Relative Valuation

Learning Objectives
Understand why investors prefer to use relative
valuation measures to value stocks

Understand the different relative valuation

techniques, their relation to fundamentals and
their application

Understand the considerations to be kept in mind

while applying relative valuation multiples.
 Relative Valuation
In relative valuation, the objective is to value assets based on
how similar assets are currently priced in the market.

There are two components to relative valuation.

To value assets on relative basis, prices have to be

standardized by converting prices into multiples of earnings,
book values or sales.

To find similar firms. Firms can differ on risk, growth potential

and cash flows.
Why is Relative Valuation Popular?
Fewer explicit assumptions

Quick estimation

Simpler to understand and present to clients than the DCF

valuation

More likely to reflect the current market mood.

 Relative Valuation Techniques
Price to Earnings (P/E) Ratio

Price to Book Value (P/BV) Ratio

Price to Sales Ratio

Price to Cash Flow Ratio

 Price-Earnings Ratio
P/E ratio is the ratio of the current price of the stock to either
of the following measures of EPS
The trailing EPS
The forward EPS

Stock market analysts focus on the P/E ratio as the ratio is

considered a useful indicator of expectations of growth
opportunities.
Earning power (reflected in EPS) is a chief driver of investment
value.
 P/E ratio and Fundamentals
The justified P/E ratio is positively related to payout ratio and
growth rate and negatively to the required rate of return.
D1
P0
kg

P0 D / EPS0 D0 / EPS0 (1 g ) (1 b) (1 g )
1
EPS0 kg kg kg

P0 (1 b)

EPS1 kg
 P/E Ratio and Growth Opportunities
We can think of the value of a firm as the sum of the value of assets
already in place or no-growth value of the firm and the present
value of future investments that the firm will make (PVGO)
E

0
1
P P
VG
O
k
The above equation can be rearranged as:

P
1PV
G
O

0

1
1
EkE/
k
1
When PVGO=0, P0 =E1/k and P/E ratio =1/k (e.g. in the case of
preference shares

Thus expectation of growth goes towards increasing the P/E

multiple.
 P/E and ROE
D1
P0
k g
E1 (1 b)
P0
k ( ROE b)

P0 (1 b)

E1 k ( ROE b)

P/E ratio increases with ROE.

It also increases with increase in b as long as ROE>k.
When a firm has good investment opportunities, the
market will reward it with a higher P/E if it exploits these
opportunities more aggressively by plowing back
earnings.
 PEG Ratio

P/E ratios are commonly taken as proxies for expected

growth in dividends or earnings.
A common wall-street rule-of-thumb is that growth rate
ought to be roughly equal to the P/E ratio, or the ratio of
P/E to g (PEG ratio) should be equal to 1.
Higher P/E ratio stocks are almost invariably expected to
show rapid earnings growth, even if the expected growth
rate does not equal P/E ratio.
Risky stocks have lower P/E ratios as for them the
required rate of return k is higher.
 PEG Ratio
PEG is useful but must be used with care for several reasons:

PEG does not factor in differences in risk.

PEG does not account for differences in the duration of

growth. For example, dividing P/Es by short-term (five-year)
growth forecasts may not capture differences in long-term
growth prospects.
 P/E in a Cyclical Business
In the case of a cyclical business (steel, automobiles), high
P/Es on depressed EPS at the bottom of the cycle and low P/Es
at the top of the cycle reflect the countercyclical property of
P/Es known as the Molodovsky effect.
In such cases, analysts use normalized EPS. The normalized
EPS can be calculated using the following two of the several
available methods.
The method of historical average EPS calculated over the
most recent full cycle.
The method of average return on equity where the average
ROE over the most recent full cycle is multiplied with the
current book value per share. This method accounts for a
change in the size of the business.
 Dealing with Extremely Low, Zero, or
Negative Earnings
Stock selection based on P/E or other multiples involve ranking of
securities from the highest to the lowest value of the multiple.
The security with the lowest positive P/E has the lowest purchase
cost per unit of earnings among the securities ranked.
P/E cannot be calculated in the case of zero earnings.
A negative P/E security will rank below the lowest positive P/E
security, though actually it is the most costly in terms of earnings
purchased.
Normalized EPS can be used in case of negative earnings.
If the analyst is interested in a ranking, the inverse price ratio (E/P)
can be used. The ranking will now run from the cheapest to the
most costly in terms of the amount of earnings one unit of a
currency buys.
 Price-to-Book Value (P/B) Ratio
Analysts have offered several rationales for the use of P/B.

Because book value is a cumulative balance sheet amount, book value

is generally positive even when EPS is zero or negative.

It is more stable than EPS.

Book values are close to market values for companies having high
amounts of liquid assets such as finance, investment, insurance and
banking companies.

Book value has been used in valuation of companies that are not
expected to continue as a going concern.
 P/B ratio and Fundamentals
The justified P/B is an increasing function of ROE, all else equal.
E1 (1 b)
P0
kg
B ROE (1 b)
0
kg
B ROE (1 g / ROE )
0
kg
P0 ROE g

B0 kg

Because the numerator and the denominator are differences of

, respectively, ROE and k from the same quantity g, it is ROE in
relation to the required rate of return, k, that determines the
justified P/B. The larger the ROE in relation to k, the higher is
the justified P/B based on fundamentals.
 Drawbacks of P/B Ratio
Possible drawbacks of P/Bs include:

It does not include assets other than those recognized in the financial
statement. For example, human capital is more important in service
companies.

Accounting effects on book value may compromise the usefulness of the

measure.

Due to cost concept there is a significant difference between historical

cost and market value of assets

Share repurchases or issuances may distort historical comparisons.

The presence of revaluation reserve may distort the book value.

 Price-to-Sales (P/S) Ratio
Analysts have offered the following rationales for using P/S:

Sales are generally less subject to distortion or manipulation.

Sales are positive even when EPS is negative.

Sales are more stable.

P/S has been viewed as appropriate for valuing the stocks of

mature, cyclical, and zero-income companies (Martin 1998).
 P/S ratio and Fundamentals
D0 (1 g ) E0 (1 b) (1 g )
P0
kg kg
P0 ( E0 / S0 ) (1 b) (1 g )

S0 kg

E0/S0 is the businesss profit margin. The equation states that

the justified P/S is an increasing function of the profit margin
and earnings growth rate.
 Drawbacks of P/S Ratio
Possible drawbacks of using P/S in practice include the following:

A business may show high growth in sales even when it is not

operating profitably.

Share price reflects the effect of debt financing on profitability and

risk. There is a logical mismatch between price and sales.

P/S does not reflect differences in cost structures.

Revenue recognition practices have the potential to distort P/S.

 Relation Between P/E and P/S Ratios
Despite the contrasts between P/S to P/E, the ratios have a
relationship.

The fact that Sales x Net profit margin = Net income means
that (P/E) x (Net Profit Margin) = (P/S).

For two stocks with the same positive P/E, the stock with the
higher P/S has a higher (actual or forecasted) net profit
margin, calculated as the ratio of P/S to P/E.
 Example
Company A Company B
Sales (Rs. Million) 800 1000
Profit Margin 15% 12%
Profit (Rs.Million) 120 120
Number of Shares (Million) 10 10
EPS (Rs.) 12 12
Market Price per share 120 120
(Rs.)
P/E Ratio 10 10
P/S Ratio 1.5 1.2
PS Ratio/PE Ratio 0.15 0.12
 Price-to-Cash flow Ratio
Analysts have offered the following rationales for using Price to
cash flow:

Cash flow is generally less subject to distortion or manipulation.

Cash flows are more stable.

Using price to cash flow rather than P/E addresses the issue of
differences in quality of earnings between companies.
 EBITDA Multiples
Another cash flow concept used in multiples is EBITDA. In
practice, both EV/EBITDA and P/EBITDA have been used by
analysts as valuation metrics.

EV/EBITDA is preferred because the numerator includes the

value of debt and because EBITDA is pre interest representing
flow to both debt and equity.

EV = market value of equity + market value of debt cash and

marketable securities
 Reasons for Increased Use of
EV/EBITDA Multiple
The multiple can be computed even for firms
that are reporting net losses, since EBITDA are
usually positive.

It allows for comparison across firms with

different financial leverage.
 Considerations in Using Multiples
Multiples should be properly defined.
For example, PE ratio could be trailing or forward; basic or diluted.
In times of rising earnings, forward P/E yields will have lower values.

The multiple should be consistent.

The numerator can be an equity value (market price, value of equity) or a firm
value (enterprise value).

The denominator can be an equity measure (EPS, net income, book value of
equity) or a firm measure (operating income, EBITDA, or book value of
capital).

Consistency requires that if the numerator of a multiple is an equity value,

the denominator should also be equity value.
 Considerations in Using Multiples
The multiple should be uniformly defined for all firms. If a
trailing P/E is used, it should be the trailing P/E for all the
firms.
To use multiples, you need to have a sense of how the
multiple varies across firms in the market. In other words, you
need to know what a high value, a low value or a typical value
are for the multiple in question.
You need to identify the fundamental variables that
determine each multiple and how changes in these variables
affect the value of the multiple. Values depend on three
variables: risk, growth and cash generating potential.
 Considerations in Using Multiples
Although it is useful to know the fundamentals that
determine a multiple, it is also critical to understand how the
multiple changes as the fundamentals change.
For example, if a firm has a growth rate of twice the industry
average, should its P/E be twice as high or less or more? To
make this judgment, one needs to know how the P/E ratio
changes as the growth rate changes.
To apply the multiples, one has to find comparable firms.
Comparable firms may not necessarily belong to the same
industry or business.
A comparable firm is the one with cash flows, growth
potential and risk similar to the firm being valued.
 Considerations in Using Multiples
Adjustment for differences in firms can be made based on
subjective judgment or by using modified multiples.

A modified multiple takes into account the most important variable

determining the multiple or the companion variable.

For example, P/E ratio can be divided by the growth in EPS to

calculate PEG ratio.

P/BV ratio can be divided by ROE.

Price to Sales ratio can be divided by the net margin to derive a

modified multiple.
 Example
For example, an industry has an average trailing
P/E of 25, an average PEG of 2 and an expected
average growth of 12.5%.
A firm with a P/E of 9 belonging to this industry
may appear undervalued on relative basis.
If this firm has a growth rate of 3.5%, then
applying the average PEG ratio of 2, the P/E
multiple should be 7.
Based on this adjusted P/E, the firm would
appear overvalued.