Relative Valuation Techniques

Relative Valuation
Techniques
Concept of Price Multiples
DCF vs. Relative Valuation
• Discounted cash flow techniques attempt to estimate a specific value
for a stock based on its estimated growth rates and its discount rate.
• Relative valuation techniques implicitly contend that it is possible to

determine the value of an economic entity (i.e., the market, an
industry, or a company) by comparing it to similar entities on the basis
of several relative ratios that compare its stock price to relevant
variables that affect a stock’s value, such as earnings, cash flow, book
value, and sales (indicate investors’ prevailing attitude towards a
stock’s value)
DCF vs. Relative Valuation
• Both of these approaches and all of these valuation techniques have
several common factors:
• All of them are significantly affected by investor’s required rate of return on
the stock because this rate becomes the discount rate or is a major
component of the discount rate;
• All valuation approaches are affected by the estimated growth rate of the
variable used in the valuation technique
Discounted Cash Flow Techniques
• These techniques are obvious choices for valuation because they are
the epitome of how we describe value—that is, the present value of
expected cash flows
• Dividends: Cost of equity as the discount rate
• Operating cash flow: Weighted Average Cost of Capital (WACC)
• Free cash flow to equity: Cost of equity as the discount rate
• Dependent on growth rates and discount rate
Why Relative Valuation
Techniques
• Provides information about how the market is currently valuing stocks
• aggregate market
• alternative industries
• individual stocks within industries
• No guidance as to whether valuations are appropriate
• best used when you have a good set of comparable entities
• aggregate market and company’s industry are not at a valuation extreme
Relative Valuation Techniques
• When we compare a price multiple, such as PIE, for a firm to those of
other firms based on market prices, we are using price multiples based
on comparables.
• By contrast, price multiples based on fundamentals tell us what a

multiple should be based on some valuation model and therefore are
not dependent on the current market prices of other companies to
establish value.
• Method of comparables is based on fundamentals.

Relative Valuation Techniques
• Value can be determined by comparing to similar stocks based on
relative ratios
• Relevant variables include earnings, cash flow, book value, and sales
• Relative valuation ratios include price/earning; price/cash flow;
price/book value and price/sales
• The most popular relative valuation technique is based on price to
earnings
Price Multiples
• Price-earnings (P/E) ratio: The PIE ratio is a firm's stock price divided
by earnings per share and is widely used by analysts and cited in the
press.
• Price-sales (P/S) ratio: The PIS ratio is a firm's stock price divided by
sales per share
• Price-book value (P/B) ratio: The PIB ratio is a firm's stock price
divided by book value of equity per share
• Price-cash flow (P/CF) ratio: The PICF ratio is a firm's stock price
divided by cash flow per share, where cash flow may be defined as
operating cash flow or free cash flow.
Multiples Based on Fundamentals
Earnings Multiplier
• Price/Earnings Ratio= Earnings Multiplier
Current Market Price


Expected Earnings
Multiples Based on Fundamentals
Earnings Multiplier
• Combining the Constant DDM with the P/E ratio approach by dividing
earnings on both sides of DDM formula to obtain
Pi D1 / E1

E1 kg
Earnings Multiplier
• P/E based on fundamentals is also referred to as a justified P/E.
• Leading vs. Trailing P/E
• The P/E ratio is determined by

• Expected dividend payout ratio (D/E)
• Required rate of return on the stock (k)
• Expected growth rate of dividends (g)
• Dividend displacement of earnings

Earnings Multiplier
Assume the following information for AGE stock (1) Dividend payout = 50% (2)
Required return = 12% (3) Expected growth = 8% (4) D/E = .50 and the growth rate,
g=.08. What is the stock’s P/E ratio?
• What if the required rate of return is 13%
• What if the growth rate is 9%

The Price-Cash Flow Ratio
• Why Price/CF Ratio
• Companies can manipulate earnings but Cash-flow is less prone to manipulation
• Cash-flow is important for fundamental valuation and in credit analysis
• The Formula
Pt
P / CFi 
CFt 1
• Where:
P/CFj = the price/cash flow ratio for firm j
Pt = the price of the stock in period t
CFt+1 = expected cash low per share for firm j
The Price-Book Value Ratio
• Widely used to measure bank values
• Fama and French (1992) study indicated inverse relationship between P/BV
ratios and excess return for a cross section of stocks
• The Formula
Pt
P / BV j 
BVt 1
• Where:
P/BVj = the price/book value for firm j
Pt = the end of year stock price for firm j
BVt+1 = the estimated end of year book value per share for firm j
The Price-Sales Ratio
• Sales is subject to less manipulation than other financial data
• This ratio varies dramatically by industry
• Relative comparisons using P/S ratio should be between firms in similar industries
• The Formula
Pt
P/Sj 
St 1
• Where:
P/Sj = the price to sales ratio for Firm j
Pt = the price of the stock in Period t
St+1 = the expected sales per share for Firm j
Multiples based on Comparables
• Valuation based on price multiple comparables (or comps) involves using a
price multiple to evaluate whether an asset is valued properly relative to a
benchmark.
• Common benchmarks include the stock's historical average (a time series

comparison) or similar stocks and industry averages (a cross-sectional
comparison).
• The economic principle guiding this method is the law of one price, which
asserts that two identical assets should sell at the same price, or in this case,
two comparable assets should have approximately the same multiple
• The analyst should be sure that any comparables used really
are comparable !!
• Price multiples may not be comparable across firms if the
firms are of different sizes, in different industries, or will
grow at different rates.
• The disadvantages of using price multiples based on
comparables are
• a stock may appear overvalued by the comparable method but
undervalued by the fundamental method, or vice versa
• Different accounting methods used by firms
• Cyclical firms

Relative Valuation Techniques

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Relative Valuation

• Relative valuation techniques implicitly contend that it is possible to

• By contrast, price multiples based on fundamentals tell us what a

• Method of comparables is based on fundamentals.

Current Market Price

• Leading vs. Trailing P/E

• The P/E ratio is determined by

• Dividend displacement of earnings

• What if the required rate of return is 13%

• What if the growth rate is 9%

• Common benchmarks include the stock's historical average (a time series

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