsh SIVB BB&T Corp. BBT
BancWest Corp. BWE Mercant ile Bankshares MRBK Wachovia Corp. WB
Hudson Unit ed Bancorp HU Compass Bancshares CBSS PNC Financial Serv. PNC
Provident Finl Group PFGI Popular Inc BPOP SunTrust Banks STI
Pacif ic Cent ury Fin' l BOH First Securit y FSCO St at e St reet Corp. STT
Cent ura Banks CBC No. Fork Bancorp NFB Mellon Financial Corp. MEL
Trust mark Corp. TRMK Nat l Commerce Bancrp NCBC Morgan ( J.P.) & Co JPM
Sky Finl Group Inc SKYF UnionBancal Corp UB First Union Corp. FTU
Wilmingt on Trust WL M&T Bank Corp. MTB Fleet Bost on Fin' l FBF
Valley Nat l Bancp NJ VLY Zions Bancorp. ZION Bank of New York BK
Commerce Bancorp NJ CBH Union Plant ers UPC Chase Manhat t an Corp. CMB
Cullen/ Frost Bankers CFR Sout hTrust Corp. SOTR Wells Fargo WFC
Summit Bancorp SUB Bank of America BAC
Aswath Damodaran 133
IBM: The Rise and Fall and Rise Again
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00
10.00
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Year
P
r
i
c
e
t
o
B
o
o
k
40.00%
30.00%
20.00%
10.00%
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
R
e
t
u
r
n
o
n
E
q
u
i
t
y
PBV ROE
Aswath Damodaran 134
PBV Ratio Regression
Model Summary
.686
a
.470 .469 167.8482
Model
1
R R Square
Adjust ed R
Square
St d. Error of
t he Est imat e
Predict ors: ( Const ant ) , Bet a, ROE1, Expect ed Growt h in
EPS: next 5 y
a.
Coef f icient s
a,b
2.719 .199 13.678 .000
6.325E02 .008 .159 8.302 .000
9.656 .253 .667 38.183 .000
1.438 .183 .150 7.862 .000
( Const ant )
Expect ed Growt h
in EPS: next 5 y
ROE1
Bet a
Model
1
B St d. Er r or
Unst andardized
Coef f icient s
Bet a
St andar
dized
Coef f icient s
t Sig.
Dependent Variable: PBV Rat io a.
Weight ed Least Squares Regression  Weight ed by Market Cap
b.
Aswath Damodaran 135
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
Aswath Damodaran 136
Cross Sectional Regression for Greece: May 2001
Coef f icient s
a
2.106 .280 7.531 .000
11.631 1.535 .418 7.579 .000
( Const ant )
ROE
Model
1
B St d. Er r or
Unst andardized
Coef f icient s
Bet a
St andar
dized
Coef f icient s
t Sig.
Dependent Variable: PBV
a.
R squared = 22%
Number of firms in sample = 272
Aswath Damodaran 137
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
Aswath Damodaran 138
Value/Book Ratio: Description
Value/ BV of Capit al
1400
1200
1000
800
600
400
200
0
St d. Dev = 2.63
Mean = 2.53
N = 4813.00
Aswath Damodaran 139
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:
n Dividing both sides by the book value, we get:
n If we replace, FCFF = EBIT(1t)  (g/ROC) EBIT(1t),we get
V
0
=
FCFF
1
WACC g
V
0
BV
=
FCFF
1
/BV
WACC g
V
0
BV
=
ROC  g
WACC g
Aswath Damodaran 140
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.
Aswath Damodaran 141
Value/Book and the Return Spread
Value/ BV Rat ios and Ret urn Spreads

0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
4.50

2
%

1
%
0
%
1
%
2
%
3
%
4
%
5
%
6
%
7
%
8
%
9
%
1
0
%
ROC  WACC
V
a
l
u
e
/
B
V
R
a
t
i
o
WACC=8%
WACC=10%
WACC=12%
Aswath Damodaran 142
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.
Aswath Damodaran 143
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
Aswath Damodaran 144
Price/Sales Ratio: Cross Sectional Distribution
PS RATIO
1400
1200
1000
800
600
400
200
0
St d. Dev = 2.55
Mean = 1.87
N = 4634.00
Aswath Damodaran 145
Price/Sales Ratio: Determinants
n The price/sales ratio of a stable growth firm can be estimated
beginning with a 2stage equity valuation model:
n Dividing both sides by the sales per share:
P
0
·
DPS
1
r − g
n
P
0
Sales
0
· PS=
Net Profit Margin*Payout Ratio* ( 1+ g
n
)
rg
n
Aswath Damodaran 146
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:
n Dividing both sides by the sales per share:
where Net Margin
n
= Net Margin in stable growth phase
P
0
=
EPS
0
*Payout Ratio*(1 + g )* 1 −
(1+ g)
n
( 1 +r)
n

.
`
,
r  g
+
EPS
0
* Payout Ratio
n
* ( 1 + g )
n
* ( 1 + g
n
)
( r g
n
)(1+ r)
n
P
0
Sales
0
=
Net Margin * Payout Ratio*( 1+g) * 1 −
( 1+g)
n
( 1+r)
n

.
`
,
r  g
+
Net Margin
n
* Payout Ratio
n
* ( 1+g)
n
*(1 + g
n
)
(r  g
n
)(1 + r)
n
]
]
]
]
]
Aswath Damodaran 147
Price Sales Ratios and Profit Margins
n The key determinant of pricesales ratios is the profit margin.
n A decline in profit margins has a twofold effect.
• First, the reduction in profit margins reduces the pricesales ratio directly.
• Second, the lower profit margin can lead to lower growth and hence lower
pricesales 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
Aswath Damodaran 148
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
Payout Ratio 20% 60%
Expected Growth (.1)(2.5)(.8)=20% (.06)(2.5)(.4)=.06
Riskless Rate =6%
PS =
0.10 * 0.2 * (1.20) * 1 −
(1.20)
5
(1.12875)
5

.
`
,
(.12875  .20)
+
0.06 * 0.60 * (1.20)
5
* (1.06)
(.115 .06) (1.12875)
5
]
]
]
]
]
= 1.06
Aswath Damodaran 149
Effect of Margin Changes
Price/ Sales Rat ios and Net Margins
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
1.8
2% 4% 6% 8% 10% 12% 14% 16%
Net Margin
P
S
R
a
t
i
o
Aswath Damodaran 150
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%
IMAGESOV2VD 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%
FOLLIFOLLIE 10.82 29.08%
Aswath Damodaran 151
Regression Results: PS Ratios and Margins
n Regressing PS ratios against net margins,
PS = .10 + 36.29 (Net Margin) R
2
= 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
Aswath Damodaran 152
Predicted PS Ratios
Symbol Company PS Predict ed 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 IMAGESOV2VD 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 FOLLXFOLLXE 10.82 10.45 3.51%
Aswath Damodaran 153
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.
Aswath Damodaran 154
A Case Study: The Internet Stocks
ROWE
GSVI
PPOD TURF BUYX ELTX
GEEK RMII
FATB TMNT
ONEM
ABTL INFO
ANET
ITRA
IIXL
BIZZ
EGRP
ACOM
ALOY
BIDS SPLN
EDGR
PSIX ATHY AMZN
CLKS
PCLN APNT
SONE NETO
CBIS
NTPA CSGP
INTW
RAMP
DCLK
CNET
ATHM MQST
FFIV
SCNT
MMXI
INTM
SPYG
LCOS
PKSI
0
10
20
30
0.8 0.6 0.4 0.2
Adj Mar gi n
A
d
j
P
S
Aswath Damodaran 155
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) R
2
= 0.04
(0.49)
n This is not surprising. These firms are priced based upon expected
margins, rather than current margins.
Aswath Damodaran 156
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.
Aswath Damodaran 157
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.
Aswath Damodaran 158
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 etailers, Amazon looks reasonably attractive since the average
price/future earnings per share of etailers 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
= $30.46/1.1294
5
= $16.58.
Aswath Damodaran 159
PS Regression
Model Summary
.851
a
.723 .723 88.1869
Model
1
R R Square
Adjust ed R
Square
St d. Error of
t he Est imat e
Predict ors: ( Const ant ) , Bet a, MARGIN, PAYOUT, Expect ed
Growt h in EPS: next 5 y
a.
Coef f icient s
a,b,c
4.392E02 .005 .199 9.210 .000
.807 .115 .087 7.007 .000
23.747 .466 .876 50.955 .000
.607 .085 .187 7.110 .000
Expect ed Growt h
in EPS: next 5 y
PAYOUT
MARGIN
Bet a
Model
1
B St d. Er r or
Unst andardized
Coef f icient s
Bet a
St andar
dized
Coef f icient s
t Sig.
Dependent Variable: PS RATIO a.
Linear Regression t hrough t he Origin b.
Weight ed Least Squares Regression  Weight ed by Market Cap c.
Aswath Damodaran 160
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) R
2
= 45.29%
Aswath Damodaran 161
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 DebtCash
Total Revenues
Aswath Damodaran 162
Value/Sales Ratio: Cross Sectional Distribution
EV/ SALES
1400
1200
1000
800
600
400
200
0
St d. Dev = 2.48
Mean = 2.01
N = 4644.00
Aswath Damodaran 163
Value/Sales Ratios: Analysis of Determinants
n If pretax 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 aftertax
operating margin= (EBIT (1t)/Sales
g = Growth rate in aftertax operating income for the first n years
g
n
= Growth rate in aftertax operating income after n years forever (Stable
growth rate)
RIR
Growth, Stable
= Reinvestment rate in high growth and stable periods
WACC = Weighted average cost of capital
Value
Sales
0
= After  tax Oper. Margin *
(1  RIR
growth
)(1+ g)* 1−
(1 +g )
n
(1+ WACC)
n

.
`
,
WACC g
+
(1 RIR
stable
)(1+ g)
n
* ( 1 +g
n
)
(WACC g
n
) ( 1+WACC)
n
]
]
]
]
]
]
Aswath Damodaran 164
Value/Sales Ratio: An Example
n Consider, for example, the Value/Sales ratio of Coca Cola. The
company had the following characteristics:
Aftertax 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%
Aftertax Cost of Debt = 4.16% D/(D+E) 2.35%
Cost of Capital= 12.33% (.9765)+4.16% (.0235) = 12.13%
Value of Firm
0
Sales
0
=. 1856*
( 1.65)(1.2016)* 1−
(1.2016)
10
(1.1213)
10

.
`
,
. 1213.2016
+
( 1.20)(1.2016)
10
* (1.06)
(.1213.06)(1.1213)
10
]
]
]
]
]
]
= 6.10
Aswath Damodaran 165
Value Sales Ratios and Operating Margins
Coca Cola: The Operat ing Margin Ef f ect
0
2
4
6
8
10
12
6% 8% 10% 12% 14% 16% 18% 20%
Operat ing Margin
V
a
l
u
e
/
S
a
l
e
s
R
a
t
i
o
0
50
100
150
200
250
$
V
a
l
u
e
Value/ Sales
$ Value
Aswath Damodaran 166
MSEL
GDYS
RET.TO MLG
MHCO
ZANY PSRC
FINL ROSI FLWS
LVC
TWMC SPGLA
SAH RUSH
MDA DBRN
GADZ
WLSN CELL
FNLY JILL
I BI CLWY
ANIC VOXX CHRS PSS
BKE Z
MTMC
HMY PBY
URBN
ROST
AEOS
PGDA
CC
BEBE ITN
CAO
GBIZ
DAP RUS
MNRO
SCHS
HLYW
MENS LE
LIN MDLK
RAYS PIR
GLBE ZQK
MIKE CWTR IPAR
ANN
AZO NSIT BBY
LTD
ZLC ORLY
FOSL
PSUN
CLE
PLCE
JWL
SATH
PCCC
WSM
TLB
HOTT
CPWM
TWTR
SCC
BFCI
TOO
VVTV
MBAY
BID
DABR
ISEE
CHCS
CDWC
LUX
0.0
0.5
1.0
1.5
2.0
0.000 0.075 0.150 0.225
Operat ing Margin
V
/
S
a
l
e
s
U.S. Specialty Retailers: V/S vs Operating Margin
Aswath Damodaran 167
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.
Aswath Damodaran 168
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 wellknown and respected brand name
is that firms can charge higher prices for the same products, leading to
higher profit margins and hence to higher pricesales 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
Aswath Damodaran 169
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
Aswath Damodaran 170
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
Aswath Damodaran 171
Value/Sales Ratio Regression: Market
Model Summary
.615
a
.379 .378 110.8277
Model
1
R R Square
Adjust ed R
Square
St d. Error of
t he Est imat e
Predict ors: ( Const ant ) , Expect ed Growt h in EPS: next 5 y,
OPMGN
a.
Coef f icient s
a,b
.107 .090 1.196 .232
11.854 .340 .583 34.903 .000
6.041E02 .004 .238 14.274 .000
( Const ant )
OPMGN
Expect ed Growt h
in EPS: next 5 y
Model
1
B St d. Er r or
Unst andardized
Coef f icient s
Bet a
St andar
dized
Coef f icient s
t Sig.
Dependent Variable: EV/ SALES a.
Weight ed Least Squares Regression  Weight ed by Market Cap b.
Aswath Damodaran 172
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
Aswath Damodaran 173
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.
Aswath Damodaran 174
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.
Aswath Damodaran 175
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 Rsquared 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.
Aswath Damodaran 176
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.)
Aswath Damodaran 177
The Statistical Approach
n One of the advantages of running regressions of multiples against
fundamentals across firms in a sector is that you get Rsquared 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 Rsquared provides the best estimate of value for firms
in a sector.
Aswath Damodaran 178
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
Aswath Damodaran 179
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 sectorbased 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 marketbased
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.
Aswath Damodaran 180
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?
Aswath Damodaran 181
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