Market-Based

Valuation:
Price and Enterprise
Value Multiples
 Valuation Indicators

Enterprise Value Multiples

Price Multiples
Total market value of all
Ratios of stock’s market price
sources of company’s capital
to some measure of
to a measure of fundamental
fundamental value per share.
value for the entire company.

Momentum Indicators
Ratios of price or other
fundamentals to the time
series of their past values, or
in some cases, their expected
values
 Valuation Indicators
Price multiples are used to evaluate the price of a share of stocks to
judge whether the share is undervalued, fairly priced, or overvalued in
term per share earnings, net assets, cash flows and some other
measures.

The enterprise value multiples are also used to evaluate the market
value of an entire enterprise relative to the amount of Earnings before
interests, taxes, depreciation and amortization (EBITDA), sales or
operating cash flows.
 Methods for Price &
Enterprise Value Multiples
1) Method of Comparable
• Applies to comparison of multiple similar assets.
• Economic rationale is the law of one price: 2 identical assets
should sell at same price
• A P/E of 20 means it takes 20 units to purchase 1 unit of earnings.
2) Method Based on Forecasted Fundamentals
• Reflects firm fundamentals and future cash flows
• (e.g. a DCF relative to forecasted or current EPS of the same
company)
Methods of Comparables for Price
Multiples
Company A’s stock is trading at $37.50 with an EPS of $1.50.
If a close competitor to company A, i.e. company B is trading
a P/E of 22, assuming the two companies have a similar
operating and financial profile:

◦ Company A’s stock is overvalued relative to Company B

given its P/E is 25 (= $37.5 / $1.50)
◦ Company A’s stock should trade at $33 (=$1.50 * 22) to be
identical with the company B.
 Price-to-Earnings Multiple
Rationales & Drawbacks
Rationales
EPS or earning power (the
denominator) is driver of value –
it is determined based on the
complex rules of accrual
accounting.
Widely used
Differences in P/Es reflect the
differences in long-run average
stock returns (empirical findings)
Drawbacks
Zero, negative, or very small
earnings
Permanent (recurring) vs.
transitory (nonrecurring)
components of earnings are
difficult to be differentiated.
Management discretion for
earnings may distort the EPS
from being an accurate reflection
of economic performance.
 Price-to-Earnings Multiple
Definitions

Trailing P/E Forward P/E

Preferred Preferred
Uses last when Uses next when trailing
year’s forecasted year’s earnings are
earnings earnings are earnings not reflective
not available of future
 Example: Forward P/E
Stock price $20 .00
2011:Q1 EPS $0 .18
2011:Q2 EPS $0 .25
2011:Q3 EPS $0 .32
2011:Q4 EPS $0 .35
2011 Fiscal year forecast $1 .10

2012:Q1 EPS $0 .43

2012:Q2 EPS $0 .48
2012:Q3 EPS $0 .50
2012:Q4 EPS $0 .59
2012 Fiscal year forecast $2 .00
 Example: Forward P/E
1) Forward P/E based on EPS for the next 4 quarters:

EPS for the next 4 quarters = $0.35  $0.43  $0.48  $0.50  $1.76

Forward P/E based on EPS for the next 4 quarters  $20  $1.76  11.4

2) Forward P/E based on EP S for the NTM (next 12 months):

   
EPS for the NTM  1 $1.10  11 $2.00  $1.925
12 12
Forward P/E based on EPS for the NTM  $20  $1.925  10.4
 Example: Forward P/E
3) Forward P/E based on the current fiscal year's EPS:

EPS for the current fiscal year  $1.10

Forward P/E based on EPS for the current fiscal year  $20  $1.10  18.2

4) Forward P/E based on the next fiscal year's EPS:

EPS for the next fiscal year  $2.00

Forward P/E based on EPS for the next fiscal year  $20  $2.00  10.0
 Issues in Calculating EPS
EPS Dilution is the division
of total earnings by the Underlying/Persistent
number of shares that Earnings:
would be outstanding if removal of non-recurring
holders of convertible items in earnings
securities.

Normalized Earnings: is the Differences in Accounting

estimate of the earnings that
Methods: LIFO vs FIFO
a firm could achieve in mid-
inventory accounting
cyclical conditions.
Example: Underlying Earnings
Reported EPS from previous four quarters $4.00

Restructuring earnings $0.10

Amortization of intangibles $0.15

Impairment charge $0.20

Stock price $50.00

 Example: Underlying Earnings
P/E based on reported earnings  $50  $4.00  12.5

Reported core earnings  $4.00  $0.10  $0.15  $0.20  $4.45

P/E based on reported core earnings  $50  $4.45  11.2

Underlying earnings  $4.00  $0.20  $4.20

P/E based on und erlying earnings  $50  $4.20  11.9

Example: Normalized Earnings
Year EPS BVPS ROE
2010 $0.66 $4.11 16.1%
2009 $0.55 $3.67 15.0%
2008 $0.81 $2.98 27.2%
2007 $0.73 $2.12 34.4%
2006 $0.34 $1.61 21.1%

2011 stock price $24.00

Example: Normalized Earnings
1) Method of historical average EPS

Average (normalized) EPS

($0.66  $0.55  $0.81  $0.73  $0.34)

  $0.618
5

P/E  $24.00  $0.618  38.8

Example: Normalized Earnings
2) Method of average ROE

Average ROE
(16.1%  15.0%  27.2%  34.4%  21.1%)
  22.8%
5
Average (normalized) EPS
 Average ROE  Current equity book value per share
Average (normalized) EPS
 22.8%  $4.11  $0.937

P  E  $24.00  $0.937  25.6

 Forward P/E
If the current market price of a stock is $15 as of March 1,
2003, and the most recently reported quarterly EPS (for the
quarter ended December 31, 2002) is $0.22.
◦ And if forecasts of EPS are as follows:
◦ $0.15 for the quarter ending March 31, 2003
◦ $0.18 for the quarter ending June 30, 2003
◦ $0.18 for the quarter ending September 30, 2003
◦ $0.24 for the quarter ending December 31, 2003
The sum of the forecasts for the next four quarters to report is $0.15 +
$0.18 + $0.18 + $0.24 = $0.75, and the Forward P/E for this stock is
$15/$0.75 = 20.0.
 NTM Forward P/E
Next Twelve Month (NTM) forward P/E is slightly different in
application:
For example, assume that in August 2013, an analyst is looking at
Microsoft Corporation, which has a June fiscal year end, so at the
time of the analyst’s security (from September to June) there are
10 months remaining until the company’s 2014 fiscal year end.
The NTM EPS for Microsoft would be calculated as
[(10/12) * FY14 EPS] + [(2/12) * FY15 EPS]
To solve for NTM Forward P/E.
This is a good measure for comparison of companies with
different fiscal year-ends.
 Justified P/E
The P/E can also be calculated using the DCF or DDM approach,

◦ where P/E of a share of stock can be related to the value of a

stock as calculated under the constant growth model.

◦ P/E can be treated as a function of two fundamentals: the

required rate of return, r, and the expected (stable) dividend
growth rate, g.
◦ Linking P/Es to a DCF model helps us address what value the
market should place on a dollar of EPS when we are given a
particular set of expectations about the company’s
profitability, growth, and cost of capital.
Justified Forward P/E from
Fundamentals
D1
V0 
rg
P0 D1 E1

E1 rg
P0 1 b

E1 rg
 Justified P/E
All else being equal, the higher the expected
dividend growth rate or the lower the stock’s
required rate of return, the higher the stock's
intrinsic value and the higher its justified P/E.
Justified Trailing P/E from
Fundamentals
D 0 (1  g)
V0 
r  g
P0 D 0 (1  g ) E0

E0 r  g
P0 (1  b )(1  g )

E0 r  g
Example: Justified Forward P/E
from Fundamentals

Retention ratio 0 .36

Dividend growth rate 4.0%

Required return on stock 10.0%

Example: Justified Forward P/E
from Fundamentals

P0 1 b
=
E1 rg
P0 1  0.36
= =10.7
E1 0.10  0.04
 Justified P/E
When assuming a complex DCF model for valuing the stock with varying
growth rates or varying dividends, we may not be able to express the P/E as
a function of fundamental variables. Nevertheless, we can still calculate a
justified P/E by dividing the DCF value (per share) by the forecasted EPS:
For example, if we have obtained an FCFE of ¥6,722 for a stock,
and its forecasted EPS is ¥600, we can calculate the justified
forward P/E based on forecasted fundamental to be:
6,722/600 = 11.2
while based on the current closed market price of the stock at
¥6,340, the justified P/E is about 6 percent lower (=10.6) than the
forward P/E.
 Example: Justified P/E from
Regression on Fundamentals
Predicted P/E 
11.5   2.2  DPR  +  0.03  Beta  + 16.2  EGR 

Values for subject firm

Dividend payout ratio 0.40

Beta 1 .20
Earnings growth rate 6.00%
Actual P/E 15 .0
 Example: Justified P/E from
Regression on Fundamentals
Predicted P/E 

11.5   2.2  DPR    0.03  Beta   16.2  EGR 

 11.5   2.2  0.4  +  0.03 1.2   16.2  0.06 

 13.3
 Method of Comparables
Benchmark Value of the
Multiple Choices

Industry Broad Firm’s

Industry
or sector market historical
peers
index index values
 Method of Comparables
Using Peer Company Multiples
• Law of one price
• Risk and earnings growth adjustments for different P/Es
• Firms with expected earnings growth higher than the benchmark
should sell for higher price multiples.
• Firms with higher risk than the benchmark should sell for lower
price multiples.
• One method of adjusting for differences in expected earnings
growth between the firm and the benchmark is to calculate the
P/E-to-growth ratio (PEG) – lower PEG is more attractive, lower
than 1 are especially attractive. (In other words, a stock with
greatest expected growth rate (or lowest risk) is more
attractively valued).
Example: Method of Comparables
Using P/E and PEG
Values for subject firm
Five-year EPS growth rate 8.0%
Consensus EPS forecast $4.50
Current stock price $28.00

Values for peer group

Median P/E 9 .00
Median PEG 1 .60
 Example: Method of Comparables
Using P/E and PEG
Forward P/E  $28.00  $4.50  6.2
The subject firm is undervalued because of lower P/E

PEG  6.2  8.0  0.78

The subject firm is undervalued because of lower P EG

Intrinsic value  9.0  $4.50  $40. 50

The subject firm is undervalued because of lower price of $ 28.00
 Method of Comparables
Using Peer Company Multiples
• When using peer company multiples as a benchmark, we use
the average or median P/E of the most closely matched
individual stock as a benchmark.

• However, using the average or median of a group of stocks or

an equity index in typically expected to generate less valuation
error than using a single stock.

• Economists and investment analysts often group the

companies by similarities and differences in their business
operations into sectors or based on their industry
classifications.
 Method of Comparables
Using Industry and Market
Multiples
Industry or Sector Index
Mean vs. median
Check industry valuation against market

Broad Market Index:

A firm might be fairly valued within the industry but over- or
under-valued relative to the broad market.
Adjust for differences in fundamentals & size
Financial databases often report the average P/E of the
market with individual P/Es weighted by the company’s
market cap.
Use relative values on a historical basis to verify if the equity
index itself is efficiently priced.
 Method of Comparables
Using Industry and Market Multiples
Higher market P/E than average of historical market P/E (as in 2001
compared to the average of 1871-2001) is because of either,

Lower-than-average interest rates and/or,

Higher-than-average expected growth rate.

The market is as a whole overvalued (as was the case in 2001

which was followed by a sharp downturn in US equities), or
That the earnings are abnormally low.
 Method of Comparables
Valuing the Market
 Fed Model: S&P 500 Earning Yield vs. T-Bond Yield
 Risk-free rate is a component of the required rate of return that is
inversely related to value.
 Based on the Fed Model, the return on the S&P 500 is predicted on
the basis of the relationship between forecasted earnings yields and
yields on bonds.

 The two yields are closely linked

 The earning yield E/P is inverse of Price Earning ratio (P/E)
 If the market earning yield (E/P) for S&P 500 is lower than 10-
year T-bond yield, the S&P is considered overvalued, because the
T-bond offers a higher yield than the stock, making stocks
unattractive.
 Method of Comparables
Valuing the Market
 A zero coupon bond A selling at 950 with a par-value of 1000
will have a yield of 5.26%. Now, if a newly issued comparable
zero-coupon bond B offers a 10% yield, the investors are
willing to purchase the bond B unless the bond A’s price
declines to the fair price of 909 or lower to represent a 10% or
higher yield than that of the bond B.

 For the same reason, a lower earning yield of the S&P 500 than
the 10-year T-bond yield offers an overvalued, less attractive
investment in the S&P 500 compared to 10-year bond.
 Method of Comparables
Using Own Historical Multiples
Rationale: Regression of P/E to the Mean over time
Approaches:
Average of four middle values over past 10 years
Five-year average trailing P/E
Potential Problems from Changes in
Firm business
Firm financial leverage
Interest rate environment
Economic fundamentals
Inflationary environment
 Using P/Es for Terminal Value
P/E Based on
Justified P/E
Comparables

P/E = Grounded in market

(D/E)/(r – g) data

If comp is mispriced,
Sensitive to required
terminal value will
inputs
be mispriced

These multiples are known as terminal price multiples.

 Example: Using P/Es for
Terminal Value
Values for subject firm
Required rate of return 11.0%
EPS forecast for year 3 $2.50

Values for peer group

Mean dividend payout ratio 0 .40
Mean ROE 8.0%
Median P/E 9 .00
Example: Using P/Es for Terminal
Value
Using Gordon Growth Model
D3  EPS3  Dividend payout ratio
D3  $2.50  0.40  $1.00

Retention ratio  1  Dividend payout ratio

Retention ratio  1  0.40  0.60

g  Retention ratio  ROE

g  0.60  8%  4.8%

D3 1  g  $1.00 1  0.048 
V3    $16.90
rg 0.11  0.048
Example: Using P/Es for Terminal
Value
Using Comparables

V3  P/E  EPS3

 9.0  $2.50  $22.50

 Price-to-Book Value Multiple
Rationales
Book Value (from B/Sheet) Is Usually Positive

More Stable than EPS

Appropriate for Financial Firms: adjustment of book values with market

values

Appropriate for Firms that Will Terminate

Can explain long-run average stock returns

Price-to-Book Value Multiple
Drawbacks
Does Not Recognize Nonphysical Assets

Misleading when Asset Levels Vary: for example it is not

appropriate for firms with small asset levels
Can Be Misleading Due to Accounting Practices: acquired intangible
assets are recognized in the balance sheet while those generated
internally are not.

Less Useful when Asset Age Differs due to inflation

and technological changes

Can Be Distorted Historically by Repurchases

Adjustments to Book Value
Inventory Accounting:
Firms using LIFO will have
Intangible Assets understated book values
in inflationary
environments.

Off-Balance- Sheet Items

must be accounted for.
Fair Value adjustment
E.g. guarantee to pay
another firm’s debt.
 Justified P/B
P0 ROE  g

B0 rg

PB increases as ROE increases

The larger the spread between ROE and r, the higher the P/B.

P0 PV  Expected future residual earnings 

 1
B0 B0
 Price-to-Sales
Multiple Rationales
Sales Less Easily Manipulated

Sales Are Always Positive

P/S Appropriate For Mature, Cyclical, & Distressed Firms

P/S More Stable Than P/E

Can Explain Stock Returns

 Price-to-Sales
Multiple Drawbacks
Sales ≠ Earnings & Cash Flow
Numerator & Denominator Not Consistent: Stock
prices are net the cost of debt (interest expense).
However, sales is a predebt (pre-interest expense)
figure
P/S Does Not Reflect Cost Differences
P/S Can Be Misleading Due to Accounting Practices:
Revenue recognition (speeding up revenue) may
distort the ratio
 Justified P/S

P0 (E0 / S 0 )(1  b)(1  g )


S0 rg

g  b  ROE

 Sales   Total assets 

g  b  PM 0      
 Total assets   Shareholders’ equity 
Example: Calculating the Actual &
Justified
P/E, P/B, & P/S

Stock price $50 .00

EPS $2 .00
Dividends per share $1 .20
Book value of equity per share $6 .25
Sales per share $15 .00
ROE 22.5%
Required return on stock 12.0%
Example: Calculating the Actual
P/E, P/B, & P/S
P0 $50
Actual   25.0
E0 $2

P0 $50
Actual   8.0
B0 $6.25

P0 $50
Actual   3.3
S0 $15
Example: Calculating the Inputs for
the Justified
P/E, P/B, & P/S

Dividend payout ratio  $1.20  $2.00  0.60

Retention ratio (b)  1  0.60  0.40

Growth rate in dividends ( g )  0.40  22.5%  9.0%

Example: Calculating the Justified
P/E, P/B, & P/S
P0 (1  b)(1  g ) (1  0.60)(1  0.09)
   21.8
E0 rg 0.12  0.09

P0 ROE  g 0.225  0.09

   4.5
B0 rg 0.12  0.09

P0 (E0  S0 )(1  b)(1  g ) ($2  $15)(0.6)(1.09)

   2.9
S0 rg 0.12  0.09
 Price-to-Cash-Flow
Multiple Rationales
Cash Flow Less Easily Manipulated

P/C Ratio More Stable Than P/E

Ratio Addresses Quality of Earnings Issue with P/E: conservatism

in accounting, provision for doubtful debts.

Ratio Can Explain Stock Returns

Price-to-Cash-Flow
Multiple Drawbacks
Cash Flow Can Be
Distorted

FCFE can be used as an

alternative to CFO, but it is
still more Volatile and More
Frequently Negative

Cash Flow Increasingly

Managed by Firms
 Definitions of Cash Flow
• Earnings + Depreciation +
CF Amortization + Depletion

CFO • From statement of cash flows

FCFE • Most valid but volatile

EBITDA • Best used with enterprise value

Justified Price-to-Cash-Flow
Ratio

FCFE 0 (1  g )
V0 
rg
 Dividend Yield
Rationales & Drawbacks

Rationales Drawbacks
Only one component of return:
capital appreciation is ignored
Component of return

Dividends may displace future

earnings: different dividend
payout ratio
Dividends less risky than future
capital gains
Market may not favor dividends
Justified Dividend Yield

D0 r  g

P0 1 g
 Inverse Price Ratios
Price Ratio Inverse Price Ratio

Price-to-earnings (P/E) Earnings yield (E/P)

Price-to-book (P/B) Book-to-market (B/P)

Price-to-sales (P/S) Sales-to-price (S/P)

Price-to-cash-flow (P/CF) Cash flow yield (C/P)

Price-to-dividends (P/D) Dividend yield (D/P)

 Enterprise Value/EBITDA Multiple
Rationales & Drawbacks

Rationales Drawbacks
Useful for comparing firms of
different leverage: EBITDA IS pre- Exaggerates cash flow from
interest operation if working capital is
growing
Useful for comparing firms of
different capital utilization: capital
incentive companies
FCFF more strongly grounded than
EBITDA
Usually positive
 Momentum Indicators:
Earnings Surprises
Price or other fundamentals, such as earnings are related to the time
series of their own past values, or in some cases to the fundamental’s
expected value.
Unexpected earning ( or earnings surprise) is equal to the
difference between reported earnings and expected earnings.

UE t  EPSt  E  EPSt 
The main rationale behind earnings surprise is that the positive
surprises may be associated with persistent positive abnormal
returns.
 Momentum Indicators:
Earnings Surprises
Standardized unexpected earnings
Numerator is the unexpected earnings at time t,
Denominator is the standard deviation of past unexpected
earnings over 20 quarters prior to time t.

EPSt  E  EPSt  UE t
SUE t  
  EPSt  E  EPSt     UEt 