Business Valuation

Relative Valuation

1
Outline

 Relative Valuation:
1-Comparable
2-Equity Multiple
3-Firm Multiple
4-Relative Valuation and DCF Valuation
5-Weighted Average Valuation Method

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1-Comparable: House Valuation

 Suppose you want to sell your home (or an office building), to determine the
price, you estimate first the price per square meter for your home. Then you
just have to multiply the estimated price per square meter by the square meter
of your home.

 There are different ways to define the price per square meter of your home.

 In relative valuation, we use a "valuation ratio". The advantage is its connection

with the observed market price. In fact, the price is determined "relative" to the
values or prices accorded to similar assets/entities at the time.

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1-Comparable: The method

 In DCF Method, we directly value firm through its future cash flows. But in the
method of comparables (or “comps”), the value of the firm is based on the
value of other comparable firms or transactions.

 Same or Comparable Industry Method:

– Select the firms in target’s industry or a comparable industry.
– Estimate the market value to earnings or revenue ratios for the average of
these firms.
– Multiply this multiple by the target's earnings or revenues (key attribute).

 Comparable Transactions’ Method:

– Select the acquisitions that are comparable and recent.
– Observe the prices paid for those companies.
– Apply that valuation to the firm.

 Comparable Company Analysis (Multiples Analysis):

– https://www.youtube.com/watch?v=o23ZNzcY-B8

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1-Comparable: Advantages and Disadvantages

 Relative valuation:
– Advantages
– Disadvantages

 Same or Comparable Industry Method:

– The ease of use and the availability of data.
– The presumption that industry multiples are actually comparable.

 Comparable Transactions’ Method:

– Accurate when the transaction is truly comparable and very recent.
– Truly comparable transactions are rare.

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1-Comparable: The process

 In relative valuation, the value of an asset/entity is compared to the values

assessed by the market for similar or comparable assets/entities.

 First, we identify comparable assets/entities and obtain values for these

assets/entities.
 Second, we convert these market values into price multiples by selecting the
proper key attributes or value indicators (such as Earnings per Share, EBITDA,
etc).
 Third, we apply the price multiple to the firm by multiplying it with its key
attribute or value indicator.

 The relative valuation formula:

MVT = (MVC / VI C ) VI T

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2-Equity Valuation: Price-Earnings ratio Multiple

 The price-earnings ratio is the most common valuation multiple. Note that PE
valuation approach is used to estimate the value of the firm’s equity, not the
enterprise value.

 The price-earnings ratio of a firm is the share price divided by its earnings per
share. When you buy a stock, your aim is to receive the firm's future earnings.
If the stock price is high, you will expect higher current earnings.

 In relative valuation, we will look for P/E ratio of comparable firms and calculate
the average P/E ratio.

 To compute a firm’s P/E ratio, we can either use the earnings over the prior 12
months or the expected earnings over the coming 12 months.

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2-Equity Valuation: Price-Earnings ratio Multiple

 How PE ratio evolves:

– Firms with higher growth will have a higher PE ratio.
– Firms with higher risk will have a lower PE ratio.
– Firms with lower reinvestment needs will have a higher PE ratio.

 The difficulty is that firms with higher growth have also higher risk and higher
reinvestment rates.

 A firm's P/E ratio is 15 and the other's firm is 10. The former's ratio is not more
expensive than the latter if its growth prospects, profitability, and the rate at
which profits are reinvested in the firm are higher than the latter.

 Assuming constant growth forever:

1+ g
PE = × (Payout Ratio)
ke − g

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2-Equity Valuation: Problem 3.1

 In 2019, the Pfizer Company was willing to sell its generic division, Upjohn. To
estimate the value of the equity, you can apply an average P-E ratio for similar
firms to the generic division’s earnings. The generic division earned $783 million
in 2018. a) By determining the P-E ratios for seven of the generic companies in
the world, a first approximation can be calculating. b) Since the revenues of
Pfizer’s generic division make it the third largest generic company from these
seven companies ranked behind Sun Pharmaceutical Industries and Dr Reddy’s,
the value of the equity should be refine.
Payout Cost of Growth Share EPS Market
Ratio Equity Price Capitalization
(billions)
Sun Pharmaceutical Indus. 1.90 94.91% 6% 6.84 3.01 16.41
Cipla 0.15 34.80% 4% 9.47 19.16 7.64
Dr. Reddy’s 0.16 7.40% 7% 60.56 1.40 10.05
Hikma Pharmaceuticals 0.22 9.50% 8% 31.08 2.00 7.15
Sawai Pharmaceutical 0.30 5.38% 3% 49.55 3.87 2.14
Lupin 0.15 21.95% 4% 11.44 13.40 5.18
Endo International 0.00 12.01% 7% 3.43 2.81 0.79

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2-Equity Valuation: Price-Earnings to Growth ratio Multiple

 The price-earnings to growth takes into account earnings growth. To obtain

PEG, PE is divided by expected earnings growth. Taking into account the future
potential of the company, its growth, the PEG ratio indicate us if the high PE
ratio is superficial or supported by future growth. It is sometimes favored over
the price-earnings ratio because it also accounts for growth:
PE
PEG =
g
 The PEG ratio tells us if a company's stocks is overpriced, underpriced or just at
the right price.
 Investors can pay more for a stock whose PEG ratio is greater than 1, an
overvalued firm, if the increase in earnings will result in future financial returns
that significantly exceed the firm’s cost of equity.
 With PEG ratio, it is possible to select the most attractive target by comparing
the potential market values of a number of different firms in the same industry.
 Assuming constant growth forever:
1+ g
PEG = × (Payout Ratio)
(ke − g ) g

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2-Equity Valuation: Problem 3.2

 As an analyst, you are asked to determine which of these electrical group,

Siemens, General Electric, Legrand or Schneider Electric is more attractive as an
acquisition target. For Siemens and General Electric, the projected annual
earnings growth rate is 3.4% and 1.0% whereas this rate is 6.3% for Legrand
and 4.5% for Schneider Electric. Siemens‘s, General Electric's, Legrand's and
Schneider Electric's current earnings per share are $8.66, $1.40, $2.69 and
$5.97, respectively. The current share prices as of August 7, 2020, for Siemens
is $132.13, for General Electric is $6.35, for Legrand is $79.43 and for
Schneider Electric is $117.50. The industry average price-to-earnings
price to earnings ratio and
growth rate are 17.24 and 3.8 percent, respectively. Based on this information,
which firm is a more attractive takeover target as of the point in time the firms
are being compared? The PEG ratio focuses on P/E ratios and earnings growth
rates. What other factors, if known, might change your answer to the previous
question?

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2-Equity Valuation: Problem 3.2

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2-Equity Valuation: Price Book Value ratio Multiple

 Using Book Value (BV) is an Asset-Oriented Method. The multiple is a ratio

between market value of equity and book value.

 Book value (BV) is (total assets - total liabilities). Besides shareholders’ equity =
total assets - total liabilities.

 The book value represents what the market is willing to pay for a firm’s assets.
The book value of firms in rate-of-return
rate of return regulated industries, such as
telephone, electric, and gas utilities, plays a role in determining future
profitability.

 This multiple is applied when earnings power or tangible value are in the assets.

 Assuming constant growth forever:

P0 1
= ROE (Payout Ratio)(1 + g )
BV0 ke − g

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2-Equity Valuation: Price Tangible Book Value ratio Multiple

 Using Tangible Book Value (TBV) is an Asset-Oriented Method. The multiple is a

ratio between market value of equity and tangible book value.

 Tangible book value (TBV) is (total assets - total liabilities - Other intangibles
assets – goodwill).

 The tangible book value reflects at what common shareholders can expect to
receive if the firm goes bankrupt. It corresponds to the liquidation of all of its
assets at their book values.

 This multiple is often used for valuing distribution firms where inventory through
current assets constitute a large percentage of total assets or financial services
firms where tangible book value is primarily cash or liquid assets.

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2-Equity Valuation: Problem 3.3

 Tech Data distributes microcomputer-related hardware and software products.

On August 7, 2020, its market price per share was $144.90. The firm’s
shareholders’ equity is $3107 million and goodwill is $1976 million. Tech Data
has 35.66 million shares outstanding. Its beta is 1.02 and the average annual
net income growth rate projected for seven-year is 9.8 percent. In the table,
there is various information on Tech Data's competitors. Using the tangible book
value per share, is Tech Data undervalued or overvalued compared to its August
7, 2020, share price?

Projected 7-Year Net

Competitors Market Value/TBV Beta
Income Growth Rate (%)
Synnex Corporation 14.20 1.49 13.4
Arrow 2.44 1.44 9.8
Avnet 1.07 1.04 6.5
Electrocomponents 8.67 1.01 10.9

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2-Equity Valuation: Case Study 1.2 (1)

 In 2022, as an analyst, you have to value the Hermès Group Company. To

estimate the value of the equity, you will apply an average P-E ratio for similar
firms and also an average PEG ratio based on the data available in the table. For
Hermès Group, the growth is 10% and the EPS is equal to €27.75.

Growth Share Price EPS Market

Capitalization
(billion)
Kering 13% 541.10 29.77 66.54
LVMH 9% 682.60 26.36 340.72
Estée Lauder 14% 265.30 6.53 94.47
PVH 8% 65.88 13.32 4.41
Richemont 30% 11.70 0.37 64.34

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2-Equity Valuation: Case Study 1.2 (2)

 In 2022, as an analyst, you have to value the Hermès Group Company. To

estimate the value of the equity, you will apply an average Price Book Value
ratio for similar firms and also an average Price Tangible Book Value ratio based
on the data available in the table. For Hermès Group, the Book Value is €9.4
billion and the Tangible Book Value is equal to €9.1 billion.

Book Other Tangible Market

Value Intangibles + Book Capitalization
Goodwill Value (billion)
Kering 13.35 10.03 3.32 66.54
LVMH 47.12 50.76 -3.64 340.72
Estée Lauder 5.59 0.10 5.49 94.47
PVH 5.29 6.14 -0.85 4.41
Richemont 19.81 5.88 13.93 64.34

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3-Firm Valuation: The multiples

 The firm’s enterprise value represents the total value of the firm’s underlying
business rather than just the value of equity. It permits the comparison of firms
with different amounts of leverage.

 To form an appropriate multiple, the enterprise value is divided by a measure of

earnings or cash flows before interest payments. The firm multiples are
enterprise value to EBIT, EBITDA or Free Cash Flow.

 The enterprise value to EBITDA multiple is considered as a crude measure of a

firm’s cash flow. It is preferred because capital expenditures can vary
substantially from period to period and affects the EBIT or Free Cash Flow.

 Enterprise Value vs Equity Value:

– https://www.youtube.com/watch?v=aHSyRdcDeBU

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3-Firm Valuation: Enterprise value to EBIT, EBITDA or FCFF

 Enterprise value to EBITDA multiple is good valuation tool for businesses in

which most of the value comes from existing assets, especially for mature
businesses whose value comes not mainly from future opportunities.
Enterprise Value Market Value of Equity + Market Value of Debt - Cash
=
EBITDA EBITDA

 Nevertheless, if the expected Free Cash Flow growth is constant, we can use the
following formula:
Enterprise Value 1 + g
=
FCFF0 kc − g

 Most analysts find Free Cash Flow to complex to use in multiples and choose
instead EBIT:
Enterprise Value 1+ g
= (1 + RIR)
EBIT(1 - T) kc − g
Depreciation and Amortization - ∆ Working capital - Gross capital expenditures
RIR =
EBIT(1 - T)

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 3-Firm Valuation: Problem 3.4

 Repsol and Eni are geographically diversified integrated oil and gas companies,
as of December 31, 2020, the market value of Repsol’s common equity was
$15.21 billion and Eni’s was $36.80 billion. Their market value of existing debt
are $12.62 billion and $18.11 billion, respectively. Repsol’s and Eni’s current
income, balance sheet, and cash flow statements as of December 31, 2020 are
shown in the tables. Which firm has the higher enterprise value to EBITDA?

Income Statement (12/2020) Balance Sheet (12/2020) Cash Flow (12/2020)

Repsol Eni Repsol Eni Repsol Eni
Revenue 33.28 43.99 Cash 6.32 14.92 Net income -3.34 -8.64
Cost of sales 30.78 40.82 Other current assets 7.26 24.53 Depreciation 6.71 8.30
Other expenses 5.27 5.66 Long-term assets 35.72 73.26 Change in working capital 0.69 -0.02
EBIT -2.77 -2.49 Total assets 49.30 112.71 Investments 0.22 -4.59
Interest expense -0.07 1.76 Current liabilities 10.52 23.69 Financing -1.20 3.25
Earnings before taxes -2.70 -4.25 Long-term debt 14.06 26.06 Change in cash balances 1.34 3.42
Taxes 0.64 4.39 Other long-term liabilities 6.12 25.46
Net income -3.34 -8.64 Total liabilities 30.70 75.21
Shareholders’ equity 18.36 37.42
Equity + Total liabilities 49.06 112.63

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3-Firm Valuation: Problem 3.5

 Johnson Controls, Visteon and Lear are automotive parts suppliers. The
perpetual growth rate for Johnson Controls and for Visteon is 2.5% and 4.5%,
respectively, while their weighted average cost of capital is 6.3% and 12.4%,
respectively. The tax rate for all is Johnson’s one. The reinvestment rate of
Visteon is 0.41 and Lear's interest expense is $0.1 billion and earnings before
tax is $0.33 billion. Johnson’s Income Statement and Cash Flow are presented
in the tables below. What is Lear's enterprise value?
Johnson Ctrls Income Stat. (2020)
Revenue 22.32
Cost of sales 14.90
Other expenses 6.37
EBIT 1.05
Interest expense 0.15
Earnings before taxes 0.90
Taxes 0.11
Net income 0.79

Johnson Ctrls Cash Flow (2020)

Depreciation 0.44
Amortization 0.39
∆ Working capital 0.81
∆ Gross PP&E -0.44

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3-Firm Valuation: Case Study 1.3

 In 2022, as an analyst, you have to value the Hermès Group Company. To

estimate the value of the equity, you will apply an average Firm Value to EBIT
ratio for similar firms and also an average Firm Value to EBITDA based on the
data available in the table. For Hermès Group, the EBIT is €4.21 billion and the
EBITDA €7.26 billion. Hermès Group has €6700 million in cash, and €1800
million in debt.
EBIT EBITDA Firm Market
Value Capitalization
(billion)
Kering 5.60 14.51 72.11 66.54
LVMH 19.71 49.61 367.14 340.72
Estée Lauder 3.54 13.43 98.14 94.47
PVH 0.88 5.34 7.48 4.41
Richemont 3.37 12.03 62.87 64.34

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4-Relative Valuation and DCF Valuation: Growth rate

 Estimating Growth Rates : Based EPS Growth Rate

2016 0.66
on historical growth rates, an 2017 0.90 36.36%
arithmetic and geometric mean 2018 0.91 1.11%
can be estimated. We can also 2019 1.27 39.56%
2020 1.13 -11.02%
use a regression model. 2021 1.27 12.39%
Arithmetic 15.68%
 Estimating Positive earnings: Geometric 13.99%

EPS Growth Rate EPSt-EPSt-1 Modified

Growth Rate
2015 1.27
2016 1.13 -11.02% -0.14 -11.02%
2017 1.27 12.39% 0.14 12.39%
 Estimating Negative earnings: 2018 0.91 -28.35% -0.36 -28.35%
2019 -0.10 -110.99% -1.01 -110.99%
2020 0.66 -760.00% 0.76 115.15%
2021 0.62 -6.06% -0.04 -6.06%
Arithmetic -4.81%
Geometric -11.26%

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4-Relative Valuation and DCF Valuation: Growth rate

 There is an effect of size on growth that should be taken into account and the
period used has also an impact.

Income Net Income Growth Rate

(Million) (Million)
2016 19.10
2017 86.20 67.10 351.31%
2018 186.30 100.10 116.13%
2019 306.70 120.40 64.63%
2020 354.90 48.20 15.72%
2021 430.00 75.10 21.16%
Geometric 86.42%
2022 801.60 371.60
2023 1494.32 692.72
2024 2785.67 1291.35
2025 5192.98 2407.31
2026 9680.63 4487.65

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4-Relative Valuation and DCF Valuation: Comparison

 The DCF approach seeks to estimate the intrinsic value of an entity from the
underlying fundamental attributes of the entity by determining future cash flows
and discount rates. The method of comparables uses observed market prices by
reflecting relative value based on current market prices.

 In relative valuation, a significant proportion of securities are undervalued or

overvalued (Dispersion of multiples in an industry, Differences between
accounting conventions in Countries, An entire industry can be overvalued like
the Internet boom of the late 1990s). There is no clear guidance about how to
adjust for these differences. The relative valuation is more adapted to the needs
of portfolio managers making comparison with the market.

 The relative valuation approach requires less information than the DCF
valuation. The audience is more receptive to the relative valuation since findings
and recommendations are easy to understand and judge. Sometimes, the
relative valuation can help to identify some weak points in the DCF valuation.

 Using relative valuation is easy if the number of assets/entities comparable is

large, if these assets/entities are priced in a market and if some variable are
common to standardize the price.
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5-Weighted Average Valuation Method

 The value is derived through the combination of the different methods : DCF
method, Price-Earnings ratio Multiple, Price-Earnings to Growth ratio Multiple,
Price Book Value ratio Multiple, etc.

 It is inappropriate to take the average of the estimates, given the good and
poor estimates the same weight.

 In the Weighted Average Valuation Method, each estimate obtained from

different multiples is weighted based on the precision and the reliability of each
estimate. The higher weight is for the more accurate estimation.

 It is nevertheless difficult to determine the weights when some of the estimates

are subjective and some are based on quantitative methods.

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5-Weighted Average Valuation Method: Case Study 1.4

 In 2022, as an analyst, you have to value the Hermès Group Company. Based
on your valuation of the equity, you give 40% to the DCF Method, 5% to the
PEG Method, 40% to the TBV Method, and 15% to the EBIT Method. The
number of share outstanding is 105 million. What is the stock price of Hermès
Group Company?

Method DCF PE PEG BV TBV EBIT EBITDA

Equity Value (B€) 177.60 806.98 571.06 76.05 127.00 86.87 50.10

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