Relative Valuation

1
Relative Valuation

• Value assets based on how similar assets are
  currently priced in the market

2
Multiples Selection

• Price-to-sales (revenue)
• Price-to-book (replacement)
• Price-to-earnings
• Price-to-EBIT
• Price-to-EBITDA
• Price-to-EVA (economic value added)

3
Multiples Selection

• Sector-specific multiples
• Price-to-dream (click/ users/ negotiation)
• Price-to-patents (intangible assets)
• Price-to-a basket of related variables
• MultipleSelected Benchmark Book Value
  Intangible Value

4
Popularity

• A valuation based on multiples and comparable
  firms has fewer assumptions and quicker
  calculations than a discounted cash flow
  valuation
• Simple to understand and easy to present to
  clients
• Likely to reflect the current mood of the market

5
Pitfall

• The preference to negotiate
• The difficulty of benchmark selection
• Easy to be misused via manipulating the selection
  of variable multiples and comparable firms
• The key variables such as risk,
• growth, and
• cash flow potential
• are ignored

6
Steps to Using Multiples

• Definitional tests
• Consistency
• Description tests
• Distributional characteristics
• Outliers and averages
• Biases in estimating multiples
• Analytical tests
• Relationship
• Companion variables

7
Steps to Using Multiples

• Application tests
• What is a comparable firm?
• Controlling for differences across firms
• - subjective adjustments
• - modified multiples
• - sector regressions
• - issues in time series and cross section

8
Price-Earnings Ratio (PE)

• PE ratio is the most widely used and misused of
  all multiples
• PE ratio price per share/ earnings per share
• The volatility in earnings per share
• Management options outstanding
• Cross-sectional distribution of PE ratio
• Current PE, trail PE, and forward PE
• Compare PE ratios across time and across
  countries
• Compare PE ratios across firms in a sector

9
PE growth ratio (PEG)

• Compare PE ratios to the expected EPS growth rate
  to identify undervalued and overvalued stocks
• PEG PE ratio / (expected EPS growth rate100)
• PEG is widely used in analyzing high-tech (high
  growth) stocks
• Analysts estimates of growth in earnings per
  share over the next 5 years is used in
  conjunction with the current PE ratio
• Compare PEG with control for differences in risk,
  growth, and payout ratio

10
Low PE growth ratio (PEG)

• The lower the PEG, the more undervalued the stock
• If Stock Archer has a PE ratio of 10 (Price 20
  and EPS 2) and EPS growth rate of 20 in the
  next 5 years, Archers PEG is 0.5.
• PEG PE ratio / (expected EPS growth rate100)
• PEG (20/2) / (20100) 0.5
• Peter Lynch considers one as the PEG benchmark

11
High PE growth ratio (PEG)

• The lower the PEG, the more undervalued the stock
• If Stock Archer has a PE ratio of 40 (Price 80
  and EPS 2) and EPS growth rate of 20 in the
  next 5 years, Archers PEG is 0.5.
• PEG PE ratio / (expected EPS growth rate100)
• (80/2) / (20100) 2.0
• Is PEG of 2 too high for Stock Archer?

12
PE (PEG) Relative to Market

• Industry (market) Relative PE
• Current PE (firm)/ current PE (industry
  market)
• Industry (market) Relative PEG
• Current PEG (firm)/ current PEG (industry
  market)
• If Stock Archer has a PE ratio of 40
• and the industry has a PE ratio of 20,
• Archers Industry Relative PE is 2.

13
Price to Adjusted Earnings

• Price to earnings before RD expenses
• PE market value of equity/ (net income RD
  expenses)
• PE market value of equity/ (net income RD
  expenses amortization of RD)
• Enterprise value to EBITDA multiples
• EV/EBITDA (market value of equity market
  value of debt cash)/ EBITDA

14
Book Value Multiples

• The book value of equity is the difference
  between the book value of assets and the book
  value of liabilities,
• a number that is largely determined by
  accounting conventions and affected by accounting
  rules

15
Book Value Multiples

• Be a relatively stable, intuitive measure of
  value
• Can be compared across similar firms for signs of
  under- or overvaluation
• Evaluate firms with negative earnings
• Book value is affected by accounting decisions on
  depreciation and other variables
• Book value may not carry much meaning for firms
  with high intangible assets

16
Definition

• Price-to-book ratio price per share/ book value
  of equity per share
• Price-to-book ratio market value of equity/
  book value of equity

17
Definition Examples

• An example of the constant growth dividend model
  
• P DPS/ (k-g)
• DPSEPS (Payout ratio)
• PEPS (Payout ratio)/ (k-g)
• ROEEPS/ BV of equity per share
• PBV ROE Payout ratio/ (k-g) P/BVPBVROE
  Payout ratio/ (k-g)

18
Adjustment for Buybacks and Acquisitions

• Assume a firm that has a market value of equity
  of 100 million and a book value of equity of 50
  million
• Its price-to-book ratio is 2.
• If the firm borrows 25 million and buys back
  stock, its book value of equity will decline to
  25 million and its market equity will drop to
  75 million.
• The resulting price-to-book ratio is 3.

19
Adjustment for Buybacks and Acquisitions

• With acquisitions, the effect on price-to-book
  ratios can vary dramatically depending on how the
  acquisition is accounted for
• by using purchase accounting
• (market value of the acquired firm) or
• pooling accounting
• (book value of the acquired firm)

20
Tobins Q

• Tobins Q market value of assets in place/
  replacement cost of assets in place
• Tobins Q is a measure of the quality of a firms
  management
• The role of inflation and the role of technology
  change
• Firms that earn negative excess returns and do
  not utilize their assets efficiently will have a
  Tobins Q that is less than one.

21
Tobins Q

• Firms that utilize their assets more efficiently
  will trade a a Tobins Q that exceeds one.
• The replacement cost of assets is difficult to
  estimate
• Tobins Q in practice
• market value-to-book ratio
• market value of debt and equity/ book value
  of debt and equity

22
Revenue Multiples

• Price-to-sales ratio market value of equity/
  revenues
• A revenue multiple measures the value of the
  equity or a business relative to the revenue that
  it generates
• Revenue multiples are available even for the most
  troubled firms and for very young firms
• Revenue is difficult to manipulate relative to
  earnings and book which are influenced by
  accounting decisions on depreciation, inventory,
  RD, acquisition accounting, and extraordinary
  charges
• Firms with high revenues and negative earnings

23
Sector-Specific Multiples

• The value of a firm can be standardized using a
  number of sector-specific multiples
• Link firm value to operating details and output
• Be computed with no reference to accounting
  measures
• Be employed in desperation
• The value of steel companies can be compared
  based on market value per ton of steel produced,
  and the value of electricity generators can be
  computed on the basis of kilowatt hour of power
  produced

24
Some examples

• Value per subscriber (market value of equity
  market value of debt cash)/ number of
  subscribers Cable firms
• Value per commodity unit (market value of
  equity market value of debt cash)/ number of
  units of commodity in reserves gold-mining firms
• Value per unit product (market value of equity
  market value of debt cash)/ number of units
  produced (or capacity) steel firms