Sample - Good-Quality Dissertation 3 PDF

BSc (Hons) Accounting & Finance
The valuation accuracy of the Price-to-Earnings and the

Price-to- Book valuation multiples: A focus on the retailing
industry sector of Western Europe
Submitted by: Eliana Kafa
Student ID: 110001990
Supervisor: Dr Pawel Bilinski
Submission date: April 2014

Undergraduate School
Plagiarism Statement
Student Name: Eliana Kafa
Degree: BSc (Hons) Accounting & Finance
Dissertation Title: The valuation accuracy of the Price-to-Earnings and the
Price-to- Book valuation multiples: A focus on the retailing industry
sector of Western Europe.
Supervisor Name: Dr Pawel Bilinski
“I certify that I have complied with the guidelines on plagiarism outlined in my Course
Handbook in the production of this dissertation and that it is my own, unaided work”
Signature:
______________________________________________________________
Eliana Kafa
Acknowledgments
I would like to take this opportunity to thank my supervisor, Dr Pawel Bilinski for his
continued support and informative discussions and comments throughout this project.
Without his guidance and his valuable suggestions I would not be able to complete this
dissertation. Furthermore, I am greatly indebted to Cass Business School for providing me
with the necessary facilities required to carry out the research for this dissertation.
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Table of Contents
Abstract ...................................................................................................................................... 5
1. Introduction .............................................................................................................................. 5
2. Literature Review ..................................................................................................................... 8
2.1 Accuracy of valuation models based on combinations of multiples .................................. 11
2.2 Choice of the comparable firms ......................................................................................... 12
3. Research Design ....................................................................................................................... 14
3.1 Simple multiple valuation .................................................................................................. 14
3.2 Combination of simple multiple valuations ....................................................................... 16
3.3 Performance measurement ................................................................................................. 17
3.4 Hypothesis Testing ............................................................................................................. 18
4. Data and Sample....................................................................................................................... 18
5. Empirical Results ..................................................................................................................... 20
5.1 Formal tests of the three research hypotheses ................................................................... 20
5.1.1 A comparison of the accuracy of the P/E and P/B valuation models ........................ 20
5.1.2 The effect of the industry fineness: A comparison of the valuation accuracy at the
retailing industry group and the specialty retail industry levels ............................... 22
5.1.3 Does a combined P/E-P/B valuation multiple model provide more accurate results
than the single P/E and P/B valuation models? ....................................................... 23
6. Sensitivity Analysis .................................................................................................................. 26
6.1 The impact of firm size ...................................................................................................... 26
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6.2 Adjustment for outliers and the use of harmonic mean in calculating the benchmark
multiple............................................................................................................................... 28
6.3 Expanding the time period ................................................................................................. 29
6.4 Assigning weights to the combined P/E-P/B valuation model .......................................... 31
7. Summary and Conclusion ........................................................................................................ 31
References ................................................................................................................................ 33
Appendix A: Adjustment for outliers and the use of harmonic mean in calculating the
benchmark multiple - Test Statistics tables ....................................................... 36
Appendix B: Multiple Linear Regression Analysis ................................................................. 38
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Tables
Table 1: Descriptive statistics of underlying sample .................................................................. 20
Table 2: Test statistics of the absolute percentage valuation errors of the P/E and P/B
valuation models for the years 2011 and 2012 ............................................................... 21
Table 3: Test statistics of the absolute percentage valuation errors of the multiple valuation
models between the retailing industry group and the specialty industry for the years
2011 and 2012 ................................................................................................................ 22
Table 4: Correlation between simple multiple valuation outcomes scaled by stock prices ......... 23
Table 5: Test statistics of the absolute percentage valuation errors between the P/E and the
combined P/E-P/B valuation multiples models for the years 2011 and 2012 ............... 24
Table 6: Test statistics of the absolute percentage valuation errors between the P/B and the
combined P/E- P/B valuation multiples models for the years 2011 and 2012. .............. 25
Table 7: Comparison of the test statistics of the absolute percentage valuation errors and the
weighted absolute percentage errors for the years 2011 and 2012. .............................. 27
Table 8: Test statistics of the absolute percentage valuation errors for the years 2008 and
2012 ................................................................................................................................ 30
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ABSTRACT: In this study I evaluate the accuracy of the price-to-earnings (P/E), the
price-to-book (P/B) and the combined P/E-P/B valuation multiples methods. I have chosen
the comparable firms on the basis of the Global Industrial Classification system (GICS).
Using two industry levels, the retailing industry group and the sub-industry specialty retail, I
evaluate the impact the granularity of the industry definitions has on the accuracy of the stock
valuation. I find that the P/E valuation multiple yields more accurate valuations than the P/B
valuation multiple and that the level of the industry definition used for the selection of the
comparable firms affects the accuracy of the valuation. However, the latter result is mainly
driven by small firms as the accuracy of valuation for large firms is not affected by the level
of industry definition. The combined P/E-P/B model outperforms the simple P/B model;
however, its accuracy is not different than that of the P/E valuation model. In addition, I
show that the size of the firms affects the valuation accuracy of all the three valuation models;
that is, for larger firms the valuation models yield more accurate estimates.
1. INTRODUCTION
Over the past years several studies have shown that accounting data contain valuable
information for equity valuation (Ohlson, 1995; Cheng and McNamara, 2000; Ohlson and
Zhang, 1998; Feltham and Ohlson, 1996; Liu and Ohlson, 2000). To illustrate, for initial
public offerings (IPOs) the only available guide to the value of equity is accounting data.
According to Black (1980) “The surprising thing is that, even though accountants have not
formally recognized the goal of having an earnings figure that measures value, they have done
a remarkably good job of achieving this goal” (p 9).
Accounting-based valuation approaches and more specifically the multiple-based valuation

approach are used extensively in practice. Barker (1999) provides a summary of previous
literature on valuation models used by professional investors and financial analysts. He
observes that previous studies show that the price-to-earnings multiple (P/E) is very important
while the importance of the discounted cash flow (DCF) models, technical analysis, and beta
analysis is questionable. Furthermore, by conducting a new survey of UK analysts and fund
managers, Baker verifies the importance of the P/E model and the dividend yield model; on
the other hand, he finds that the DCF and dividend discount models are less important. In
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addition, Lie and Lie (2002) argue that even though the theoretical emphasis is on DCF
analysis in practice the multiple valuation models are generally preferred. Finally, by
reviewing the valuation methodologies used by analysts for 26 large listed companies in
United Kingdom, Demirakos et al. (2004) support the increased use of valuation multiples in
practice. They find that analysts typically use the P/E model and the DCF valuation methods
and that “analysts who construct explicit valuation models still adopt a comparative valuation
model as their preferred model” (p 221).
The main reason for the popularity of the valuation multiples is their simplicity as opposed to
other more complex valuation techniques and also the fact that they reflect the market mood.
However, the latter can also be considered as one of the major disadvantages of this approach
especially when the firms are overvalued or undervalued (Damodaran, 2006).
In practice, the P/E multiple is one of the most widely accepted valuation method (Demirakos
et al., 2004; Barker, 1999; Cheng and McNamara, 2000). According to Cheng and McNamara
(2000) its popularity is due to the fact that it is considered to be related to the risk and growth
of a stock. On the other hand, academics show an increased interest on the price-to-book ratio
(P/B) which also appears to be related to profitability, risk and growth (Bernard, 1994).
Ohlson (1995, 1988) suggests that the P/B ratio can be used as an index of a firm’s
productivity efficiency. In addition, Penman (1996) investigates the relationship of P/E and
P/B ratios and finds that the P/E ratio reflects earnings increases which are positively
correlated to future return on equity and negatively correlated to current return on equity. On
the other hand the P/B multiple indicates only returns on equity.
Despite its simplicity, a valuation using multiples still requires some important choices to be
made. First, the multiples to be used in the valuation need to be determined. Second, the
choice of the comparable firms is crucial. Although the industry membership rule is the
standard approach in practice, the empirical research identifies alternative methods of
choosing comparables which are likely to improve the valuation accuracy by considering the
growth, risk and profitability characteristics of the firms (Bhoraj and Lee, 2002; Herrmann
and Richter, 2003; Mînjina, 2009). Determining the statistical measure for the aggregation of
comparable firms’ multiples is also very important.
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However, despite its extensive use in practice, equity valuation based on multiples has only
recently gained wider academic interest (Cooper and Cordeiro, 2008). Previous empirical
studies show that multiple-based valuation can produce equally accurate results as more
sophisticated methods such as DCF valuation models (Kaplan and Ruback, 1995; Hotchkiss
and Gilson, 2000). Motivated by the increasing use of multiples in valuation by the
practitioners and the fact that few studies have been conducted on the accuracy of the
multiple-based valuation using recent data, I assess the accuracy of the P/E and P/B valuation
multiples for the retail industry stocks listed on exchanges in Western Europe 1 for the years
2011 and 2012. In addition, I study whether a combined P/E-P/B valuation multiple results in
a more accurate valuation. Finally, I assess the impact of the fineness of the industry
definition on the valuation accuracy by comparing the valuation outcomes at two different
industry levels, the retailing industry group and the specialty retail level according to the
Global Industrial Classification System (GICS)2.
I show that the P/E valuation multiple produces more accurate valuations than the P/B
valuation multiple and that the level of the industry used for the selection of the comparable
firms affects the accuracy of the valuation. While the combined P/E-P/B model outperforms
the simple P/B model, its accuracy does not show any statistically significant difference from
that of the P/E valuation model.
Sensitivity analysis in section 6 indicates that the size of the firm affects the valuation
accuracy of all the three valuation models; that is, for larger firms the valuation models yield
more accurate estimates. Moreover, I find that for larger firms the industry fineness has no
effect on the valuation accuracy. Further, I show that after adjusting for outliers, the median
and the harmonic mean yield approximately the same valuation outcomes. I also show that
expanding the time-period under investigation leads to more meaningful and statistically
significant comparisons. Finally, I find that trying to improve the outcomes of the combined
1
Bloomberg lists the following countries in Western Europe: Austria, Belgium, Cyprus, Denmark, Faeroe Island,
Gibraltar, Finland, France, Germany, Gibraltar, Greece, Guernsey,Iceland ,Ireland, Isle of Man ,Italy,
Jersey ,Liechtenstein, Luxembourg, Malta, Monaco, Netherlands, Norway, Portugal, Reunion, San Marino ,
Spain, Svalbard and Jan Mayen Islands, Sweden, Switzerland, United Kingdom.
2
GICS is a standardized classification system for equities developed jointly by Morgan Stanley Capital
International (MSCI) and Standard & Poor's. The GICS structure consists of 10 sectors, 24 industry groups, 67
industries and 156 sub-industries. The assignment of companies is made by a judgment as to the company’s
principal business activity which is based primarily on sales. Because a company is classified on the basis of one
business activity a given company appears in just one group at each level of the classification.
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P/E-P/B valuation model with the use of multiple linear regression analysis does not work in
my sample as the regression coefficients for the P/B valuation outcomes are indistinguishable
from zero.
However, there are certain limitations to my findings. First, the fact that I use a cross-country
sample and the Bloomberg database does not provide information how to calculate historic
multiples, render the conclusions vulnerable to differences in multiples’ definitions among the
various countries. In addition, I drop out of the sample the companies with negative earnings
and book value drivers. This is likely to introduce an upward bias to the valuation outcomes
(Damodaran, 2006). A third limitation is that I exclude the target firm when calculating the
benchmark multiple of the valuation. This is due to time constraints.
The following section reviews the relevant literature and Section 3 describes how the data is
collected and analysed. Section 4 defines the research design and shows how the comparable
firms are determined and how the benchmark valuation multiples are calculated. Section 5
discusses the empirical results and Section 6 presents the sensitivity analysis. Finally the
conclusions are presented in Section 7.
2. LITERATURE REVIEW
Despite the extensive use in practice, equity valuation based on multiples has only recently
gained significant academic attention. Previous research compares the accuracy of the
multiples valuation with the accuracy of more sophisticated valuation methods used to
calculate the intrinsic value of a firm such as the DCF valuation model. In addition, much of
this research focuses on the evaluation of the accuracy of various valuation multiples, the
choice of the statistical measure used in valuing the target firm and on determining how
comparable firms should be identified (Kaplan and Ruback, 1995; Hotchkiss and Gilson, 2000;
Liu et al., 2002; Lie and Lie, 2002).
The literature shows that multiple-based valuation can give the same degree of accuracy as
more sophisticated methods such as DCF valuation models (Kaplan and Ruback, 1995;
Hotchkiss and Gilson, 2000). It also indicates that the use of forecasted earnings measures
result to more accurate valuation outcomes than those obtained with the use of historic
performance measures (Kim and Ritter, 1999; Liu et al., 2002; Lie and Lie, 2002). However,
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the results in terms of historic multiples are diverse and no single historic performance
measure appears better. With regards to the statistical measure for the aggregation of
comparable firms’ multiples, the literature shows that the arithmetic mean provides poor
valuation accuracy compared to the median or the harmonic mean (Baker and Ruback, 1999;
Herrmann and Richter, 2003).
Kaplan and Ruback (1995) compare the estimates obtained by using discounted cash flow
models to the estimates of other relative valuation methods which rely on comparable firms in
similar industries that participate in similar business activities. They observe that both
methods perform equally well and that the comparable approaches are more useful when they
are used together with a DCF valuation model. In addition they suggest that “there is no
obvious method to determine which measure of performance …. is the most appropriate for
comparison” (p 1067). They propose that when the comparable companies and the firm under
valuation have the similar future cash flow expectations and the value driver is related to the
value of the firm, the comparable methods will provide more accurate results than the
discounted cash flow approach. However, they do acknowledge that in most cases comparable
companies do not perfectly match either in terms of cash flows or risk. This is illustrated by
Kim and Ritter (1999) who show that for IPOs the comparable valuation methods do not
provide accurate results.
Following Kaplan and Ruback (1995), Hotchkiss and Gilson (2000) estimate the market
values of a sample of 63 U.S. public firms during 1984-1993 by using both discounted cash
flow and comparable company multiple valuation methods. They find that “these methods
generally yield unbiased estimates of value, but the dispersion of valuation errors is very wide”
(p 43). These findings concur with those of Kaplan and Ruback (1995).
Kim and Ritter (1999) focus on IPO’s valuation. In their study, they not only use historical
accounting value drivers but also consider forecasted earnings multiples as well. By doing so,
they find that the P/E multiple based on forecasted earnings produces more accurate results
than all the other multiples while the forecasting power of the historic P/E, market to
book ,and price-to-sales multiples is very limited.
Liu et al. (2002) use a sample of US companies and they examine the performance of
different multiples, how the performance of these multiples is affected across industries and
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time and what is the impact of using alternative approaches to compute multiples. They find
that multiples using forecasted earnings give more accurate valuation results than multiples
based on historic earnings and that the cross-section accuracy of book values is comparatively
low. More specifically, comparing the performance of drivers selected from historical data,
they find that sales produce the worst performance and that earnings outperform book value.
The latter appears to be consistent among various industries and time periods. Finally, they
support that the selection of the comparable firms on the basis of industry classification,
yields more accurate valuation results than the selection on a cross-sectional basis.
Lie and Lie (2002) examine various multiples used by practitioners to estimate the value of a
firm. Contrary to Liu et al. (2002), their study shows that the estimates of the asset multiples
(market value to book value of assets) are more accurate than those of the sales and the
earnings multiples. However, both studies agree that the use of forecasted earnings instead of
historic earnings improves the valuation accuracy of the P/E multiple.
Park and Lee (2003) analyse the valuation accuracy of P/E, P/B, Price to sales, and Price to
cash flow multiples for the Japanese stock market. Like Lie and Lie (2002) their findings
show that the P/B provides better valuation than the other multiples.
A recent study conducted by Schreiner (2007) investigates the performance of various

multiples using a sample of European companies. Consistent with literature, Schreiner’s
findings suggest that forward-looking multiples outperform trailing multiples. He also shows
that the estimates obtained by using equity value multiples are more accurate than those
obtained using entity value multiples and that “knowledge-related multiples deliver better
value predictions than traditional multiples” (p 105).
Baker and Ruback (1999) focus on the appropriate choice of the statistical measure for the
calculation of the benchmark multiple. Even though the median is generally considered as the
best measure for mitigating the effects of outliers, skewness and kurtosis of the distribution,
they compare and contrast the performance of four different statistical measures: the median,
the simple mean, the harmonic mean and the value-weighted mean. They determine that when
the valuation multiple is calculated using the harmonic mean it provides more accurate results.
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Herrmann and Richter (2003) argue that in the case of asymmetric distributions the median
and the harmonic mean are superior to the arithmetic mean since the latter leads to
overestimated valuations. They compare the valuation accuracy of all the three statistical
measures and they conclude that the arithmetic mean provides the least accurate valuation.
Even though this is consistent with previous research, they find that the median produces
more accurate results and that the harmonic mean often underestimates the value of the target
firm. These findings do not agree with Baker and Ruback’s (1999) results.
2.1 Accuracy of valuation models based on combinations of multiples
The literature is not only restricted to the assessment of the valuation performance of single
multiples but it also investigates whether a combined valuation model of different multiples
improves the valuation accuracy.
Beatty et al. (1999) assess the accuracy of various combined valuation models by assigning
weights to the valuation outcomes of different simple multiples based on earnings, book value
of equity, dividends and total assets. They find that the most accurate model is the “regression
weight model” (p 182) where weights are determined by regressing prices on earnings and
book values.
Yoo (2006) also investigates whether a combination of multiples improves the valuation
accuracy of the simple multiple valuation method. The weights of each multiple to be used in
the combined valuation model are determined by conducting an “out-of-sample regression of
the stock prices on the valuation outcomes from each simple multiple valuation” (p 112). He
finds that a combined valuation model of several simple historic valuation outcomes improves
the valuation accuracy. He argues that in spite of simple valuations multiples sharing similar
information, each multiple may also include extra information which increases the accuracy
of the valuation outcomes. However, the accuracy of the combination of outcomes produced
by historic value multiples and forecasted earnings multiples is no better than the accuracy of
the simple valuation multiple that uses forecasted earnings.
Cheng and McNamara (2000) use a sample of US companies to test the valuation accuracy of
the P/E and P/B multiples and a combination of P/E-P/B assigning equal weights. Although
the assignment of equal weights to the valuation outcomes of P/E and P/B models may not be
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optimal, Cheng and McNamara (2000) observe that this simple combination improves the
accuracy of the valuation.
2.2 Choice of the comparable firms
The choice of comparable firms is also of importance and academic papers focus on how the
comparable firms should be used for a valuation model to yield the most accurate valuation
outcomes. Even though the traditional method is selecting the comparables on the basis of
industry classification, the literature identifies alternative ways, such as considering the
growth, risk and profitability characteristics of the firms when choosing comparables, which
are likely to improve the valuation accuracy (Alford, 1992; Cheng and McNamara, 2000;
Bhojraj and Lee, 2002; Herrmann and Richter, 2000; Cooper and Cordairo, 2008; Mînjina,
2009).
Alford (1992) evaluates the performance of the P/E model by using industry membership,
earnings growth and risk as the criteria for the selection of the comparable firms. His results
show that the selection of comparable firms on the basis of industry membership or a
combination of risk and earnings growth can improve the valuation accuracy while a selection
based only on growth or risk does not improve the accuracy of the estimates. He also
examines how the composition of Standard Industrial Classification (SIC) codes affect the
performance of the P/E valuation model, and observes that “the accuracy of selecting
comparable firms by industry improves as the number of SIC digits used in matching firms
increases, up to the third digit” (p 96). Moreover, he shows that by selecting the comparable
firms using the criteria of size and earnings growth in addition to the industry classification
does not necessarily improve the accuracy of the valuation.
Herrmann and Richter (2003) take a sample of European and US firms and show that “a
selection of comparable assets based on control factors is superior to a selection based on SIC
industry codes” (p 194). More specifically, they argue that selecting comparable firms based
on growth and profitability characteristics, yield more accurate valuations than those obtained
by selecting companies purely on the basis of the same classification.
Mînjina (2009) examines the valuation performance of various multiples in Bucharest Stock
Exchange by using both the industry membership and return on equity (ROE) as the selection
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method of comparable firms. Selecting the comparable firms on the basis of industry
membership, Mînjina (2009) finds that the most accurate valuation is produced by the price-
to-cash flow (P/CF) multiple. When ROE is used in the selection process, multiples such as
P/E, P/B, P/CF and price-to-total assets provide the most accurate results. In both cases the
P/S multiple leads to the least accurate valuation.
Cheng and McNamara (2000) find that the performance of various valuation methods depends
on how comparable firms are defined. When industry membership is used in the selection, the
accuracy of the combined P/E-P/B model is higher than that of the single P/E or P/B multiples.
When the selection is based on ROE, their findings disclose that all the valuation models
provide similar accurate results. Based on their findings, they suggest the use of the combined
P/E-P/B valuation model and the selection of comparable firms using the criteria of industry
membership. Moreover, Cheng and McNamara (2000) examine the impact of industry
fineness and they find, like Alford (1992), that the valuation accuracy is improved with the
use of a narrower industry definition for the selection of comparable firms. They also assess
the effect that the number and the size of the firms in the target firm’s industry will have on
the valuation accuracy of the P/B, P/E and the combined P/E-P/B multiple valuation models.
They find that the accuracy of the valuation is higher for firms in industries which contain
numerous companies. The reason for this is that the accuracy of a benchmark valuation
multiple may be affected by the number of observations in an industry; the larger the number
of observations, the higher the accuracy of the valuation multiple. Another reason is that the
more the comparable firms are, the more likely they will reflect industry characteristics such
as competition. In addition, Cheng and McNamara (2000) show that from the three valuation
models, the number of the firms used affect the P/B the most. An interesting observation is
that although the P/E produces more accurate valuations its comparative advantage is lost in
industries with a larger number of firms where the P/B seems to be more accurate. With
regard to the size effect of the firms, Cheng and McNamara (2000) find that for larger firms,
the accuracy of all the valuation models is higher and that among the three valuation models
considered, the P/E valuation model is the one affected the most by changes in the industry
firms’ size.
Cooper and Cordairo (2008) investigate how the valuation accuracy is affected by increasing
the number of comparable firms and consider the trade-off between a narrower industry
definition associated with fewer, more closely related firms and a broader industry definition
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associated with a larger number of firms. Supporting Cheng and McNamara’s (2000) findings,
they argue that an increase in the number of comparables leads to an improvement of the
valuation accuracy. However, they state that “ if there are firms in the same industry with
growth rates close to that of the target firm, then it is better to use a small number of
comparables” (p 1). This is because the addition of a larger number of firms increases the
noise and deteriorates the accuracy of the valuation.
Against the backdrop of past studies, I estimate the valuation accuracy of the simple P/E and
P/B valuation multiples and the composite P/E-P/B valuation models at the retailing industry
group and the specialty retail levels, where the industry definitions follow the Global
Industrial Classification System (GICS). I also compare my findings with those of studies
presented in the literature review.
3. RESEARCH DESIGN
3.1 Simple multiple valuation
The simple multiple valuation method, estimates the equity value of a firm i at a specified
time period t by multiplying the equity valuation multiple by the value driver of the firm
under valuation as follows:
Equity Value estimateit = Equity Multiple derived from comparable firms × Value driverit
The choice of equity multiples instead of entity multiples is based on previous findings that
the use of entity multiples results to high valuation errors. (Schreiner, 2007; Mînjina, 2009).
The per-share value of the target firm is estimated as:
̂ ( )
where:
 i: the firm being valued (target firm)
 t : time in years
 ̂ : the estimated stock price of firm i in year t
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 (P/X)Cit: the average ratio of the stock price (P) to a value driver (X) of the
comparable firms
 Xit: the value driver of firm i in year t.
The two multiples I use are the P/E and P/B ratios, as calculated in the Bloomberg database at
the end of the calendar years 2011 and 2012. P/E is calculated as the last price divided by the
trailing 12-month earnings per share before extraordinary items or basic earnings per share
before extraordinary items if only annual earnings exist. P/B is calculated as the last price
divided by the book value per share. Bloomberg provides the book values from the most
recent reporting period (quarterly, semi-annually or annually).
I also choose the value drivers of the comparable firms in a way to be consistent with the
Bloomberg definition. The earnings value driver used is the basic earnings per share
excluding extraordinary items at the end of 2011 and 2012. For the P/B valuation the book
value per share is used. As information for the companies’ book value per share is reported on
a quarterly, semi-annual or annual basis the book values used in the single valuation multiples
are the ones of the most recent reporting period.
Based on the findings of Liu et al. (2002) which show that the performance of the value
drivers is improved by selecting firms from the same industry, I use the industry classification
for choosing the comparable firms and I take all the firms which are in the same industry with
the target firm. To select industry levels I use the GICS classification system. The choice of
this classification system is based, mainly, on the work of Bhojraj et al. (2003) who, by
comparing four different classification codes, they show that “GICS classifications are
significantly better at explaining stock return comovements, as well as cross-sectional
variations in valuation multiples, forecasted and realized growth rates, research and
development expenditures, and various key financial ratios” (p 745).
To investigate whether the valuation accuracy is improved by taking a narrower industry

definition, as suggested by Alford (1992), I select the comparable firms from both the
retailing industry group level and the specialty retail industry level and I proceed with the
calculation of the benchmark multiple to be used in the valuation.
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For the calculation of the benchmark multiple I consider only the median and the harmonic
mean since previous literature indicates that these measures produce more accurate estimates
than the arithmetic mean (Baker and Ruback, 1999; Herrmann and Richter, 2003). Some of
previous researchers use only the harmonic mean to calculate the benchmark valuation
multiple based on previous studies which show that it develops more accurate valuations
(Baker and Ruback, 1999; Liu et al., 2002; Mînjina, 2009). However, all these studies adjust
for outliers before conducting the valuation. On the other hand, other researchers (Alford,
1992; Cheng and MacNamara, 2000; Lie and Lie, 2002; Schreiner, 2007) favour the use of
median as a statistical estimator based on the fact that median helps to mitigate the effects of
outliers and therefore provides more reliable valuation results. In order to avoid problems that
are likely to arise from the existence of outliers in the data, I use the median to calculate the
benchmark valuation multiple.
Following the procedure used by Liu et al. (2002) and Yoo (2006) on the simple multiple
valuation approach I estimate the equity value of the target firm by multiplying the valuation
multiples benchmark by the target firm’s corresponding value driver.
The simple multiple valuation model I use in this study has two main limitations. First, except
of the general definition of the P/E and P/B multiples, Bloomberg does not provide
information on how the historic multiples are calculated and which earnings measures and
book values per share are used for the calculation of these multiples. As different companies
or countries adopt different definitions for each multiple this might limit the reliability of the
data used. Further to this, the industry multiples include the firm under valuation. However,
given the relatively large number of companies in each industry classification (195 in the
retailing sector and 113 in the specialty sector for both years 2011 and 2012), the impact of
including the firm under consideration should be negligible (Liu et al., 2002).
3.2 Combination of simple multiple valuations
The combined valuation method I use in this study takes a simple average of the valuation
outcomes obtained from each single valuation multiple for the retailing industry group and the
specialty retail industry as shown below:
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̂ ̂
̂
where, ̂ is the equity value estimate derived by using a combination of the P/E and P/B
valuation multiples and ̂ and ̂ are the estimated equity values derived by using the P/E
and P/B in the single valuation multiple model.
Even though this method is consistent with the method used by Cheng and McNamara (2000),
it has the limitation that equal weights are assigned to earnings and book value; this which
might not be the optimal allocation and therefore may affect the valuation accuracy. As is the
case with previous literature, in the sensitivity analysis section of this study, I use the multiple
linear regression analysis to determine the optimal weights assigned to each multiple and thus
improve the accuracy of the valuation model (Beatty et al., 1999; Yoo, 2006).
3.3 Performance measurement
Based on the assumption of market efficiency that the stock prices incorporate all the
available information in the market and thus they reflect the true value of a firm’s equity, I
use the actual stock price as the benchmark to assess the accuracy of the valuation. For each
valuation model I define the absolute value of the prediction error ( as the absolute
difference between the actual stock price of the target firm ( at the end of each year and
the estimated price obtained by the valuation model ( ̂ :
| ̂ |
For the comparisons to be meaningful, I control for size differences among firms by scaling
the errors with the actual stock price of the target firm as follows:
| ̂ |
The use of the percentage difference between estimated values and market values, as the
measure of valuation accuracy is supported by previous studies (Alford, 1992; Cheng and
McNamara, 2000; Liu et al., 2002).
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3.4 Hypothesis Testing
In this study I test three hypotheses. Firstly, following Cheng and McNamara (2000) I
evaluate the accuracy of both the P/E and P/B multiples. To achieve this I compare the
accuracy of the two multiples at both the retailing industry group and the specialty retail
industry levels by formulating and testing the following hypotheses:
Hypothesis 1: The accuracy of price estimates based on the P/E ratio is the same as
based on the P/B ratio.
Secondly, on the basis of the empirical findings by Alford (1992) and Liu et al. (2002) which
show that the accuracy of valuation is improved when a narrower industry definition is used, I
test how the accuracy of the P/E and the P/B valuation multiples changes as the choice of the
comparable firms is narrowed down from the retailing industry group to the specialty retail
industry. The hypothesis setting I use in this case is:
Hypothesis 2: The accuracy of the two multiples is the same at both the retailing
industry group and the specialty retail industry levels.
Finally, as in Cheng and McNamara (2000) and Yoo (2006), I test whether the valuation
accuracy is improved by using a combination of P/E and P//B multiples rather than a single
P/E or P/B multiple. I formulate and test the following hypothesis:
Hypothesis 3: There is no difference in the accuracy of the composite multiples

approach compared to the simple valuation multiple method.
I use the paired sample t-test for testing all the hypotheses in this study. The major advantage
of this test is that it allows the reduction of the possibility of some external factors influencing
the valuation accuracy. For all the tests I use Microsoft Excel.
4. DATA AND SAMPLE
I select the sample from the Western Europe’s companies listed in the retailing industry group
and the specialty retail industry of the GICS classification system. From each of these two
industry levels I choose 45 companies for two consecutive years, 2011 and 2012. I collect the
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data for the P/E and P/B multiples, the earnings per share, the book values, the stocks’ actual
prices and market capitalisation values from the Bloomberg database.
In 2011 and 2012 the number of companies listed in the retailing industry group of the
Bloomberg database is 168 and 170 respectively. For the same time period the corresponding
numbers of companies listed in the specialty retail industry are 86 and 90. Out of these
companies, I select only those with positive earnings per share (EPS) and book values for
both the 2011 and 2012 time period. This is because for companies with negative EPS and
book values the P/E and the P/B ratios will also be negative which even though
mathematically possible, does not make economic sense. This highlights a limitation of the
particular study since the elimination of money-losing firms from the sample creates an
upward bias in the calculation of the industry average P/E and P/B multiple (Damodaran,
2006). The elimination of all negative value drivers reduces the number of companies to 195
and 113 in the retailing industry group and the specialty retail industry respectively.
For the selection of the final sample of 45 companies I use the simple random sampling
method. In order to ensure that differences in valuation errors are driven exclusively by the
characteristics of the multiple valuation model, that is the choice of the multiple, and not by
differences between firms’ characteristics I select the same 45 companies from each of the
two industry levels for both years 2011 and 2012. This selection ensures that the results are
not affected by differences in the characteristics of the sampled firms.
Table 1 presents the mean, median and inter-quartile range, of the P/E and P/B multiples of
the 45 companies of the sample for the years 2011 and 2012 at the retailing industry group
and the specialty retail industry levels. Looking at the P/E multiple, the mean is higher than
the median for both 2011 and 2012 reflecting the fact that P/E multiples can be very high
positive numbers but cannot be less than zero; this indicates a positively skewed distribution.
The large difference of the mean values between 2011 and 2012 is the result of a number of
firms in the sample recording a significant decrease in their earnings during this period.
Similarly, the mean of the P/B multiple is higher than the median for both years which shows
that there is a number of firms with high book values. Furthermore, the distribution of the P/B
multiples is positively skewed. The IQR represents the spread of data from the median with
the boundary between first and third quartile. It can be seen that dispersion of P/E multiple
varies more compared to P/B.
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Table 1. Descriptive statistics of underlying sample
Multiple Descriptive Statistics Period

2011 2012
Mean 11.778 19.262
P/E Median 3.666
9.327
IQR 8.585 10.064
Mean 2.632 2.620
P/B Median 1.331
1.189
IQR 2.056 2.597
Number of observations 45 45
Note: P/E: End-of-year stock price divided by earnings per share before extraordinary expenses.
P/B: End-of-year stock price divided by end-of-year common stock equity.
The share prices used for multiples computation are closing prices from the last trading day of each year. IQR
represents the interquartile range
5. EMPIRICAL RESULTS
5.1 Formal tests of the three research hypotheses
To assess the valuation accuracy of the P/E, P/B and the combined P/E-P/B valuation
multiples in the retailing industry group and the specialty retail industry I formulate and test
the following hypotheses using the paired two sample for means t-test between the absolute
percentage errors of the outcomes of the respective valuation models for 2011 and 2012. For
all the three hypotheses I calculate the benchmark multiple which is used in the valuation
model as the median of all the multiples of the firms in the retailing industry group and the
specialty retail industry.
5.1.1 A comparison of the accuracy of the P/E and P/B valuation models
In the first hypothesis I test the performance differences between the P/E and the P/B single
valuation models. The null hypothesis is that the accuracy of the price estimates based on the
two multiples is the same and is tested against the alternative hypothesis that the valuation
accuracy differs among the two multiples models.
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Table 2 shows the results of the paired sample t-test of the absolute percentage errors between
the P/E and the P/B models for the years 2011 and 2012 for the retailing industry group and
the specialty retail industry.
Comparing the mean absolute percentage errors of the two valuation multiples the P/E
valuation model appears to be 17% and 18% more accurate than the P/B valuation model in
the retailing industry group and the specialty retail industry respectively. The p-values for the
retailing industry group and the specialty retail industry are 0.012 and 0.008 respectively. The
t-statistic is -2.573 for the retailing industry group and -2.692 for the specialty retail industry.
Consequently, these p-values and the t-statistics lead to the rejection of the null hypothesis in
both industry levels at the 0.05 significance level. For the specialty retail industry the
hypothesis that that the accuracy of the price estimates based on the two multiples is the same
is also rejected at the 0.01 significance level. This implies that the accuracy of the P/E
valuation model is significantly higher than the accuracy of the P/B valuation model at both
industry levels with the accuracy being more significant in the specialty retail industry.
Table 2: Test statistics of the absolute percentage valuation errors of the P/E and P/B valuation models for
the years 2011 and 2012.
Significance 0.05 0.01
Industry
level:level: Retailing Specialty Retail Retailing Specialty Retail
E(P/E) E(P/B) E (P/E) E(P/B) E(P/E) E(P/B) E (P/E) E(P/B)
Mean 0.466 0.637 0.461 0.640 0.466 0.637 0.461 0.640
t-stat -2.573 -2.692 -2.573 -2.692
P(T<=t) two-tail 0.012 0.008 0.012 0.008
T critical two-tail 1.987 1.987 2.632 2.632
Note: E(P/E) are the absolute percentage valuation errors of the outcomes derived using the P/E multiple.
E(P/B) are the absolute percentage valuation errors of the outcomes derived using the P/B multiple.
The superiority of the P/E valuation model implies that earnings assess better the value of the
firm than book values. The superiority of the P/E over the P/B multiple is in line with the
results of previous studies (Kim and Ritter, 1999; Liu et al., 2002; Cheng and McNamara,
2000).
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5.1.2 The effect of the industry fineness: A comparison of the valuation accuracy at the
retailing industry group and the specialty retail industry levels.
In the second hypothesis I test whether the accuracy of the valuation improves when the
comparable firms are chosen on the basis of a narrower industry definition as is the case with
previous research findings (Alford, 1992). I test the hypothesis by using data from two
different industry levels of the GICS codes, the retailing industry group and the specialty
retail industry. The null hypothesis is that the two multiples provide equally accurate results at
both the retailing industry group and the specialty retail industry levels.
Table 3 shows the t-statistics of the absolute percentage valuation errors of both the P/E and
the P/B valuation multiples models in the retailing industry group and the specialty industry
for the period 2011-2012.
Table 3: Test statistics of the absolute percentage valuation errors of the multiple valuation models
between the retailing industry group and the specialty industry for the years 2011 and 2012.
Significance level: 0.05 0.01
E(PER) E(PES) E(PBR) E(PBS) E(PER) E(PES) E(PBR) E(PBS)
Mean 0.466 0.461 0.637 0.640 0.466 0.461 0.637 0.640
t-stat 4.717 -4.416 4.717 -4.416
P(T<=t) two-tail 0.000 0.000 0.000 0.000
Note: E(PER) are the absolute percentage valuation errors of the outcomes derived from the P/E valuation
model in the retailing industry. E(PES) are the absolute percentage valuation errors of the outcomes derived
from the P/E valuation model in the specialty retail industry. E(PBR) are the absolute percentage valuation
errors of the outcomes derived from the P/B valuation model in the retailing industry. E(PBS) are the absolute
percentage valuation errors of the outcomes derived from the P/B valuation model in the specialty retail
industry.
The p-values are almost zero and therefore the null hypothesis that the two multiples yield
equally accurate results in the two industry levels is rejected at both the 0.05 and 0.01
significance levels. The positive value 4.717 of the t-statistic for the P/E multiple implies that
the P/E multiple yields more accurate outcomes at the specialty retail industry level and the
difference in accuracy is significant at both the 0.05 and 0.01 levels of significance. On the
contrary, the negative value -4.416 of the t-statistic for the P/B valuation multiple indicates
more accurate valuation estimates in the retailing industry group and this accuracy difference
is statistically significant at both the 0.05 and 0.01 levels of significance.
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The difference in the accuracy of the P/E valuation multiple model is consistent with the
previous studies of Alford (1992) and Liu et al. (2002) which support that there is an
improvement in the valuation accuracy when the comparable firms are chosen on the basis of
a narrower industry definition. On the other hand, the results for the P/B model do not agree
with these studies.
5.1.3 Does a combined P/E-P/B valuation multiple model provide more accurate results
than the single P/E and P/B valuation models?
Finally I assess whether the use of the combined P/E-P/B valuation model results to a more
accurate valuation than the use of the single P/E or P/B model.
Consistent with previous literature such as Yoo (2006) and Liu et al. (2002) who investigate
the possibility of a combined valuation model to result to more accurate valuation outcomes,
Table 4 shows the correlation of the outcomes of P/E and P/B scaled by the price for both the
retailing industry group and the specialty retail industry.
Table 4: Correlation between simple multiple valuation outcomes scaled by stock prices
Retailing Industry Group Specialty Retailing Industry

̂(P/E) / P ̂(P/B) / P ̂(P/E) / P ̂(P/B) / P
̂(P/E) / P 1 1
̂(P/B) / P 0.499 1 0.499 1
Note: P is the actual stock price. ̂(P/E) is the estimated price using the P/E valuation model. ̂(P/B) is the estimated
price using the P/B valuation model.
The correlation between the outcomes of the P/E and P/B valuation models is 0.499 for both
the retailing industry group and the specialty retailing industry. The positive correlation
between the valuation outcomes of the two simple P/E and P/B valuation multiples models
indicates the existence of common information between the two multiples. However, since
these correlations are less than 1, the use of a combined P/E- P/B valuation model may
improve the accuracy of the valuation estimates.
To assess this, I test the hypothesis that the combined P/E-P/B model will give more accurate
valuations than the simple P/E and P/B models.
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Cheng and McNamara (2000) provide a simple approach to the combined valuation multiples
model by calculating the outcomes of the combined valuation as the simple average of the
valuation outcomes given by the single P/E and P/B valuation models. Following the rationale
of Cheng and McNamara, Table 5 and 6 show the results of the paired t-test of the absolute
percentage valuation errors between the combined P/E-P/B valuation multiple model and the
single P/E and P/B valuation models respectively.
Beginning with table 5, the p-values 0.188 and 0.153 and the t-statistics 0.891 and 1.029, for
the retailing industry group and the specialty retail industry respectively, do not allow the
rejection of the null hypothesis that the combined P/E-P/B and the simple P/E models will
give equally accurate valuations; this holds true both at the .05 and .01 levels of significance.
Table 5: Test statistics of the absolute percentage valuation errors between the P/E and the combined
P/E-P/B valuation multiples models for the years 2011 and 2012
Significance 0.05 0.01
Industry
level:level Retailing Specialty Retail Retailing Specialty Retail
E(CPE) E(P/E) E(CPE) E(P/E) E(CPE) E(P/E) E(CPE) E(P/E)
Mean 0.496 0.466 0.496 0.461 0.496 0.466 0.496 0.461
t-stat 0.891 1.029 0.891 1.029
P(T<=t) one-tail 0.188 0.153 0.188 0.153
T critical one-tail 1.662 1.662 2.369 2.369
Note: E(CPE) are the absolute percentage valuation errors of the outcomes derived using the combined P/E-P/B
valuation model. E(P/E) are the absolute percentage valuation errors of the outcomes derived using the P/E
multiple valuation model.
This implies that contrary to the expectations from the value of the correlation between the
P/E and the P/B multiples and the empirical results of previous literature the combined P/E-
P/B method does not outperform the P/E single valuation multiple as it does not improve the
accuracy of the valuation outcomes. On the contrary, the single P/E valuation multiple is on
average 3% more accurate than the combined P/E-P/B valuation multiple. However, this
difference is statistically insignificant at both the 0.05 and 0.01 levels of significance. A
possible explanation may be extracted from the result of the first hypothesis, the comparison
of the P/E and the P/B single valuation multiples models. As shown in Table 2 the P/E
valuation model significantly outperforms the P/B multiple (the P/E valuation model appears
to be 17% and 18% more accurate than the P/B valuation model in the retailing industry
group and the specialty retail industry respectively).
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On the other hand, Table 6 compares the accuracy of the combined P/E-P/B valuation model
to the valuation accuracy of the single P/B valuation model. In this case, since both the p-
values ( 0 for both industry levels) and the values of t-statistics (-3.774 for the retailing
industry group and -3.859 for the specialty industry) lead to the rejection of the null
hypothesis it can be said that there is a significant difference in the valuation accuracy of the
two valuation models. The negative values of the t-statistics imply that the combined P/E-P/B
valuation model yields more accurate valuations compared to the ones obtained by using the
single P/B valuation model, and these findings are consistent with those of previous studies in
the literature.
Table 6: Test statistics of the absolute percentage valuation errors between the P/B and the combined P/E-
P/B valuation multiples models for the years 2011 and 2012.
Significance level: 0.05 0.01
Industry level: Retailing Specialty Retail Retailing Specialty Retail
E(CPE) E(P/B) E(CPE) E(P/B) E(CPE) E(P/B) E(CPE) E(P/B)

Mean 0.496 0.637 0.496 0.640 0.496 0.637 0.496 0.640
t-stat -3.774 -3.859 -3.774 -3.859
P(T<=t) one-tail 0.000 0.000 0.000 0.000
valuation model. E(P/B) are the absolute percentage valuation errors of the outcomes derived using the P/B
valuation model.
Even though the use of the simple arithmetic mean represents a straight-forward and simple
way to derive the combined valuation model, the inconsistency with previous literature leads
to a consideration of alternative methods of deriving the combined valuation model.
Cheng and McNamara (2000) themselves highlight that calculating the combined valuation
multiple model by using the simple arithmetic mean of the valuation outcomes of the two
single valuation multiples is likely to be inappropriate and that the assignment of weights to
both the P/E and P/B multiple outcomes is likely to lead to more reliable results.
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6. SENSITIVITY ANALYSIS
6.1 The impact of firm size
In the previous section I assess the performance of each valuation multiple by calculating the
absolute percentage pricing error for each target company, assigning the same weights to all
firms irrespective of their size. In order to assess how the accuracy of the valuation multiples
is affected by the size of the firms and whether some valuation multiples work better for
smaller or larger firms, I replicated the procedure implemented in the previous section by
assigning weights to the absolute percentage valuation errors, with the weights being the
market capitalisations of the respective firms.
Table 7 provides a comparison between the findings of the previous section with those
obtained by using the weighted absolute percentage valuation errors in conducting the
relevant tests.
Consistent with the literature and the previous findings, Panel A of Table 7 shows that the use
of the weighted absolute percentage valuation errors support the superiority of the P/E over
the P/B valuation model.
The mean values of errors obtained with the weighted absolute percentage valuation errors
analysis for P/E and P/B are much lower than those obtained in the previous section. In the
retailing sector the mean values of errors are 0.005 and 0.008 while the respective values in
the previous section are 0.466 and 0.637. This is also the case in the specialty retail industry
with the mean values of the weighted absolute percentage valuation errors being 0.005 and
0.008 as opposed to 0.461 and 0.640 respectively.
These results indicate that the P/E and P/B valuation multiples are likely to work better for
larger firms resulting to more accurate valuation outcomes. Cheng and MacNamara (2000)
also find that large firms enjoy better valuation accuracy. However, the statistical significance
of the results obtained by assigning weights is marginally lower as indicated by the p-values
and the t-statistics.
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Table 7: Comparison of the test statistics of the absolute percentage valuation errors and the weighted
absolute percentage errors for the years 2011 and 2012.
Significance level : 0.05

Panel A : A comparison of the accuracy of the P/E and P/B valuation models
Retailing Industry Group Specialty Retail Industry
E(P/E) E(P/B) W(P/E) W(P/B) E(P/E) E (P/B) W(P/E) W(P/B)
Mean 0.466 0.637 0.005 0.008 0.461 0.640 0.005 0.008
t-stat -2.573 -2.375 -2.692 -2.384
P(T<=t) two-tail 0.012 0.020 0.008 0.019
Panel B: A comparison of the valuation accuracy at the retailing industry group and the specialty retail industry
levels
E(PER) E(PES) W(PER) W(PES) E(PBR) E(PBS) W(PBR) W(PBS)
Mean 0.466 0.461 0.005 0.005 0.637 0.640 0.008 0.008
t-stat 4.717 -1.858 -4.416 0.510
P(T<=t) two-tail 0.000 0.066 0.000 0.611
Panel C: A comparison of the valuation accuracy of the combined P/E-P/B valuation multiple and the single P/E
and P/B valuation models
C1. Combined P/E-P/B and the single P/E model
E(CPE) E(P/E) W(CPE) W(P/E) E(CPE) E(P/E) W(CPE) W(P/E)
Mean 0.496 0.466 0.007 0.005 0.496 0.461 0.007 0.005
t-stat 0.891 2.257 1.029 2.262
P(T<=t) one-tail 0.188 0.013 0.153 0.013
C2. Combined P/E-P/B and the single P/B model
E(CPE) E(P/B) W(CPE) W(P/B) E(CPE) E(P/B) W(CPE) W(P/B)
Mean 0.496 0.637 0.007 0.008 0.496 0.640 0.007 0.008
t-stat -3.774 -2.491 -3.859 -2.504
P(T<=t) one-tail 0.000 0.007 0.000 0.007
Note: E(P/E) are the absolute percentage errors of the P/E model. E(P/B) are the absolute percentage errors of the P/B
model. W(P/E) are the weighted absolute percentage errors of the P/E model. W(P/B) are the weighted absolute
percentage errors of the P/B model. E(PER) are the absolute percentage errors of the P/E model in the retailing industry.
E(PES) are the absolute percentage errors of the P/E model in the specialty retail industry. E(PBR) are the absolute
percentage errors of the P/B model in the retailing industry. E(PBS) are the absolute percentage errors of the P/B model in
the specialty retail industry. W(PER) are the weighted absolute percentage errors of the P/E model in the retailing
industry. W(PES) are the weighted absolute percentage errors of the P/E model in the specialty retail industry. W(PBR)
are the weighted absolute percentage errors of the P/B model in the retailing industry. W(PBS) are the weighted absolute
percentage errors of the P/B model in the specialty retail industry. W(CPE) are the weighted absolute percentage errors of
the combined P/E-P/B valuation model. E(CPE) are the absolute percentage errors of the combined P/E-P/B valuation
model.
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Eliana Kafa
Panel B of the same table shows that for both the P/E and the P/B valuation models the p-
values and the t-statistics do not allow the rejection of the null hypothesis that the two
multiples yield the same valuation accuracy at the two industry levels. This implies that
changes in the industry fineness do not affect the valuation outcome. When comparing the
results of the sensitivity analysis with those of the initial analysis it appears that for larger
firms the selection of the industry level has no impact on the valuation accuracy.
In contrast to the results of the previous section, the use of the weighted pricing errors
suggests that the accuracy of the P/E simple valuation multiple is higher than that of the
combined P/E-P/B valuation multiple (Panel C1of Table 7). This could be interpreted as an
indication that for larger firms the simple P/E valuation model yields more accurate valuations
than the combined P/E-P/B model. With regards to the P/B valuation model, the findings are
consistent with those in the previous section (Panel C2 of Table 7). The combined P/E-P/B
model performs better than the simple P/B valuation model. However, the statistical
significance of the outcomes is lower in the case of the weighted pricing errors indicating that
the combined P/E-P/B method is comparatively better for smaller firms.
6.2 Adjustment for outliers and the use of harmonic mean in calculating the benchmark
multiple.
The existence of seven outliers identified with the use of z-core and Excel3 is likely to distort
the results and does not allow the use of the harmonic mean in the calculation of the
benchmark multiple to be used in the valuation. Following previous findings in the literature
(Baker and Ruback, 1999; Liu et al., 2002; Mînjina, 2009) that the use of the harmonic mean
yields more accurate valuations, I re-examine the performance of the three (P/E, P/B,
combined P/E-P/B) valuation multiples using the harmonic mean after the elimination of the
outliers.
3 To identify the outliers I use the “Real Statistics Using Excel software”. This is additional statistical software
on Excel. The Real Statistics program assumes that the sample is normally distributed. The identification of
outliers in the sample is based on the z-scores of the sample items. Items with z-scores or z-scores are
considered as outliers.
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Eliana Kafa
The results of the statistical analysis (refer to Appendix A) indicate that in general terms, with
the exception of the performance of the P/E valuation model at the two industry levels, the
harmonic mean and the median produce equally accurate valuations. However, the results
show certain differences between the outcomes obtained with the use of the two statistical
measures. More specifically, the use of median shows that the valuation accuracy of the P/E
model is higher at the specialty retail sector, while the harmonic mean does not indicate any
significant difference in the accuracy of the P/E valuation model at the two industry levels.
On the other hand, although both measures show that there is no statistically significant
difference between the combined P/E-P/B valuation model and the P/E model, the harmonic
mean shows that on average the combined P/E-P/B multiple provides slightly better estimates
than the single P/E multiple.
6.3 Expanding the time period
To assess the robustness of the valuation outcomes and the validity of the conclusions reached
I extend the time period of the sample to five years, from 2008-2012. By doing this, the
number of observations increases to 430 for the retailing industry group and 254 for the
specialty retail industry. However, the number of the common companies constituting the
final sample is reduced to 28 companies while the number of observations is increased to 140
for the whole time period of five years.
Table 8 indicates the results of the paired sample t-test for the expanded time period. The
statistical significance of the results is higher than that of the results of the previous section.
Panel A of Table 8 shows that, consistent with all the previous findings and results, the P/E
outperforms the P/B valuation multiples model at both the retailing and the specialty retail
sector levels. From Panel B it is evident that the valuation accuracy of both the P/E and the
P/B models is higher at the specialty retail industry level. Although this contradicts the
relevant findings of the initial analysis concerning the P/B multiple’s accuracy at the two
industry levels, it is consistent with Alford’s (1992) findings.
The combined P/E-P/B and the single P/E valuation models do not show any statistically
significant difference in the valuation accuracy (Panel C1 of Table 8). This is consistent with
the findings of the initial analysis but still does not agree with previous literature. On the other
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hand, the combined P/E-P/B outperforms clearly the single P/B model as it was the case with
the initial analysis (Panel C2 of Table 8).
Table 8: Test statistics of the absolute percentage valuation errors for the years 2012-2018.
Panel A : A comparison of the accuracy of the P/E and P/B valuation models
E (P/E) E (P/B) E (P/E) E (P/B)
Mean 0.400 0.579 0.388 0.553
t-stat -3.249 -3.182
P(T<=t) two-tail 0.001 0.002
T critical two-tail 1.977 1.977
Panel B: A comparison of the valuation accuracy at the retailing industry group and the specialty retail
industry levels
E (PER) E (PES) E (PBR) E (PBS)
Mean 0.400 0.388 0.579 0.553
t-stat 3.514 3.896
P(T<=t) two-tail 0.001 0.000
Panel C: A comparison of the valuation accuracy of the combined P/E-P/B valuation multiple and the
single P/E and P/B valuation models
C1. Combined P/E-P/B and the single P/E model
E(CPE) E(P/E) E(CPE) E(P/E)
Mean 0.435 0.400 0.422 0.388
t-stat 1.276 1.309
P(T<=t) one-tail 0.102 0.096
T critical one-tail 1.656 1.656
C2. Combined P/E-P/B and the single P/B model

E(CPE) E (P/B) E (CPE) E(P/B)
Mean 0.435 0.579 0.422 0.553
t-stat -4.723 -4.565
P(T<=t) one-tail 0.000 0.000
Note: E(P/E) are the absolute percentage errors of the P/E model. E(P/B) are the absolute percentage errors of
the P/B model. E(PER) are the absolute percentage errors of the P/E valuation model in the retailing industry.
E(PES) are the absolute percentage errors of the P/E model in the specialty retail industry. E(PBR) are the
absolute percentage errors of the P/B model in the retailing industry. E(PBS) are the absolute percentage errors
of the P/B model in the specialty retail industry. E(CPE) are the absolute percentage errors of the combined P/E-
P/B valuation model.
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Eliana Kafa
6.4 Assigning weights to the combined P/E-P/B valuation model
The findings of my initial analysis show that there is no statistically significant difference in
the valuation accuracy of the combined P/E-P/B and the simple P/E models. These are not
consistent with the findings from previous studies in the literature. To test the robustness of
these results, I attempt to assign weights in the calculation of the combined P/E-P/B valuation
model. Following the procedure used by Yoo (2006), I attempt to determine the weights by
regressing the actual stock prices on the valuation outcomes of the simple P/E and P/B models.
The results of the multiple linear regression analysis (refer to Appendix B) do not allow the
determination of appropriate weights since the regression coefficients of the P/B valuation
outcomes are statistically insignificant in both the retailing industry group and the specialty
retail sector. This implies that the regression model justifies only the use of the P/E multiple.
However, this may be due to the fact that linear regression analysis is not the appropriate
mathematical model or that the quality of data provided by the Bloomberg database is
questionable.
7. SUMMARY AND CONCLUSION
In this study I evaluate the accuracy of the single P/E, P/B and the combined P/E-P/B
valuation multiples models by taking a sample of 45 companies in the retailing industry of
Western Europe for the years 2011 and 2012. I select comparable firms on the basis of the
industry membership as it appears in the GICS codes. Following previous findings (Alford,
1992; Liu et al., 2002), I assess the impact of the industry finesses by taking two separate
industry levels, the retailing industry group and the specialty retail industry. I evaluate the
accuracy of the three models by comparing the absolute percentage errors between the actual
and the estimated equity price of each firm, scaled by the actual price. In all the three models I
calculate the benchmark valuation multiple as the median of the valuation multiples of the
comparable firms.
Consistent with the literature (Kim and Ritter, 1999; Alford, 1999; Cheng and McNamara,
2000; Liu et al., 2002), I find that the P/E valuation model yields more accurate valuations
than the P/B model. The superiority of the P/E applies to both the retailing industry group and
the specialty retail industry levels indicating that earnings estimate better the value of a firm
than book values.
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Eliana Kafa
Testing for the effect of the industry fineness on the valuation accuracy, like Alford (1992), I
show that the performance of the P/E model in the specialty retail industry outperforms its
performance in the retailing industry group. On the other hand, I show that the P/B model
provides more accurate valuations in the retailing industry group.
Contrary to the expectations and the previous literature, while the combined P/E-P/B model
clearly outperforms the simple P/B model, its accuracy does not show any statistically
significant difference from that of the simple P/E valuation model. This is likely to be due to
the poor valuation performance of the P/B valuation model as compared to the P/E model.
However, this is an issue which requires further investigation.
I also examine the effect on the valuation accuracy of the three models of four additional
factors: the comparable firms’ size, the use of the harmonic mean after adjusting for outliers,
the expansion of the time period from two to five years, and the use of multiple regression
analysis in determining the appropriate weights to be assigned to the combined P/E-P/B
valuation model.
I show that the size of the comparable firms affects the performance of all the three valuation
models implying that a multiple-based valuation using the P/E, P/B or a combination of the
two yields more accurate results for larger firms with the industry fineness having no impact
on the valuation accuracy of these estimates. I find that the adjustment for outliers and the use
of the harmonic mean does not lead to any improvement in the valuation accuracy of the three
models. However, worth mentioning is the fact that although there is no statistically
significant difference between the combined P/E-P/B valuation and the simple P/E model this
is the only case in this study where the combined method appears to give marginally better
estimations than the P/E valuation model. Further I show that expanding the time period to
five years (2008-2012) significantly improves the statistical accuracy of the results. Finally,
my effort to use multiple regression analysis to improve the accuracy of the combined P/E-
P/B valuation model does not provide any meaningful conclusions. This justifies further
research.
The weak performance of the P/B valuation multiple shown throughout this study is not
justified by previous theoretical and empirical findings regarding the valuation relevance and
importance of the book value. This requires an assessment of the P/B multiple valuation with
the use of more observations and different definitions of comparable firms.
- 32 -
Eliana Kafa
REFERENCES
Alford, A.W. (1992) ‘The Effect of the Set of Comparable Firms on the Accuracy of the
Price-Earnings Valuation Method’. Journal of Accounting Research, 30(1), pp.94-108.
Baker.M, Ruback. R.S (1999) ‘ Estimating Industry Multiples’. Harvard Business School.
Barker, R. (1999) ‘The role of dividends in valuation models used by analysts and fund
managers’. The European Accounting Review, 8 (2), pp.195-218.
Beatty, R., Riffe, S. and Thompson, R. (1999) ‘The method of comparables and tax court
valuation of private firms: an empirical investigation’. Accounting Horizon, 13 (3),
pp.177-99.
Bernard, V.L. (1994) ‘Accounting-Based Valuation methods, Determinants of Market-to-

Book Ratios, and Implications for Financial Statement Analysis’. University of Michigan.
Bhojraj, S., Lee C.M.C. (2002) ‘Who Is My Peer? A Valuation- Based Approach to the
Selection of Comparable Firms’. Journal of Accounting Research, 40 (2), pp.407-439.
Bhojraj, S., Lee, C.M.C. & Oler, D.K. (2003) ‘What's My Line? A Comparison of
Industry Classification Schemes for Capital Market Research’, Journal of Accounting
Research, 41, (5), pp. 745-774.
Black, F. (1980) ‘The Magic in Earnings: Economic Earnings versus Accounting

Earnings’. Financial Analysts Journal, 36 (6), pp.19-24.
Cheng, C.S.A., McNamara, R. (2000) ‘The Valuation Accuracy of the Price-Earnings and
Price-Book Benchmark Valuation Methods’. Review of Quantitative Finance and
Accounting, 15 (4), pp.349-370 .
Cooper, I., Cordeiro, L. (2008) ‘Optimal equity valuation using multiples: The number of
comparable firms’. Working Paper, SSRN.
Damodaran, A. (2006), Damodaran on valuation: security analysis for investment and

corporate finance, Wiley.
Demirakos, E.G., Strong, N.C., Walker, M. (2004) ‘What Valuation Models Do Analysts
Use?’. Accounting Horizons, 18 (4) , pp.221-240.
- 33 -
Eliana Kafa
Feltham, G.A, Ohlson, J.A. (1995) ‘Valuation and Clean Surplus Accounting for
Operating and Financial Activities’. Contemporary Accounting Research, 11(2), pp.689-
731.
Herrmann V., Richter F. (2003) ‘Pricing with performance-controlled multiples’.

Schmalenbach Business Review : ZFBF, 55 (3), pp. 194-219.
Hotchkiss, E.S., Gilson, S.C. (2000) ‘Valuation of bankrupt firms’. The review of
financial studies, 13(1), pp. 43-74.
Kaplan, S.N., Ruback, R.S. (1995) ‘The Valuation of Cash Flow Forecasts: An Empirical
Analysis’. The Journal of Finance, 50 (4), pp. 1059-1093.
Kim, M., Ritter, J.R. (1999) ‘Valuing IPOs’. Journal of Financial Economics, 53 (3), pp.
409-437.
Lie, H.J., Lie, E. (2002) ‘Multiples Used to Estimate Corporate Value’. Financial
Analysts Journal, 58 (2), pp. 44-54.
Liu, J., Nissim, D., Thomas, J. (2002) ‘Equity Valuation Using Multiples’. Journal of
Accounting Research, 40(1), pp. 135-172.
Liu, J., Ohlson, J.A., (2000) ‘The Feltham-Ohlson (1995) model: Empirical implications’.
Journal of Accounting, Auditing & Finance, 15 (3), pp. 321.
Mînjina. D. I. (2009) ‘Relative Performance of Valuation Empirical Evidence on

Bucharest Stock Exchange’. The Review of Finance and Banking, 1 (1).
Ohlson, J.A. (1988) ‘Accounting Earnings, Book Value and Dividends. The theory of the
Clean Surplus Equation’. Columbia University.
Ohlson, J.A. (1995), ‘Earnings, Book Value and Dividends in Equity Valuation’.
Contemporary Accounting Research, 11(2), pp. 661-687.
Ohlson, J.A., Zhang, X. (1998) ‘Accrual Accounting and Equity Valuation’. Journal of
Accounting Research, 36, pp. 85-111.
Park, Y.S., Lee, J. (2003) ‘An empirical study on the relevance of applying relative
valuation models to investment strategies in the Japanese stock market’. Japan and the
world economy, 15 (3), pp. 331-339.
- 34 -
Eliana Kafa
Penman, S.H. (1996) ‘The Articulation of Price-Earnings Ratios and Market-to-Book

Ratios and the Evaluation of Growth’. Journal of Accounting Research, 34 (2), pp. 235-
259.
Real Statistics Using Excel. 2013, Charles Zaiontz [Online] Available from:
http://www.real-statistics.com/sampling-distributions/identifying-outliers-missing-data/
[Accessed 25 January 2014] .
Schreiner, A. (2007) ‘Equity valuation using multiples: an empirical investigation’,

University of St. Gallen, Dissertation for Doctor of Business Administration.
Yoo, Y.K. (2006) ‘The valuation accuracy of equity valuation using a combination of
multiples’. Review of Accounting and Finance, 5 (2), pp. 108-123.
- 35 -
Eliana Kafa
APPENDIX A
Adjustment for outliers and the use of harmonic mean in calculating the benchmark
multiple - Test Statistics tables.
Table A1: Test statistics of the absolute percentage valuation errors between the P/E and P/B multiple
valuation models for the years 2011 and 2012.

E (P/E) E (P/B) E (P/E) E (P/B)
Mean 0.425 0.536 0.415 0.559
t-stat -2.608 -2.597
P(T<=t) two-tail 0.011 0.006
Note: E(P/E) are the absolute percentage valuation errors of the outcomes derived using the P/E valuation
model. E(P/B) are the absolute percentage valuation errors of the outcomes derived using the P/B valuation
model
Table A2: Test statistics of the absolute percentage valuation errors of the valuation multiples models
between the retailing industry group and the specialty industry for the years 2011 and 2012.
Significance level: 0.05

E (PER) E (PES) E (PBR) E (PBS)
Mean 0.425 0.415 0.536 0.559
t-stat 0.307 -1.964
P(T<=t) two-tail 0.760 0.053

Note: E(PER) are the absolute percentage valuation errors of the outcomes derived using the P/E valuation
model in the retailing industry. E(PES) are the absolute percentage valuation errors of the outcomes derived
using the P/E valuation model in the specialty retail industry. E(PBR) are the absolute percentage valuation
errors of the outcomes derived using the P/B valuation model in the retailing industry. E(PBS) are the absolute
percentage valuation errors of the outcomes derived using the P/B valuation model in the specialty retail
industry.
- 36 -
Eliana Kafa
Table A3: Test statistics of the absolute percentage valuation errors between the P/E and the combined
P/E-P/B multiple valuation model for the years 2011 and 2012.

E(CPE) E(P/E) E(CPE) E(P/E)
Mean 0.423 0.425 0.435 0.415
t-stat -0.082 0.641
P(T<=t) one-tail 0.467 0.261
valuation model. E(P/E) are the absolute percentage valuation errors of the outcomes derived using the P/E
valuation model.
Table A4: Test statistics of the absolute percentage valuation errors between the P/B and the combined
P/E- P/B valuation multiples models for the years 2011 and 2012.

E(CPE) E (P/B) E (CPE) E(P/B)

Mean 0.423 0.536 0.435 0.559
t-stat -4.144 -4.030
P(T<=t) one-tail 0.000 0.000
valuation model. E(P/B) are the absolute percentage valuation errors of the outcomes derived using the P/B
multiple valuation model.
- 37 -
Eliana Kafa
APPENDIX B
Multiple Linear Regression Analysis
B1: Retailing Industry Group – Summary Output from Excel
Regression Statistics
Multiple R 0.877
R Square 0.769
Adjusted R Square 0.763
Standard Error 11.941
Observations 90.000
ANOVA
Significance
df SS MS F F
Regression 2.000 41214.607 20607.304 144.527 0.000
Residual 87.000 12404.806 142.584
Total 89.000 53619.414
Standard Upper Lower Upper

Coefficients Error t Stat P-value Lower 95% 95% 95.0% 95.0%
Intercept 3.490 1.443 2.419 0.018 0.623 6.358 0.623 6.358
PE 1.007 0.137 7.362 0.000 0.735 1.279 0.735 1.279
PB -0.189 0.135 -1.400 0.165 -0.457 0.079 -0.457 0.079
Note: PE: the estimated price using the simple P/E multiple valuation model
PB: the estimated price using the simple P/B multiple valuation model
38
Eliana Kafa
B2: Specialty Retail Industry - Summary Output from Excel
Regression Statistics
Multiple R 0.893
R Square 0.798
Adjusted R Square 0.788
Standard Error 11.479
Observations 45.000
ANOVA
Significance
df SS MS F F
Regression 2.000 21797.297 10898.648 82.708 0.000
Residual 42.000 5534.431 131.772
Total 44.000 27331.728
Standard P- Upper Lower Upper

Coefficients Error t Stat value Lower 95% 95% 95.0% 95.0%
Intercept 2.719 1.961 1.386 0.173 -1.239 6.677 -1.239 6.677
PE 0.991 0.187 5.311 0.000 0.615 1.368 0.615 1.368
PB -0.220 0.187 -1.180 0.244 -0.597 0.156 -0.597 0.156
Note: PE: the estimated price using the simple P/E multiple valuation model
PB: the estimated price using the simple P/B multiple valuation model
39

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BSc (Hons) Accounting & Finance

The valuation accuracy of the Price-to-Earnings and the

Submitted by: Eliana Kafa

Student ID: 110001990

Supervisor: Dr Pawel Bilinski

Submission date: April 2014

Student Name: Eliana Kafa

Degree: BSc (Hons) Accounting & Finance

Dissertation Title: The valuation accuracy of the Price-to-Earnings and the

Price-to- Book valuation multiples: A focus on the retailing industry

sector of Western Europe.

Supervisor Name: Dr Pawel Bilinski

2. Literature Review ..................................................................................................................... 8

2.1 Accuracy of valuation models based on combinations of multiples .................................. 11

2.2 Choice of the comparable firms ......................................................................................... 12

3. Research Design ....................................................................................................................... 14

3.1 Simple multiple valuation .................................................................................................. 14

3.2 Combination of simple multiple valuations ....................................................................... 16

3.3 Performance measurement ................................................................................................. 17

3.4 Hypothesis Testing ............................................................................................................. 18

4. Data and Sample....................................................................................................................... 18

5. Empirical Results ..................................................................................................................... 20

5.1 Formal tests of the three research hypotheses ................................................................... 20

than the single P/E and P/B valuation models? ....................................................... 23

6. Sensitivity Analysis .................................................................................................................. 26

6.1 The impact of firm size ...................................................................................................... 26

6.3 Expanding the time period ................................................................................................. 29

6.4 Assigning weights to the combined P/E-P/B valuation model .......................................... 31

7. Summary and Conclusion ........................................................................................................ 31

benchmark multiple - Test Statistics tables ....................................................... 36

Appendix B: Multiple Linear Regression Analysis ................................................................. 38

Table 1: Descriptive statistics of underlying sample .................................................................. 20

valuation models for the years 2011 and 2012 ............................................................... 21

2011 and 2012 ................................................................................................................ 22

Accounting-based valuation approaches and more specifically the multiple-based valuation

A recent study conducted by Schreiner (2007) investigates the performance of various

2.1 Accuracy of valuation models based on combinations of multiples

2.2 Choice of the comparable firms

3.1 Simple multiple valuation

The per-share value of the target firm is estimated as:

To investigate whether the valuation accuracy is improved by taking a narrower industry

3.2 Combination of simple multiple valuations

3.3 Performance measurement

3.4 Hypothesis Testing

Hypothesis 3: There is no difference in the accuracy of the composite multiples

4. DATA AND SAMPLE

Table 1. Descriptive statistics of underlying sample

Multiple Descriptive Statistics Period

P/B: End-of-year stock price divided by end-of-year common stock equity.

5.1 Formal tests of the three research hypotheses

Retailing Industry Group Specialty Retailing Industry

E(CPE) E(P/B) E(CPE) E(P/B) E(CPE) E(P/B) E(CPE) E(P/B)

6.1 The impact of firm size

Significance level : 0.05

6.3 Expanding the time period

C2. Combined P/E-P/B and the single P/B model

6.4 Assigning weights to the combined P/E-P/B valuation model

7. SUMMARY AND CONCLUSION

Bernard, V.L. (1994) ‘Accounting-Based Valuation methods, Determinants of Market-to-

Black, F. (1980) ‘The Magic in Earnings: Economic Earnings versus Accounting

Damodaran, A. (2006), Damodaran on valuation: security analysis for investment and

Herrmann V., Richter F. (2003) ‘Pricing with performance-controlled multiples’.

Mînjina. D. I. (2009) ‘Relative Performance of Valuation Empirical Evidence on