Relative Valuation

Dr. Himanshu Joshi

Market Based Valuation: Price and

Enterprise Value Multiples
Price multiples are ratios of a stocks market price to
some measure of fundamental value per share.
Enterprise value multiples, by contrast, relate the total
market value of all sources of a companys capital to a
measure of fundamental value for the entire company.

Intuition behind price multiples..

Investors evaluates the price of a share of stock- judge
whether it is fairly valued, overvalued, or undervaluedby considering what a share buys in terms of per share
earnings, net assets, cash flows or some other measure
of a value (stated on per share basis).
A multiple summarizes in a single number the
relationship between the market value of a companys
stock (or its total capital) and some fundamental
quantity, such as earnings, sales, or book value.

Correct Use of Multiples..

What accounting issues affect particular price and
enterprise value multiples, and how can analysts
address them?
How do price multiples relates to fundamentals, such as
earnings growth rates, and how can analysts use this
information when making valuation comparison among
stocks?
For which types of valuation problems is a particular
price or enterprise value multiple appropriate or
inappropriate?
What challenges arise in applying price and enterprise
value multiples internationally?

Momentum Indicators..
Momentum indicators typically relate either price or a
fundamental (such as earnings) to the time series of its
own past values, or in some cases, to its expected
value.
The logic behind the use of momentum indicator is that
such indicators may provide information on future
patterns of returns over some time horizon.

The Methods of Comparable

The idea behind price multiples is that a stocks price
cannot be evaluated in isolation. Rather, it needs to be
evaluated in relation to what it buys in terms of
earnings, net sales, net assets.
Obtained by dividing price by a measure of value per
share, a price multiple gives the price to purchase one
unit of value.
EX.. Price/EPS = 20, means that it takes 20 units of
currency (say, Rs. 20) to buy one unit of earnings (say
Rs. 1 of earnings).
This scaling of price per share by value per share makes
possible comparison among various stocks.

Methods of Comparable..
Stocks P/E

Analysis

20

25

If they have similar risk, profit margins, and growth prospects, the
security with the P/E
Of 20 is undervalued relative to the one with P/E of 25.

Example..
Company As EPS is $1.50. its closest competitor,
Company B, is trading at a P/E of 22. Assume that
companies have similar operating and financial profits.
Q1. if company As stock is trading at $37.50, what does
that indicate about its value relative to Company B?
Q2. if we assume that Company A stock should trade at
about the same P/E as Company Bs stock, what will we
estimate as an appropriate price for company As stock?

The Method based on Forecasted

Fundamentals..
If the DCF value of a stock is $10.20 and its forecasted EPS is $1.2, the
forward P/E multiple consistent with the DCF value is
$10.20/$1.2 = 8.5
The term forward P/E refers to a P/E calculated on the basis of a forecast of
EPS.
Thus, we can approach valuation by using multiples from two perspectives:
First, we can use the method of comparable, which involves comparing an
assets multiple to a standard of comparison. Similar assets should sell at
similar prices.
Second, we can use the method based on forecasted fundamentals, which
involves forecasting the companys fundamentals rather than making
comparisons with other companies. (The Price Multiple of an asset should
be related to its expected future cash flows.)

Justified Price Multiples..

The justified Price multiple is the estimated fair value of
that multiple, which can be justified on the basis of the
method of comparable or the method of forecasted
fundamentals.
Example.. Suppose we use price-to-book ratio (P/B) in a
valuation and find that median P/B for the companys
peer group, which would be the standard of comparison,
is 2.2. The stocks justified P/B based on the method of
comparable is 2.2.
If the current book value per share is $23 then, Price =
2.2*$23 = $50.60, which can be compared with its
market price.

Justified Price Multiples..

(Fundamental)
Suppose that we are using a residual income model and
estimate that the value of stock is $46 (DCF estimate).
Then the justified P/B based on the fundamental is
$46/$23 = 2.0
This we can again compare with the actual value of
stocks P/B.
We can incorporate the insights from the method based
on fundamentals to explain differences from results
based on comparable.

Price Multiples
1. Price to Earnings = Market Price per Share/Earning Per
Share
Rationales supporting the use of P/E Multiple..
a. Earning power is chief driver of investment value, and
EPS, the denominator in the P/E ratio, is perhaps the
chief focus of security analysts attention.
b. The differences in stocks P/Es may be related to
differences in long run average returns on investments
in those stocks.

P/E Multiple..
Potential Drawbacks:
a. EPS can be zero, negative, or insignificantly small relative to price,
and P/E does not make economic sense with zero, negative, or
insignificantly small denominator.
b. The ongoing or recurring components of earnings that are most
important in determining intrinsic value, can be particularly
difficult to distinguish from transient components.
c. The application of accounting standards requires corporate
managers to choose among acceptable alternatives and to use
estimates in reporting. Doing so, managers may distort EPS as an
accurate reflection of economic performance.

Alternative Definitions of P/E..

Trailing P/E: A stocks trailing P/E is its current market
price divided by the most recent four quarters EPS.
Current P/E: to mean a P/E based on EPS for the most
recent six months plus the projected EPS for the coming
six months. This calculation blends historical and
forward looking elements.
Forward P/E: (leading P/E or prospective P/E): is a
stocks current price divided by next years expected
earnings.

Application.
Use same definition of P/E to all companies and time
period under examinations.
Valuation is a forward looking process, so analysts
usually focus on the forward P/E when earning forecasts
are available.
When earnings are not readily predictable, a trailing P/E
may be more appropriate than forward P/E.
When the firm has undergone substantial changes in
terms of M&A activities, financial leverage, divestitures
etc., trailing P/E based on the past EPS is not
informative about future, thus not relevant for
valuation.

Calculating the Trailing P/Es

While using trailing earnings to calculate a P/E, the
analyst must take care in determining the EPS to be
used in the denominator:
1. Potential dilution of EPS.
2. Transitory, non recurring components of earnings that
are company specific.
3. Transitory components of earnings ascribable to
cyclicality. (business or industry cyclicality)
4. Differences in accounting methods. (for different
company stocks)

Basic vs. Dilutive EPS..

Basic EPS Calculation

Basic EPS is the amount of income available to common
shareholders divided by the weighted average number
of shares outstanding over of period of time.
Basic EPS = (Net Income Preferred
Dividends)/Weighted average no. of Shares Outstanding

Basic EPS Calculation

Revenue Discounts
=Net Revenues
- COGS
- Cost of sales
=Gross Profit
- general, marketing, administrative expenses
= EBDITA
-Depreciation and Amortization
=EBIT (Operating Profit)
- Int (Net Interest Int Revenue Int Expenses)
= EBT
-Taxes
= EAT
- Preference Dividend
= Earnings Available to Equity Shareholders = EPS
No. of Outstanding Shares

Basic EPS Calculation

For the year ended December 31, 2009, Angler products had net
income of $25,00,000. The Company declared and paid $2,00,000 of
dividends on preferred stock. The company also had the following
common stock share information:
Shares outstanding on 1 January 2009 = 10,00,000
Shares issued on 1 April 2009 = 2,00,000
Shares repurchased on October 2009 = 1,00,000
Shares outstanding on 31 December 2009 = 11,00,000.
Q. What is the companys weighted average number of shares
outstanding?
Q. What is the companys basic EPS?

Solution
The weighted average number of shares outstanding is
determined by the length of time each quantity of
shares was outstanding:
10,00,000 x (3 Months/12 months) = 2,50,000
12,00,000 x (6 M/12M) = 6,00,000
11,00,000 x (3M/12 M) = 2,75,000
Weighted average no. of shares = 11,25,000

Solution
Basic EPS = (net Income preferred dividends)/
weighted average no of shares
= $25,00,000 - $2,00,000/11,25,000 = $2.04

Question. Basic EPS

Assume the same facts as in example 13 except that on
1 December 2009, a previously declared 2 for 1 split
took effect. Each shareholder of record receives two
shares in exchange of each current shares that he or
she owns. What is companys basic EPS?

Solution
For basic EPS calculation purpose, a stock split is
treated as if it occurred at the beginning of the period.
The weighted average number of shares would,
therefore, be double 22,50,000, and the basic EPS =
$1.02

Diluted EPS
There are three dilutive securities in the capital
structure of a company:
1. Convertible preferred;
2. Convertible debt;
3. Employee stock options.

Dilutive EPS when company has

convertible preferred stock
outstanding
If converted method: this method is based on what
EPS would have been if the convertible preferred
securities had been converted at the beginning of the
period.
If the converted preference shares are converted
there will be two effects:
1. Convertible preferred stock will longer be
outstanding; instead additional common stock will
be outstanding.
2. If such conversion had taken place, the company
would not have paid preference dividends.

Dilutive EPS when company has

convertible preferred stock outstanding
Diluted EPS = (Net Income)/(weighted average no. of
shares outstanding + new common shares that would
have been issued at conversion)

Example..
For the year ended 31 December 2009, XYZ company
had net income of $17,50,000. the company had an
average of 5,00,000 shares of common stock
outstanding, 20,000 of preferred stock, and no other
potentially dilutive securities. Each shares of preferred
pays a dividend of $10 per share, and each is
convertible into five shares of the companys common
stock.
Calculate companys basic and dilutive EPS.

Diluted EPS when company has

Convertible Debt Outstanding
If Converted Method: as if converted at the beginning.
Debt securities would no longer be outstanding; instead,
additional shares of common stock would be
outstanding.
Also, if such conversion had taken place, the company
would not have paid interest on the convertible debt, so
the net income available to common shareholders
would increase by the after tax amount of interest
expense on debt converted.

Diluted EPS when company has

Convertible Debt Outstanding
Diluted EPS = (Net Income + After Tax interest on
convertible debt Preferred dividends)/ weighted
average number of shares outstanding + additional
common stock if debt is converted.

Example..
Opponex company reported net income of $7,50,000 for
the year ended 31 December 2009. the company had a
weighted average of 6,90,000 shares of common stock
outstanding. In addition, the company has only one
potentially dilutive security: $50,000 of 6% convertible
bonds, convertible into a total of 10,000 shares.
Assuming tax rate of 30% calculate Opponexs Basic
and Diluted EPS.

Solution..
If the debt securities had been converted, debt
securities will no longer be outstanding, instead, an
additional 10,000 shares of common stock would be
outstanding.
Company would not have interest of $3000 on the
convertible debt, so the net income will increase by
$3000 (1-0.3) =$2100 (after Tax)

Diluted EPS when a company

has Stock Options, warrants or
their Equivalents Outstanding
When a company has stock options,
warrants, or their equivalents outstanding,
diluted EPS is calculated as if the financial
instruments had been exercised and the
company had used the proceeds from
exercise to repurchase as many shares of
common stock as possible at the average
market price of common stock during the
period.

Diluted EPS when a company has

Stock Options, warrants or their
Equivalents Outstanding
The number of shares outstanding for
diluted EPS is thus increased by the
number of shares that would be issued
upon exercise minus the number of shares
that would have been purchased with the
proceeds.
This method is called treasury stock
method under US GAAP. (Same method is
used under IFRS)

Diluted EPS
Assumed exercise of these financial instruments would
have the following effects:
1.The company is assumed to receive cash upon exercise
and, in exchange, to issue shares.
2. The company is assumed to use the cash proceeds to
repurchase shares at the weighted average market
price during the period.

 As result of these two effects, the number of shares

outstanding would increase by the incremental number
of shares issued. (difference between number of shares
issued to the holders of the options and number of
shares assumed to be repurchased by the company)
Exercise of these financial instrument would not affect
net income.

Diluted EPS
Diluted EPS = (Net Income Preferred Dividends)/
weighted average number of shares outstanding + (new
shares that would have been issued at option exercise
shares that could have been purchased with the
received cash) x (proportion of the year during which
the financial instruments were outstanding.)

Calculationof Diluted EPS Using

Treasury Stock Method
ABC company reported net income of $2.3 million for the
year ended 30 June 2009and had a weighted average of
8,00,000 common shares outstanding. At the beginning
of the fiscal year, the company has outstanding 30,000
options with an exercise price of $35. no other
potentially dilutive financial instruments are
outstanding. Over the fiscal year, the companys MPS
has averaged $55 per share.
Calculate the companys basic and diluted EPS.

Solution
Cash received by the company = 30,000 x $35 =
$10,50,000.
Additional shares outstanding = 30,000
Shares repurchased = $10,50,000/ $55 = 19,091
Incremental shares = 30,000 19091 = 10,909

Solution..
Calculation of Dilutive EPS for Bright-Warm Utility Company using Treasury Stock Method
Particulars
Net Income
Less: Preferred Dividends
Numerator
Weigthed average number of shars
Additional shares if option is exercised
Denominator
EPS

Basic EPS

Diluted EPS

$2,300,000
0
$2,300,000
800000
$0

$2,300,000
0
$2,300,000
800000
10909

800000

810909

$2.88

$2.84

2. Analyst Adjustment to
Nonrecurring Items..
You are calculating a trailing P/E for AstraZeneca PLC as
of 24 April 2008, when the share price closed at $41.95
in New York. In its first quarter of 2008, ended 31 March,
AZN reported EPS according to IFRS of $1.03, which
included:
$0.06 of restructuring costs,
$0.07 of amortization of intangibles arising from
acquisitions, and
$0.12 of impairment charges taken to reflect the
negative impact of a competing generic product on the
value of one of the companys patented products.

Example..
Adjusting for all of these items, AZN reported core EPS
of $1.28 = $1.03+$0.06+$0.07+$0.12.
Because core EPS differed from the EPS calculated
under IFRS, the company provided a reconciliation of
the two EPS figures.
Other data is shown in the table below:
Measure
Full
Less
Three
Plus First
Trailing 12
Year
(2007)
a

Frist
Quarters of
Quarter 2007 (c= a(2007)
b)
b

Quarter
2008 (d)

Months EPS
e = c+d

Reported EPS

$3.74

$1.02

$2.72

$1.03

$3.75

CORE EPS

$4.38

$1.07

$3.31

$1.28

$4.59

EPS excluding first

$3.74

$1.02

$2.72

$1.15

$3.87

Example..
1. Based on the companys reported EPS, determine the
trailing P/E of AZN as of 24 April 2008.
2. Determine the Trailing P/E of AZN as of 24 April 2008
using core earnings as determined by AZN.
3. Suppose you expect the amortization charges to
continue for some years and note that, although AZN
excluded restructuring charges from its core earnings
calculation, AZN has reported restructuring charges in
previous year. After reviewing all relevant data, you
conclude that, in this instance, only the asset impairment
should be viewed as clearly non recurring.

3. Analyst Adjustments for Business

Cycle Influences
1. The method of historical average EPS, in which
normalized EPS is calculated as average EPS over the
most recent full cycle.
2. The method of average return on equity, in which
normalized EPS is calculated as the average return on
equity (ROE) from the most recent full cycle,
multiplied by current book value per share.

Example.. Normalized EPS for

Business Cycle Effects
Taiwan Semiconductor Manufacturing Company (in US
$)
Measure 2001

2002

2003

2004

2005

2006

2007

EPS
(ADR)

$0.08

$0.12

$0.28

$0.58

$0.59

$0.74

$0.63

BVPS
(ADR)

$1.58

$1.64

$1.94

$2.50

$2.67

$3.03

$3.34

ROE

5.2%

7.3%

14.4%

23.1%

21.0%

24.7%

19.0%

What Influence P/E Ratio..

According to infinite period dividend discount model
P = D1/(k-g) ------------(1)
Dividing eqn. (1) by expected earnings (E1):
Dividend
P/E1 = D1/E1
(k-g)
Require
d Rate
of
Return

Payout Ratio

Expected
growth rate
of
Dividends
for the
Stock

P/E Ratio Depends upon:

Dividend Payout Ratio
Expected Required Rate of Return.
Expected Growth Rate in Dividends.
Example: Expected Payout Ratio of 50%. Required
Return = 12%, growth rate = 8%
If k = 13%
If g = 9%
If k = 11% and g = 9%

P/Es in Cross Country Comparisons..

1. The effects on EPS of differences in accounting
standards.
2.The effects of market wide benchmarks of differences
in their macroeconomic contexts. Differences in
macroeconomic contexts may distort comparisons of
benchmark P/E levels among companies operating in
different markets.
A specific case of the second point is differences in
inflation rates and in the ability of companies to pass
through inflation in their costs in the form of higher

P/Es in the Cross Country

Comparisons..
For two companies with same pass through ability, the
company operating in higher inflation environment will
have a lower justified P/E.
If inflation rates are equal but pass through rates differ,
the justified P/E should be lower for the company with
the lower pass through rate.

Summary of Price and Inverse Price

Ratio
Price Ratio

Inverse Price Ratio

Comments

Price to Earnings (P/E)

Earning Yield (E/P)

Both forms commonly used.

Price to Book (P/B)

Book to Market (B/P)

Book value is less commonly

negative than EPS. B/M is favored in
research but not common in
practice.

Price to Sales (P/S)

Sales to Price (S/P)

Rarely used, Sales in not negative or

zero for going concerns.

Price to Cash Flow

Ratio (P/CF)

Cash Flow Yield (CF/P)

Both forms are commonly used.

Price to Dividend (P/D)

Dividend Yield (D/P)

Used in discussing index valuation,

and some regular dividend paying
firms.