Relative Valuation

Aswath Damodaran

Aswath Damodaran 1
 Why relative valuation?

“If you think I’m crazy, you should see the guy who lives across the hall”
Jerry Seinfeld talking about Kramer in a Seinfeld episode

“ A little inaccuracy sometimes saves tons of explanation”

H.H. Munro

Aswath Damodaran 2
 What is relative valuation?

n In relative valuation, the value of an asset is compared to the values

assessed by the market for similar or comparable assets.
n To do relative valuation then,
• we need to identify comparable assets and obtain market values for these
assets
• convert these market values into standardized values, since the absolute
prices cannot be compared This process of standardizing creates price
multiples.
• compare the standardized value or multiple for the asset being analyzed to
the standardized values for comparable asset, controlling for any
differences between the firms that might affect the multiple, to judge
whether the asset is under or over valued

Aswath Damodaran 3
 Standardizing Value

n Prices can be standardized using a common variable such as earnings,

cashflows, book value or revenues.
• Earnings Multiples
– Price/Earnings Ratio (PE) and variants (PEG and Relative PE)
– Value/EBIT
– Value/EBITDA
– Value/Cash Flow
• Book Value Multiples
– Price/Book Value(of Equity) (PBV)
– Value/ Book Value of Assets
– Value/Replacement Cost (Tobin’s Q)
• Revenues
– Price/Sales per Share (PS)
– Value/Sales
• Industry Specific Variable (Price/kwh, Price per ton of steel ....)
Aswath Damodaran 4
 The Four Steps to Understanding Multiples

n Define the multiple

• In use, the same multiple can be defined in different ways by different
users. When comparing and using multiples, estimated by someone else, it
is critical that we understand how the multiples have been estimated
n Describe the multiple
• Too many people who use a multiple have no idea what its cross sectional
distribution is. If you do not know what the cross sectional distribution of
a multiple is, it is difficult to look at a number and pass judgment on
whether it is too high or low.
n Analyze the multiple
• It is critical that we understand the fundamentals that drive each multiple,
and the nature of the relationship between the multiple and each variable.
n Apply the multiple
• Defining the comparable universe and controlling for differences is far
more difficult in practice than it is in theory.
Aswath Damodaran 5
 Definitional Tests

n Is the multiple consistently defined?

• Proposition 1: Both the value (the numerator) and the standardizing
variable ( the denominator) should be to the same claimholders in the
firm. In other words, the value of equity should be divided by equity
earnings or equity book value, and firm value should be divided by
firm earnings or book value.
n Is the multiple uniformally estimated?
• The variables used in defining the multiple should be estimated uniformly
across assets in the “comparable firm” list.
• If earnings-based multiples are used, the accounting rules to measure
earnings should be applied consistently across assets. The same rule
applies with book-value based multiples.

Aswath Damodaran 6
 Descriptive Tests

n What is the average and standard deviation for this multiple, across the
universe (market)?
n What is the median for this multiple?
• The median for this multiple is often a more reliable comparison point.
n How large are the outliers to the distribution, and how do we deal with
the outliers?
• Throwing out the outliers may seem like an obvious solution, but if the
outliers all lie on one side of the distribution (they usually are large
positive numbers), this can lead to a biased estimate.
n Are there cases where the multiple cannot be estimated? Will ignoring
these cases lead to a biased estimate of the multiple?
n How has this multiple changed over time?

Aswath Damodaran 7
 Analytical Tests

n What are the fundamentals that determine and drive these multiples?
• Proposition 2: Embedded in every multiple are all of the variables that
drive every discounted cash flow valuation - growth, risk and cash flow
patterns.
• In fact, using a simple discounted cash flow model and basic algebra
should yield the fundamentals that drive a multiple
n How do changes in these fundamentals change the multiple?
• The relationship between a fundamental (like growth) and a multiple
(such as PE) is seldom linear. For example, if firm A has twice the growth
rate of firm B, it will generally not trade at twice its PE ratio
• Proposition 3: It is impossible to properly compare firms on a
multiple, if we do not know the nature of the relationship between
fundamentals and the multiple.

Aswath Damodaran 8
 Application Tests

n Given the firm that we are valuing, what is a “comparable” firm?

• While traditional analysis is built on the premise that firms in the same
sector are comparable firms, valuation theory would suggest that a
comparable firm is one which is similar to the one being analyzed in terms
of fundamentals.
• Proposition 4: There is no reason why a firm cannot be compared
with another firm in a very different business, if the two firms have
the same risk, growth and cash flow characteristics.
n Given the comparable firms, how do we adjust for differences across
firms on the fundamentals?
• Proposition 5: It is impossible to find an exactly identical firm to the
one you are valuing.

Aswath Damodaran 9
 Price Earnings Ratio: Definition

PE = Market Price per Share / Earnings per Share

n There are a number of variants on the basic PE ratio in use. They are
based upon how the price and the earnings are defined.
n Price: is usually the current price
is sometimes the average price for the year
n EPS: earnings per share in most recent financial year
earnings per share in trailing 12 months (Trailing PE)
forecasted earnings per share next year (Forward PE)
forecasted earnings per share in future year

Aswath Damodaran 10
 PE Ratio: Descriptive Statistics for the United States

Current, Trailing and Forward PE Ratios

U.S. Stocks - July 2000

1000

900

800

700

600
Current PE
500 Trailing PE
Forward PE
400

300

200

100

0
<4 4-8 8 - 12 12 - 16 16 - 20 20 - 25 25 - 30 30 -40 40 -50 50 -75 75 - >100
100
PE

Aswath Damodaran 11
 PE: Deciphering the Distribution

Current PE Trailing PE Forward PE

Mean 57.52 51.51 48.64
Standard Error 5.38 6.08 6.78
Median 14.47 13.68 11.52
Mode 12.00 7.00 7.50
Standard Deviation 330.59 377.93 294.10
Kurtosis 335.54 808.90 460.43
Skewness 17.12 25.96 19.59
Maximum 8043.03 14619.60 8184.40

Aswath Damodaran 12
 PE Ratio: Greece in May 2001

PE Ratios: Greece in May 2001

90

80

70

60
Number of firms

50

40

30

20

10

0
<4 4 -8 8 -12 12-16 16-20 20-24 24-28 28-32 32-36 36-40 >40
PE Ratio

Aswath Damodaran 13
 PE Ratio: Understanding the Fundamentals

n To understand the fundamentals, start with a basic equity discounted

cash flow model.
n With the dividend discount model,
DPS1
P0 =
r − gn

n Dividing both sides by the earnings per share,

P0 Payout Ratio *(1 + g n )
= PE =
EPS 0 r - gn

n If this had been a FCFE Model,

FCFE 1
P0 =
r − gn
P0 (FCFE/Earnings)*(1 + g n )
= PE =
EPS0 r-g n

Aswath Damodaran 14
 PE Ratio and Fundamentals

n Proposition: Other things held equal, higher growth firms will

have higher PE ratios than lower growth firms.
n Proposition: Other things held equal, higher risk firms will have
lower PE ratios than lower risk firms
n Proposition: Other things held equal, firms with lower
reinvestment needs will have higher PE ratios than firms with
higher reinvestment rates.
n Of course, other things are difficult to hold equal since high growth
firms, tend to have risk and high reinvestment rats.

Aswath Damodaran 15
 Using the Fundamental Model to Estimate PE For a
High Growth Firm

n The price-earnings ratio for a high growth firm can also be related to
fundamentals. In the special case of the two-stage dividend discount
model, this relationship can be made explicit fairly simply:
 ( 1 +g)n 
) *1 −
EPS0 * P a y o u t R a t i o * ( 1g +
 ( 1 +r) n  EPS 0 *Payout Ration * ( 1 +g)n * ( 1 +g n )
P0 = +
r-g (r - gn )(1+r)n

• For a firm that does not pay what it can afford to in dividends, substitute
FCFE/Earnings for the payout ratio.
n Dividing both sides by the earnings per share:
 (1+ g )n 
Payout Ratio *(1 + g )*  1 − 
P0  (1+ r) n  Payout Ratio n * ( 1 + g )n *(1 + gn )
= +
EPS 0 r -g (r - g n )(1+ r) n

Aswath Damodaran 16
 A Simple Example

n Assume that you have been asked to estimate the PE ratio for a firm
which has the following characteristics:
Variable High Growth Phase Stable Growth Phase
Expected Growth Rate 25% 8%
Payout Ratio 20% 50%
Beta 1.00 1.00
n Riskfree rate = T.Bond Rate = 6%
n Required rate of return = 6% + 1(5.5%)= 11.5%
 (1.25)5 
0 . 2 * (1.25) *  1− 5

 (1.115)  5
0.5 * (1.25) *(1.08)
PE = + = 28.75
(.115 - .25) (.115-.08) (1.115) 5

Aswath Damodaran 17
 PE and Growth: Firm grows at x% for 5 years, 8%
thereafter

PE Ratios and Expected Growth: Interest Rate Scenarios

180

160

140

120

100 r=4%
PE Ratio

r=6%
r=8%
80 r=10%

60

40

20

0
5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
Expected Growth Rate

Aswath Damodaran 18
 PE Ratios and Length of High Growth: 25% growth
for n years; 8% thereafter

PE Ratios and Length of High Growth Period

60

50

40

g=25%
PE Ratio

g=20%
30
g=15%
g=10%

20

10

0
0 1 2 3 4 5 6 7 8 9 10
Length of High Growth Period

Aswath Damodaran 19
 PE and Risk: Effects of Changing Betas on PE
Ratio:
Firm with x% growth for 5 years; 8% thereafter

PE Ratios and Beta: Growth Scenarios

50

45

40

35

30
g=25%
PE Ratio

g=20%
25
g=15%
g=8%
20

15

10

0
0.75 1.00 1.25 1.50 1.75 2.00
Beta

Aswath Damodaran 20
 PE and Payout

PE Ratios and Payour Ratios: Growth Scenarios

35

30

25

20 g=25%
g=20%
PE

g=15%
15 g=10%

10

0
0% 20% 40% 60% 80% 100%
Payout Ratio

Aswath Damodaran 21
 Comparisons of PE across time

PE Ratio for US stocks over time

35.00

30.00

25.00

20.00

PE Ratio

15.00

10.00

5.00

0.00
49

51

53

55

57

59

61

63

65

67

69

71

73

75

77

79

81

83

85

87

89

91

93

95

97
19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19
Aswath Damodaran 22
 Is low (high) PE cheap (expensive)?

n A market strategist argues that stocks are over priced because the PE
ratio today is too high relative to the average PE ratio across time. Do
you agree?
n Yes
n No
n If you do not agree, what factors might explain the higer PE ratio
today?

Aswath Damodaran 23
 E/P Ratios , T.Bond Rates and Term Structure

EP Ratios, T.Bond Rates and Tem Structure

16.00%

14.00%

12.00%

10.00%

8.00%
T.Bond Rate
T.Bond-T.Bill
E/P Ratios
6.00%

4.00%

2.00%

0.00%
60

62

64

66

68

70

72

74

76

78

80

82

84

86

88

90

92

94

96

98
19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19
-2.00%

Aswath Damodaran 24
 Regression Results

n There is a strong positive relationship between E/P ratios and T.Bond

rates, as evidenced by the correlation of 0.6836 between the two
variables.,
n In addition, there is evidence that the term structure also affects the PE
ratio.
n In the following regression, using 1960-1999 data, we regress E/P
ratios against the level of T.Bond rates and a term structure variable
(T.Bond - T.Bill rate)
E/P = 2.82% + 0.749 T.Bond Rate - 0.847 (T.Bond Rate-T.Bill Rate)
(2.84) (6.78) (-3.65)
R squared = 60.67%

Aswath Damodaran 25
 Estimate the E/P Ratio Today

n T. Bond Rate =
n T.Bond Rate - T.Bill Rate =
n Expected E/P Ratio =
n Expected PE Ratio =

Aswath Damodaran 26
 Comparing PE ratios across firms

Company Name PE Growth

PT Indosat ADR 7.8 0.06
Telebras ADR 8.9 0.075
Telecom Corporation of New Zealand ADR 11.2 0.11
Telecom Argentina Stet - France Telecom SA ADR B 12.5 0.08
Hellenic Telecommunication Organization SA ADR 12.8 0.12
Telecomunicaciones de Chile ADR 16.6 0.08
Swisscom AG ADR 18.3 0.11
Asia Satellite Telecom Holdings ADR 19.6 0.16
Portugal Telecom SA ADR 20.8 0.13
Telefonos de Mexico ADR L 21.1 0.14
Matav RT ADR 21.5 0.22
Telstra ADR 21.7 0.12
Gilat Communications 22.7 0.31
Deutsche Telekom AG ADR 24.6 0.11
British Telecommunications PLC ADR 25.7 0.07
Tele Danmark AS ADR 27 0.09
Telekomunikasi Indonesia ADR 28.4 0.32
Cable & Wireless PLC ADR 29.8 0.14
APT Satellite Holdings ADR 31 0.33
Telefonica SA ADR 32.5 0.18
Royal KPN NV ADR 35.7 0.13
Telecom Italia SPA ADR 42.2 0.14
Nippon Telegraph & Telephone ADR 44.3 0.2
France Telecom SA ADR 45.2 0.19
Korea Telecom ADR 71.3 0.44

Aswath Damodaran 27
 PE and Growth

50.0

FTE
NTT

TI

37.5

KPN

TEF
ATS
CWP

P TLK
E TLD
25.0 BTY
DT

GICOF
TLS MTA
PT TMX
SAT
SCM

CTC

12.5 OTE
TEO
NZT

TBH
IIT

0.075 0.150 0.225 0.300

Growth
Aswath Damodaran 28
 PE, Growth and Risk

Dependent variable is: PE

No Selector

R squared = 66.2% R squared (adjusted) = 63.1%

Variable Coefficient SE t-ratio prob

Constant 13.1151 3.471 3.78 0.0010
Growth rate 121.223 19.27 6.29 ≤ 0.0001
Emerging Market -13.8531 3.606 -3.84 0.0009
Emerging Market is a dummy: 1 if emerging market
0 if not

Aswath Damodaran 29
 Is Hellenic Telecom under valued?

n Predicted PE = 13.12 + 121.22 (.12) - 13.85 (0) = 27.67

n At an actual price to book value ratio of 12.2, Hellenic looks
significantly under valued. However, if the market is pricing it as an
emerging market telecomm:
n Predicted PE = 13.12 + 121.22 (.12) - 13.85 (1) = 13.82

Aswath Damodaran 30
 A Question

You are reading an equity research report on this sector, and the analyst
claims that Andres Wine and Hansen Natural are under valued because
they have low PE ratios. Would you agree?
o Yes
o No
n Why or why not?

Aswath Damodaran 31
 Using comparable firms- Pros and Cons

n The most common approach to estimating the PE ratio for a firm is

• to choose a group of comparable firms,
• to calculate the average PE ratio for this group and
• to subjectively adjust this average for differences between the firm being
valued and the comparable firms.
n Problems with this approach.
• The definition of a 'comparable' firm is essentially a subjective one.
• The use of other firms in the industry as the control group is often not a
solution because firms within the same industry can have very different
business mixes and risk and growth profiles.
• There is also plenty of potential for bias.
• Even when a legitimate group of comparable firms can be constructed,
differences will continue to persist in fundamentals between the firm
being valued and this group.

Aswath Damodaran 32
 Using the entire crosssection: A regression approach

n In contrast to the 'comparable firm' approach, the information in the

entire cross-section of firms can be used to predict PE ratios.
n The simplest way of summarizing this information is with a multiple
regression, with the PE ratio as the dependent variable, and proxies for
risk, growth and payout forming the independent variables.

Aswath Damodaran 33
 PE versus Growth

150

100
P
E
A
d
j
50

-0

-0.00 0.25 0.50 0.75

Expected Growth in EPS: next 5…

Aswath Damodaran 34
 PE Ratio: Standard Regression

Dependent variable is: PEAdj

No Selector
5903 total cases of which 3405 are missing
R squared = 24.9% R squared (adjusted) = 24.8%
s = 31.09 with 2498 - 4 = 2494 degrees of freedom

Source Sum of Squares df Mean Square F-ratio

Regression 798022 3 266007 275
Residual 2410686 2494 966.594

Variable Coefficient s.e. of Coeff t-ratio prob

Constant -17.2213 2.439 -7.06 ≤ 0.0001
Expected Grow… 155.652 6.418 24.3 ≤ 0.0001
Beta 16.4415 2.429 6.77 ≤ 0.0001
Payout Ratio 10.9341 2.177 5.02 ≤ 0.0001

Aswath Damodaran 35
 Second Thoughts?

n Based on this regression, estimate the PE ratio for a firm with no

growth, no payout and no risk.

n Is there a problem with your prediction?

Aswath Damodaran 36
 PE Regression- No Intercept

Dependent variable is: PEAdj

No Selector
5903 total cases of which 3405 are missing
R squared = •% R squared (adjusted) = •%
s = 31.39 with 2498 - 3 = 2495 degrees of freedom

Source Sum of Squares df Mean Square F-ratio

Regression 2408918 3 802973 815
Residual 2458878 2495 985.522

Variable Coefficient s.e. of Coeff t-ratio prob

Payout Ratio 3.19821 1.900 1.68 0.0924
Beta 2.37185 1.403 1.69 0.0909
Expected Grow… 145.317 6.310 23.0 ≤ 0.0001

Aswath Damodaran 37
 Problems with the regression methodology

n The basis regression assumes a linear relationship between PE ratios

and the financial proxies, and that might not be appropriate.
n The basic relationship between PE ratios and financial variables itself
might not be stable, and if it shifts from year to year, the predictions
from the model may not be reliable.
n The independent variables are correlated with each other. For example,
high growth firms tend to have high risk. This multi-collinearity makes
the coefficients of the regressions unreliable and may explain the large
changes in these coefficients from period to period.

Aswath Damodaran 38
 The Multicollinearity Problem

PE Exp Growt Beta Payout

PE 1.000
Exp Growt… 0.288 1.000
Beta 0.141 0.292** 1.000
Payout -0.087 -0.404** -0.183* 1.000
n The independent variables are correlated with the dependent variable,
which is a good thing, but they are also correlated with each other
(which is not a good thing)
n This will cause the standard errors on the coefficients to become larger
and some coefficients may have the wrong sign.

Aswath Damodaran 39
 Using the PE ratio regression

n Assume that you were given the following information for Dell. The
firm has an expected growth rate of 20%, a beta of 1.40 and pays no
dividends. Based upon the regression, estimate the predicted PE ratio
for Dell.

n Dell is actually trading at 23 times earnings. What does the predicted

PE tell you?

Aswath Damodaran 40
 Value/Earnings and Value/Cashflow Ratios

n While Price earnings ratios look at the market value of equity relative
to earnings to equity investors, Value earnings ratios look at the
market value of the firm relative to operating earnings. Value to cash
flow ratios modify the earnings number to make it a cash flow number.
n The form of value to cash flow ratios that has the closest parallels in
DCF valuation is the value to Free Cash Flow to the Firm, which is
defined as:
Value/FCFF = (Market Value of Equity + Market Value of Debt)
EBIT (1-t) - (Cap Ex - Deprecn) - Chg in WC
n Consistency Tests:
• If the numerator is net of cash (or if net debt is used, then the interest
income from the cash should not be in denominator
• The interest expenses added back to get to EBIT should correspond to the
debt in the numerator. If only long term debt is considered, only long term
interest should be added back.
Aswath Damodaran 41
 Value of Firm/FCFF: Determinants

n Reverting back to a two-stage FCFF DCF model, we get:

 (1 + g)n 
FCFF (1 + g) 1 -  n ( 1 +g )
0  ( 1 +WACC)  n FCFF ( 1 +g)
V0 = + 0 n
WACC - g (WACC - g )(1 + WACC)n
n

• V0 = Value of the firm (today)

• FCFF0 = Free Cashflow to the firm in current year
• g = Expected growth rate in FCFF in extraordinary growth period (first
n years)
• WACC = Weighted average cost of capital
• gn = Expected growth rate in FCFF in stable growth period (after n
years)

Aswath Damodaran 42
 Value Multiples

n Dividing both sides by the FCFF yields,

 (1 + g)n 
(1 + g) 1 -
V0  (1 + WACC)n  ( 1 +g)n ( 1 +gn )
= +
FCFF0 WACC - g (WACC - gn )(1 + WACC)n

n The value/FCFF multiples is a function of

• the cost of capital
• the expected growth

Aswath Damodaran 43
 Alternatives to FCFF - EBIT and EBITDA

n Most analysts find FCFF to complex or messy to use in multiples

(partly because capital expenditures and working capital have to be
estimated). They use modified versions of the multiple with the
following alternative denominator:
• after-tax operating income or EBIT(1-t)
• pre-tax operating income or EBIT
• net operating income (NOI), a slightly modified version of operating
income, where any non-operating expenses and income is removed from
the EBIT
• EBITDA, which is earnings before interest, taxes, depreciation and
amortization.

Aswath Damodaran 44
 Value/FCFF Multiples and the Alternatives

n Assume that you have computed the value of a firm, using discounted
cash flow models. Rank the following multiples in the order of
magnitude from lowest to highest?
o Value/EBIT
o Value/EBIT(1-t)
o Value/FCFF
o Value/EBITDA
n What assumption(s) would you need to make for the Value/EBIT(1-t)
ratio to be equal to the Value/FCFF multiple?

Aswath Damodaran 45
 Illustration: Using Value/FCFF Approaches to value
a firm: MCI Communications

n MCI Communications had earnings before interest and taxes of $3356

million in 1994 (Its net income after taxes was $855 million).
n It had capital expenditures of $2500 million in 1994 and depreciation
of $1100 million; Working capital increased by $250 million.
n It expects free cashflows to the firm to grow 15% a year for the next
five years and 5% a year after that.
n The cost of capital is 10.50% for the next five years and 10% after
that.
n The company faces a tax rate of 36%.
 (1.15)5 
(1.15)  1-
V0 (1.105)5  (1.15) 5 (1.05)
= + 5
= 31.28
FCFF0 .105 -.15 (.10 - .05)(1.105)

Aswath Damodaran 46
 Multiple Magic

n In this case of MCI there is a big difference between the FCFF and
short cut measures. For instance the following table illustrates the
appropriate multiple using short cut measures, and the amount you
would overpay by if you used the FCFF multiple.
Free Cash Flow to the Firm
= EBIT (1-t) - Net Cap Ex - Change in Working Capital
= 3356 (1 - 0.36) + 1100 - 2500 - 250 = $ 498 million
$ Value Correct Multiple
FCFF $498 31.28382355
EBIT (1-t) $2,148 7.251163362
EBIT $ 3,356 4.640744552
EBITDA $4,456 3.49513885

Aswath Damodaran 47
 Value/EBITDA Multiple

n The Classic Definition

Value Market Value of Equity + Market Value of Debt
=
EBITDA Earnings before Interest, Taxes and Depreciation

n The No-Cash Version

Value Market Value of Equity + Market Value of Debt - Cash
=
EBITDA Earnings before Interest, Taxes and Depreciation

n When cash and marketable securities are netted out of value, none of
the income from the cash and securities should be reflected in the
denominator.

Aswath Damodaran 48
 Value/EBITDA Distribution

Value/EBITDA Multiple

1200

1000

800

600

400

200

0
<2 2 -4 4-6 6- 8 8 - 10 10 - 12 12-14 14 - 16 16 - 18 18 - 20 20 - 30 30 - 50 > 50

Aswath Damodaran 49
 The Determinants of Value/EBITDA Multiples:
Linkage to DCF Valuation

n Firm value can be written as:

FCFF1
V0 =
WACC - g

n The numerator can be written as follows:

FCFF = EBIT (1-t) - (Cex - Depr) - ∆ Working Capital
= (EBITDA - Depr) (1-t) - (Cex - Depr) - ∆ Working Capital
= EBITDA (1-t) + Depr (t) - Cex - ∆ Working Capital

Aswath Damodaran 50
 From Firm Value to EBITDA Multiples

n Now the Value of the firm can be rewritten as,

EBITDA (1-t) + Depr (t) - Cex - ∆ Working Capital
Value =
WACC - g

n Dividing both sides of the equation by EBITDA,

Value (1- t) Depr (t)/EBITDA CEx/EBITDA ∆ Working Capital/EBITDA
= + - -
EBITDA WACC-g WACC - g WACC - g WACC - g

Aswath Damodaran 51
 A Simple Example

n Consider a firm with the following characteristics:

• Tax Rate = 36%
• Capital Expenditures/EBITDA = 30%
• Depreciation/EBITDA = 20%
• Cost of Capital = 10%
• The firm has no working capital requirements
• The firm is in stable growth and is expected to grow 5% a year forever.
• Note that the return on capital implied in this growth rate can be
calculated as follows:
g = ROC * Reinvestment Rate
.05 = ROC * Net Cap Ex/EBIT (1-t)
= ROC * (.30-.20)/[(1-.2)(1-.36)]
Solving for ROC, ROC = 25.60%

Aswath Damodaran 52
 Calculating Value/EBITDA Multiple

n In this case, the Value/EBITDA multiple for this firm can be estimated
as follows:
Value ( 1 -.36) (0.2)(.36) 0.3 0
= + - - = 8.24
EBITDA .10 - . 0 5 .10 - . 0 5 .10 - .05 .10 - .05

Aswath Damodaran 53
 Value/EBITDA Multiples and Taxes

VEBITDA Multiples and Tax Rates

16

14

12

10
Value/EBITDA

0
0% 10% 20% 30% 40% 50%
Tax Rate

Aswath Damodaran 54
 Value/EBITDA and Net Cap Ex

Value/EBITDA and Net Cap Ex Ratios

12

10

8
Value/EBITDA

0
0% 5% 10% 15% 20% 25% 30%
Net Cap Ex/EBITDA

Aswath Damodaran 55
 Value/EBITDA Multiples and Return on Capital

Value/EBITDA and Return on Capital

12

10

8
Value/EBITDA

WACC=10%
6 WACC=9%
WACC=8%

0
6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
Return on Capital

Aswath Damodaran 56
 Value/EBITDA Multiple: Trucking Companies

Company Name Value EBITDA Value/EBITDA

KLLM Trans. Svcs. $ 114.32 $ 48.81 2.34
Ryder System $ 5,158.04 $ 1,838.26 2.81
Rollins Truck Leasing $ 1,368.35 $ 447.67 3.06
Cannon Express Inc. $ 83.57 $ 27.05 3.09
Hunt (J.B.) $ 982.67 $ 310.22 3.17
Yellow Corp. $ 931.47 $ 292.82 3.18
Roadway Express $ 554.96 $ 169.38 3.28
Marten Transport Ltd. $ 116.93 $ 35.62 3.28
Kenan Transport Co. $ 67.66 $ 19.44 3.48
M.S. Carriers $ 344.93 $ 97.85 3.53
Old Dominion Freight $ 170.42 $ 45.13 3.78
Trimac Ltd $ 661.18 $ 174.28 3.79
Matlack Systems $ 112.42 $ 28.94 3.88
XTRA Corp. $ 1,708.57 $ 427.30 4.00
Covenant Transport Inc $ 259.16 $ 64.35 4.03
Builders Transport $ 221.09 $ 51.44 4.30
Werner Enterprises $ 844.39 $ 196.15 4.30
Landstar Sys. $ 422.79 $ 95.20 4.44
AMERCO $ 1,632.30 $ 345.78 4.72
USA Truck $ 141.77 $ 29.93 4.74
Frozen Food Express $ 164.17 $ 34.10 4.81
Arnold Inds. $ 472.27 $ 96.88 4.87
Greyhound Lines Inc. $ 437.71 $ 89.61 4.88
USFreightways $ 983.86 $ 198.91 4.95
Golden Eagle Group Inc. $ 12.50 $ 2.33 5.37
Arkansas Best $ 578.78 $ 107.15 5.40
Airlease Ltd. $ 73.64 $ 13.48 5.46
Celadon Group $ 182.30 $ 32.72 5.57
Amer. Freightways $ 716.15 $ 120.94 5.92
Transfinancial Holdings $ 56.92 $ 8.79 6.47
Vitran Corp. 'A' $ 140.68 $ 21.51 6.54
Interpool Inc. $ 1,002.20 $ 151.18 6.63
Intrenet Inc. $ 70.23 $ 10.38 6.77
Swift Transportation $ 835.58 $ 121.34 6.89
Landair Services $ 212.95 $ 30.38 7.01
CNF Transportation $ 2,700.69 $ 366.99 7.36
Budget Group Inc $ 1,247.30 $ 166.71 7.48
Caliber System $ 2,514.99 $ 333.13 7.55
Knight Transportation Inc $ 269.01 $ 28.20 9.54
Heartland Express $ 727.50 $ 64.62 11.26
Greyhound CDA Transn Corp $ 83.25 $ 6.99 11.91
Mark VII $ 160.45 $ 12.96 12.38
Coach USA Inc $ 678.38 $ 51.76 13.11
US 1 Inds Inc. $ 5.60 $ (0.17) NA
Average 5.61

Aswath Damodaran 57
 A Test on EBITDA

n Ryder System looks very cheap on a Value/EBITDA multiple basis,

relative to the rest of the sector. What explanation (other than
misvaluation) might there be for this difference?

Aswath Damodaran 58
 Value/EBITDA Multiples: Market

n The multiple of value to EBITDA varies widely across firms in the

market, depending upon:
• how capital intensive the firm is (high capital intensity firms will tend to
have lower value/EBITDA ratios), and how much reinvestment is needed
to keep the business going and create growth
• how high or low the cost of capital is (higher costs of capital will lead to
lower Value/EBITDA multiples)
• how high or low expected growth is in the sector (high growth sectors will
tend to have higher Value/EBITDA multiples)

Aswath Damodaran 59
 US Market: Cross Sectional Regression

Dependent variable is: AdjVeBITDA

No Selector
5903 total cases of which 2943 are missing
R squared = 22.0% R squared (adjusted) = 22.0%
s = 11.26 with 2960 - 4 = 2956 degrees of freedom

Source Sum of Squares df Mean Square F-ratio

Regression 106063 3 35354.4 279
Residual 375086 2956 126.890

Variable Coefficient s.e. of Coeff t-ratio prob

Constant 27.8050 0.6408 43.4 ≤ 0.0001
CpExVal -4.18185 2.345 -1.78 0.0747
lnGrowth 7.86554 0.3021 26.0 ≤ 0.0001
Eff. Tax Rate -7.65961 0.7666 -9.99 ≤ 0.0001

Aswath Damodaran 60
 Price-Book Value Ratio: Definition

n The price/book value ratio is the ratio of the market value of equity to
the book value of equity, i.e., the measure of shareholders’ equity in
the balance sheet.
n Price/Book Value = Market Value of Equity
Book Value of Equity
n Consistency Tests:
• If the market value of equity refers to the market value of equity of
common stock outstanding, the book value of common equity should be
used in the denominator.
• If there is more that one class of common stock outstanding, the market
values of all classes (even the non-traded classes) needs to be factored in.

Aswath Damodaran 61
 Price to Book Value: Distribution
Summary of Price/BV
No Selector
5941 total cases of which 755 are missing

Percentile 5
Price to Book Value Ratios Count 5186
Mean 3.84904
1000 Median 1.92370
StdDev 4.37355
900 Min 0.009296
Max 15
800 Lower ith %tile 0.430182
Upper ith %tile 15
700

600

500

400

300

200

100

0
0-0.5 0.5- 1 1-1.5 1.5-2 2- 2.5 2.5 - 3 3 - 3.5 3.5 - 4 4 - 4.5 4.5 - 5 5- 10 >10

Aswath Damodaran 62
 Price Book Value Ratio: Stable Growth Firm

n Going back to a simple dividend discount model,

DPS1
P0 =
r − gn

n Defining the return on equity (ROE) = EPS0 / Book Value of Equity,

the value of equity can be written as:
*(1 + gn )
BV 0 *ROE*Payout Ratio
P0 =
r - gn

P0 ROE*Payout Ratio*(1 + g n )
= PBV =
BV 0 r-g n

n If the return on equity is based upon expected earnings in the next time
period, this can be simplified to,
P0 ROE *Payout Ratio
= PBV =
BV 0 r-g n

Aswath Damodaran 63
 PBV/ROE: Oil Companies
Company Name Ticker Symbol PBV ROE
Crown Cent. Petr.'A' CNPA 0.29 -14.60%
Giant Industries GI 0.54 7.47%
Harken Energy Corp. HEC 0.64 -5.83%
Getty Petroleum Mktg. GPM 0.95 6.26%
Pennzoil-Quaker State PZL 0.95 3.99%
Ashland Inc. ASH 1.13 10.27%
Shell Transport SC 1.45 13.41%
USX-Marathon Group MRO 1.59 13.42%
Lakehead Pipe Line LHP 1.72 13.28%
Amerada Hess AHC 1.77 16.69%
Tosco Corp. TOS 1.95 15.44%
Occidental Petroleum OXY 2.15 16.68%
Royal Dutch Petr. RD 2.33 13.41%
Murphy Oil Corp. MUR 2.40 14.49%
Texaco Inc. TX 2.44 13.77%
Phillips Petroleum P 2.64 17.92%
Chevron Corp. CHV 3.03 15.69%
Repsol-YPF ADR REP 3.24 13.43%
Unocal Corp. UCL 3.53 10.67%
Kerr-McGee Corp. KMG 3.59 28.88%
Exxon Mobil Corp. XOM 4.22 11.20%
BP Amoco ADR BPA 4.66 14.34%
Clayton Williams Energy CWEI 5.57 31.02%
Average 2.30 12.23%
Aswath Damodaran 64
 PBV versus ROE regression

n Regressing PBV ratios against ROE for oil companies yields the
following regression:
PBV = 1.04 + 10.24 (ROE) R2 = 49%
n For every 1% increase in ROE, the PBV ratio should increase by
0.1024.

Aswath Damodaran 65
 Valuing Pemex

n Assume that you have been asked to value a PEMEX for the Mexican
Government; All you know is that it has earned a return on equity of
10% last year. The appropriate P/BV ratio can be estimated
P/BV Ratio (based upon regression) = 1.04 + 10.24 * 0.1 = 2.06

Aswath Damodaran 66
 Looking for undervalued securities - PBV Ratios
and ROE

n Given the relationship between price-book value ratios and returns on

equity, it is not surprising to see firms which have high returns on
equity selling for well above book value and firms which have low
returns on equity selling at or below book value.
n The firms which should draw attention from investors are those which
provide mismatches of price-book value ratios and returns on equity -
low P/BV ratios and high ROE or high P/BV ratios and low ROE.

Aswath Damodaran 67
 The Valuation Matrix

MV/BV

Overvalued
Low ROE High ROE
High MV/BV High MV/BV

ROE-r

Undervalued
Low ROE High ROE
Low MV/BV Low MV/BV

Aswath Damodaran 68
 Large Market Cap Firms: PBV vs ROE: July 2000

AMGN

LLY
DELL
22.5

SCH

MDT
15.0 QCOM KO
MSFT
ERICY SGP

INTC MRK BMY

TWX
P SBH AHP
B TXN GE
V

WMT
HD ABT
PEP
JNJ
7.5
AVE
AXP PG
NWS HWP TYC
PHA MWD
STD ENE SBC
AIG BBV BLS
SLB DT
TEF BPA
MCD C
FON GS MO
DIS MOT DD
FNM
CPQ WFC
WCOM CMB
RD
MC BAC F
T SCDCX

-0.0

0.125 0.250 0.375 0.500

ROE

Aswath Damodaran 69
 Company Symbols

Company Name Ticker SymbolCompany Name Ticker SymbolCompany Name Ticker Symbol Company Name Ticker Symbol
Matsushita Elec. ADR MC British Telecom ADR BTY Merrill Lynch & Co. MER Int'l Business Mach. IBM
Compaq Computer CPQ Amer. Int'l Group AIG Fannie Mae FNM Abbott Labs. ABT
News Corp. Ltd. ADR NWS Chevron Corp. CHV Tyco Int'l Ltd. TYC Morgan S. Dean Witter MWD
AT&T Corp. T AEGON Ins. Group AEG Amer. Express AXP Amgen AMGN
Schlumberger Ltd. SLB Sprint Corp. FON Corning Inc. GLW Dell Computer DELL
Disney (Walt) DIS Boeing BA EMC Corp. EMC Amer. Home Products AHP
Koninklijke Philips NV PHG Hewlett-Packard HWP Gen'l Electric GE Procter & Gamble PG
Time Warner TWX Banco Bilbao Vis. ADR BBV Intel Corp. INTC Pfizer, Inc. PFE
Deutsche Telekom ADR DT Wells Fargo WFC Ford Motor F Schering-Plough SGP
WorldCom Inc. WCOM Ericsson ADR ERICY BellSouth Corp. BLS Merck & Co. MRK
Motorola, Inc. MOT Texas Instruments TXN Johnson & Johnson JNJ Bristol-Myers Squibb BMY
Telefonica SA ADR TEF Micron Technology MU Lucent Technologies LU Philip Morris MO
Banco Santander ADR STD Bank of America BAC PepsiCo, Inc. PEP Lilly (Eli) LLY
Sony Corp. ADR SNE Home Depot HD Cisco Systems CSCO Oracle Corp. ORCL
Exxon Mobil Corp. XOM McDonald's Corp. MCD Goldman Sachs GS
Aventis ADR AVE SBC Communications SBC Medtronic, Inc. MDT
Enron Corp. ENE Wal-Mart Stores WMT Sun Microsystems SUNW
Pharmacia Corp. PHA Du Pont DD Applied Materials AMAT
Shell Transport SC Citigroup Inc. C Schwab (Charles) SCH
Royal Dutch Petr. RD Qualcomm Inc. QCOM Microsoft Corp. MSFT
DaimlerChrysler AG DCX SmithKline Beecham SBH Nokia Corp. ADR NOK
BP Amoco ADR BPA Chase Manhattan Corp. CMB Coca-Cola KO

Aswath Damodaran 70
 PBV Matrix: Telecom Companies

12
TelAzteca

10

TelNZ Vimple
8 Carlton

Teleglobe
FranceTel Cable&W
6
DeutscheTel
BritTel
TelItalia
Portugal AsiaSat
HongKong
BCE Royal
4 Hellenic
Nippon
DanmarkChinaTel
Espana Indast
Telmex
TelArgFrance
PhilTel Televisas
TelArgentina
2 TelIndo
TelPeru

APT
CallNet
Anonima GrupoCentro

0
0 10 20 30 40 50 60

ROE

Aswath Damodaran 71
 U.S. Banks: Market Cap > $ 1 billion

5.00

MEL

SNV
CBH

3.75

WABC

WFC CYN
CFR WL
BBT
P
B VLY CMB
V 2.50 NBAK PNC
ZION FULT SKYF
HU FBF
ASO MRBK
TRMK WB
OV
STI CBC CBSS
BPOP
FVB BAC
FSCO RGBK
UPC PFGI FTU
SOTR
1.25 KEY

UB
BOH

BWE

0.12 0.16 0.20 0.24

ROE

Aswath Damodaran 72
 Company Name Ticker Symbol Company Name Ticker Symbol Company Name Ticker Symbol
Westamerica Bancorp WABC Fulton Fin'l FULT Regions Financial RGBK
Keystone Fin'l KSTN First Va. Banks FVB Synovus Financial SNV
Colonial BncGrp. 'A' CNB City National Corp. CYN AmSouth Bancorp. ASO
One Valley Bancorp OV Hibernia Corp. `A' HIB KeyCorp KEY
National BanCorp. of Alaska,In NBAK Silicon Valley Bncsh SIVB BB&T Corp. BBT
BancWest Corp. BWE Mercantile Bankshares MRBK Wachovia Corp. WB
Hudson United Bancorp HU Compass Bancshares CBSS PNC Financial Serv. PNC
Provident Finl Group PFGI Popular Inc BPOP SunTrust Banks STI
Pacific Century Fin'l BOH First Security FSCO State Street Corp. STT
Centura Banks CBC No. Fork Bancorp NFB Mellon Financial Corp. MEL
Trustmark Corp. TRMK Natl Commerce Bancrp NCBC Morgan (J.P.) & Co JPM
Sky Finl Group Inc SKYF UnionBancal Corp UB First Union Corp. FTU
Wilmington Trust WL M&T Bank Corp. MTB FleetBoston Fin'l FBF
Valley Natl Bancp NJ VLY Zions Bancorp. ZION Bank of New York BK
Commerce Bancorp NJ CBH Union Planters UPC Chase Manhattan Corp. CMB
Cullen/Frost Bankers CFR SouthTrust Corp. SOTR Wells Fargo WFC
Summit Bancorp SUB Bank of America BAC

Aswath Damodaran 73
 IBM: The Rise and Fall

IBM: PBV and ROE

4.00 30.00%

3.50
25.00%

3.00

20.00%
2.50
P/BV Ratio

PBV
ROE

ROE
2.00 15.00%

1.50
10.00%

1.00

5.00%
0.50

0.00 0.00%
1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997
Year

Aswath Damodaran 74
 PBV Ratio Regression

Dependent variable is: AdjPBV

No Selector
5903 total cases of which 3332 are missing R squared = 46%
R squared = •% R squared (adjusted) = •%
s = 2.240 with 2571 - 4 = 2567 degrees of freedom

Source Sum of Squares df Mean Square F-ratio

Regression 30502.9 4 7625.73 1519
Residual 12885.7 2567 5.01977

Variable Coefficient s.e. of Coeff t-ratio prob

Exp Growt… 8.97383 0.4376 20.5 ≤ 0.0001
Beta 0.854662 0.1035 8.26 ≤ 0.0001
Payout Ra… -0.051989 0.1335 -0.390 0.6969
ROE 4.96796 0.2109 23.6 ≤ 0.0001

Aswath Damodaran 75
 Cross Sectional Regression for Greece: June 1999

n Using data obtained from Bloomberg for 199 Greek companies, we

ran the regression of PBV ratios against returns on equity and obtained
the following:
PBV = 2.56 + 24.00 ROE R2 = 45.37%
(4.19) (12.82)
n For instance, the predicted PBV ratios for the following companies
would be:
Company Actual PBV ROE Predicted PBV
Alpha Fin. 14.87 47% 2.56 + 24(.47)= 13.84
Girakian 2.36 1% 2.56 + 24(.01)= 2.80
Titan Cement 5.98 33% 2.56 + 24(.33)= 10.56
Michaniki 1.72 13% 2.56 + 24(.13)= 5.68

Aswath Damodaran 76
 Price Sales Ratio: Definition

n The price/sales ratio is the ratio of the market value of equity to the
sales.
n Price/ Sales= Market Value of Equity
Total Revenues
n Consistency Tests
• The price/sales ratio is internally inconsistent, since the market value of
equity is divided by the total revenues of the firm.

Aswath Damodaran 77
 Price/Sales Ratio: Cross Sectional Distribution
Summary of Price/Sales
No Selector
5941 total cases of which 1023 are missing

Percentile 5

Count 4918
Mean 2.51810
Median 1.03579
Price to Sales Ratio
StdDev 3.16625
Min 0.001524
800
Max 10
Lower ith %tile 0.105026
700 Upper ith %tile 10

600

500

400

300

200

100

0
<0.05 0..05-0.1 0.1-0.15 0.150.25 0.25-0.5 0.5-0.75 0.75-1 1-1.5 1.5-2 2-3 3 -4 4 -5 5 - 7.5 7.5 - 10 >10

Aswath Damodaran 78
 Price/Sales Ratio: Determinants

n The price/sales ratio of a stable growth firm can be estimated

beginning with a 2-stage equity valuation model:
DPS1
P0 =
r − gn

n Dividing both sides by the sales per share:

P0 Net Profit Margin*Payout Ratio * ( 1+ g n )
= PS =
Sales 0 r-gn

Aswath Damodaran 79
 PS/Margins: Brazilian Consumer Products

Company PS Ratio Net Margin

Lojas Arapua 0.01 -14.24%
Borghoff 0.03 -25.93%
Grazziotin 0.09 5.86%
Panvel 0.11 2.45%
Cia Alimentos 0.11 -12.47%
Bombril 0.13 3.32%
Makro Atacadista 0.15 1.30%
Lojas Americanas 0.18 -1.99%
IND Bebidas Antac 0.55 4.86%
Cia Antarctica 0.57 2.69%
Lojas Renner 0.62 9.25%
Tehnos Relogios 0.83 28.05%
Casa Anglo 1.04 2.30%
Souza Cruz 1.29 20.85%
Ind bebidas Antarc Polar 1.73 37.99%
Brahma 1.80 16.42%

Aswath Damodaran 80
 Price/Sales Ratio: Is DHB cheap?

n Based upon the price/sales ratios, the cheap firms are Borghoff and
Lojas Arapua. The expensive firms are firms like Souza Cruz and
Brahma. Do you agree?
o Yes
o No
n If not, what might explain why there are such big differences across
these firms?

Aswath Damodaran 81
 Regression Results: PS Ratios and Margins

n Regressing PS ratios against net margins,

PS = 0.43 + 2.93 (Net Margin) R2 = 59.29%
n Thus, a 1% increase in the margin results in an increase of 0.03 in the
price sales ratios.
n The regression also allows us to get predicted PS ratios for these firms

Aswath Damodaran 82
 PS Ratios: Actual versus Predicted Values

Company PS Ratio Net Margin Predicted PS Under or Over Valued

Lojas Arapua 0.0103 -14.24% 0.0128 -19.74%
Borghoff 0.0283 -25.93% NA NA
Grazziotin 0.0918 5.86% 0.6017 -84.74%
Panvel 0.1116 2.45% 0.5019 -77.76%
Cia Alimentos 0.1135 -12.47% 0.0646 75.75%
Bombril 0.1317 3.32% 0.5273 -75.03%
Makro Atacadista 0.1528 1.30% 0.4681 -67.35%
Lojas Americanas 0.1823 -1.99% 0.3717 -50.96%
IND Bebidas Antac 0.5513 4.86% 0.5723 -3.67%
Cia Antarctica 0.5700 2.69% 0.5088 12.03%
Lojas Renner 0.6240 9.25% 0.7010 -11.00%
Tehnos Relogios 0.8250 28.05% 1.2518 -34.09%
Casa Anglo 1.0384 2.30% 0.4973 108.80%
Souza Cruz 1.2864 20.85% 1.0408 23.60%
Ind bebidas Antarc Polar 1.7257 37.99% 1.5431 11.83%
Brahma 1.8027 16.42% 0.9110 97.87%

Aswath Damodaran 83
 Current versus Predicted Margins

n One of the limitations of the analysis we did in these last few pages is
the focus on current margins. Stocks are priced based upon expected
margins rather than current margins.
n For most firms, current margins and predicted margins are highly
correlated, making the analysis still relevant.
n For firms where current margins have little or no correlation with
expected margins, regressions of price to sales ratios against current
margins (or price to book against current return on equity) will not
provide much explanatory power.
n In these cases, it makes more sense to run the regression using either
predicted margins or some proxy for predicted margins.

Aswath Damodaran 84
 A Case Study: The Internet Stocks

30

PKSI

LCOS SPYG
20
INTM MMXI
SCNT

MQST FFIV ATHM

A
CNET DCLK
d
j RAMP
INTW
P 10 CSGP CBIS NTPA
S NETO SONEPCLN
APNT CLKS
EDGRPSIX ATHY AMZN
SPLN BIDS
ALOY ACOM EGRP
BIZZ IIXL
ITRA ANET
ONEM ABTL INFO
FATB
RMII TMNT GEEK
-0 TURF PPOD BUYX ELTX
GSVI ROWE

-0.8 -0.6 -0.4 -0.2

AdjMargin

Aswath Damodaran 85
 PS Ratios and Margins are not highly correlated

n Regressing PS ratios against current margins yields the following

PS = 81.36 - 7.54(Net Margin) R2 = 0.04
(0.49)
n This is not surprising. These firms are priced based upon expected
margins, rather than current margins. Hypothesizing that firms with
higher revenue growth and higher cash balances should have a greater
chance of surviving and becoming profitable, we ran the following
regression: (The level of revenues was used to control for size)
PS = 30.61 - 2.77 ln(Rev) + 6.42 (Rev Growth) + 5.11 (Cash/Rev)
(0.66) (2.63) (3.49)
R squared = 31.8%
Predicted PS = 30.61 - 2.77(7.1039) + 6.42(1.9946) + 5.11 (.3069) =
30.42
Actual PS = 25.63
Aswath Damodaran
Stock is undervalued, relative to other internet stocks. 86
 PS Regression

Dependent variable is: AdjPSRatio

No Selector
5903 total cases of which 3655 are missing R squared = 52%
R squared = •% R squared (adjusted) = •%
s = 1.849 with 2248 - 4 = 2244 degrees of freedom

Source Sum of Squares df Mean Square F-ratio

Regression 14960.1 4 3740.03 1094
Residual 7670.48 2244 3.41822

Variable Coefficient s.e. of Coeff t-ratio prob

AdjMgn 16.1747 0.5129 31.5 ≤ 0.0001
Exp Growth: E… 7.60241 0.3801 20.0 ≤ 0.0001
Beta -0.444203 0.0918 -4.84 ≤ 0.0001
Payout Ratio -0.585029 0.1147 -5.10 ≤ 0.0001

Aswath Damodaran 87
 Choosing Between the Multiples

n As presented in this section, there are dozens of multiples that can be

potentially used to value an individual firm.
n In addition, relative valuation can be relative to a sector (or
comparable firms) or to the entire market (using the regressions, for
instance)
n Since there can be only one final estimate of value, there are three
choices at this stage:
• Use a simple average of the valuations obtained using a number of
different multiples
• Use a weighted average of the valuations obtained using a nmber of
different multiples
• Choose one of the multiples and base your valuation on that multiple

Aswath Damodaran 88
 Picking one Multiple

n This is usually the best way to approach this issue. While a range of
values can be obtained from a number of multiples, the “best estimate”
value is obtained using one multiple.
n The multiple that is used can be chosen in one of two ways:
• Use the multiple that best fits your objective. Thus, if you want the
company to be undervalued, you pick the multiple that yields the highest
value.
• Use the multiple that has the highest R-squared in the sector when
regressed against fundamentals. Thus, if you have tried PE, PBV, PS, etc.
and run regressions of these multiples against fundamentals, use the
multiple that works best at explaining differences across firms in that
sector.
• Use the multiple that seems to make the most sense for that sector, given
how value is measured and created.

Aswath Damodaran 89
 A More Intuitive Approach

n As a general rule of thumb, the following table provides a way of

picking a multiple for a sector
Sector Multiple Used Rationale
Cyclical Manufacturing PE, Relative PE Often with normalized earnings
High Tech, High Growth PEG Big differences in growth across
firms
High Growth/No Earnings PS, VS Assume future margins will be good
Heavy Infrastructure VEBITDA Firms in sector have losses in early
years and reported earnings can vary
depending on depreciation method
REITa P/CF Generally no cap ex investments
from equity earnings
Financial Services PBV Book value often marked to market
Retailing PS If leverage is similar across firms
VS If leverage is different

Aswath Damodaran 90
 Reviewing: The Four Steps to Understanding
Multiples

n Define the multiple

• Check for consistency
• Make sure that they are estimated uniformally
n Describe the multiple
• Multiples have skewed distributions: The averages are seldom good
indicators of typical multiples
• Check for bias, if the multiple cannot be estimated
n Analyze the multiple
• Identify the companion variable that drives the multiple
• Examine the nature of the relationship
n Apply the multiple

Aswath Damodaran 91