RELATIVE VALUATION

Presented By : Jai Kumar MBA IV Sem.

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What is Relative Valuation• Valuing a company relative to other companies.

• In relative valuation, the value of an asset is compared to the values assessed by the market for similar or comparable assets.

• Most managers and financial analysts favor this approach since it is based on the ratios that they easily understand.

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Why Relative ValuationMost valuations that you see are relative valuations. There are two reasons why relative valuations are so popular:

1.If your objective is to buy or sell something, not matter what the price, you can justify your decision using relative valuation. There will always be some other assets out there which are more underpriced or overpriced than the asset you are buying or selling.

2.In contrast to the detail and time needed for discounted cash flow valuation, relative valuation is quicker and seems to require fewer assumptions about the future.

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How to do Relative ValuationThere are following steps in relative valuation:1. Identify the comparable firms based on the criteria of

similar products, size, age , growth etc.2. Identify the Multiple. Calculate the firm value as a ratio

of sales, EBIT, FCFs and market value-to-book value of assets for the comparable firms. Sales , EBIT, FCF and book value of assets are assumed as value drivers.

3. Find the average and compare the industry average to the firm specific.

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What is a Multiple• An expression of market value relative to key statistic that

is assumed to relate to that value.• To be useful statistic- earnings, cash flow or some other

measure must bear a logical relationship to the market value observed.

• Multiples may Vary because of a) Differences in the quality of the business/ value drivers.b) Accounting Differences.c) Fluctuation in cash flow or Profitsd) Mispricing

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Types of Multiple

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Mul

tiple

EnterpriseValue Multiple

EV/Sales

EV/EBITDA

EV/EBIT

EV/FCF

EV/Capacity

Equity ValueMultiple

P/E

P/BV

PEG

P/CF

P/Sales

Equity Value Multiple• P/E Ratio = Current Market Price/ EPS• Forward & Trailing P/E• Empirical research shows that Price/Earnings are

significantly related to long run average stock returns.

• Rationale for P/E : a) Data Availabilityb) Use for comparison of companies within the sectorsc) Earnings are representative of future earnings.

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Is low (high) PE cheap (expensive)?

• 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?

• Yes• No• If you do not agree, what factor might explain the high PE

ratio today?

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A Question

You are reading an equity research report on Informix, and the analyst claims that the stock is undervalued because its PE ratio is 9.71 while the average of the sector PE ratio is 35.51. Would you agree?

• Yes• No• Why or why not?

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Example: Valuing a firm using P/E ratios

• In an industry we identify 4 stocks which are similar to the stock we want to evaluate.

• The average PE = (14+18+24+21)/4=19.25• Our firm has EPS of $2.10• P/2.25=19.25 P=19.25*2.25=$40.425• Note – do not include the stock to be valued in the

average• Also do not include firm with negative P/E ratios

Stock A PE=14Stock B PE=18Stock C PE=24Stock D PE=21

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Limitation of using P/E

• Earnings are subject to different accounting policies.

• Can’t be used when earnings are negative.

• Do not explicitly take into account balance sheet risk.

• Do not explicitly take into account the amount of investment requires to support future growth.

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Price to Cash Flow• P/CF = Price Per Share/Cash Flow from Operations per Share

• This measure deals with Cash Flow , the effects of Depreciation and other non-cash factors are removed.

• Should be used as a supplement with other equity multiples.

• Lower a company Price to Cash Flows Ratio and the bigger its discount from the industry average multiple, the more likely that the firm may be undervalued.

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Used in Which Sector ?• P/CF is particularly favoured to value companies in the

Hard-Assets Business. Such as Gold Companies, Oil companies and Real State Business.

• Capital –intensive industries such as Auto Manufacturing tend to have vary low P/CF Multiple and less infrastructure heavy industries like software have high P/CF Multiple.

• But Most Cash Flows numbers are subject to more fluctuation than profits and therefore EPS tends to be more sustainable than cash flow.

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Price to Book Value• P/BV = Price per Share/ Book Value per Share.• P/BV gives some idea of whether one is paying too much

what would be left if the company went bankrupt immediately.

• Because of its close linkage to Return on Equity , it is useful to view price to book value together with ROE.

• P/BV = (Price to Earnings)* ROE• Rule of Thumb• Low ROE + High P/BV = Overvalued• High ROE+ Low P/BV = Undervalued

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Used in Which Sector• Applicable to those industries which need to revalue their

balance sheet every year.• Used in Valuing Financials especially Banks, which

squeeze a small spread from a long base of assets and multiply that spread by utilizing higher levels of leverage.

• Useful where tangible assets are source of value generation.

• But it does not take into account the intangible assets such as human capital.

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Price to Sales• P/S = Price per Share/ Sales per share

• It measures the share price against a company sales.

• Price /Sales can be useful when a company is loss making or its margins are uncharacteristically low.

• Appropriate for valuing stocks in mature or cyclical industries and start up when there is no record of earnings.

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Limitations of using P/Sales• High growth in sales may not necessarily indicate high

operating profit.

• Does not capture the high operating leverage of the company.

• Difference in revenue recognition policy can severely distort the comparison.

• EV/Sales is in many ways a better alternative as it strips out the effects of Debt.

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Price to Earnings Growth• PEG = PE Ratio/ Average forecast earnings growth• A ratio to determine the stock’s value while taking into

account earnings growth.• PEG is based on the assumption that PE ratio is positively

linearly correlated to the expected growth rate in earnings.• Rule of Thumb :• PEG >1 = Overvalued• PEG < 1 = Undervalued• PEG =1 = Fairly Valued

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Used in which sector? • Especially suitable for comparison in IT Sector.• Used to Value growth companies where it is assumed that

growth opportunities arise from reinvesting at a premium rate of return or from efficiency gains.

• At higher rates of growth PEG ratio are stable and less sensitive to changes in growth than PE Ratios , which makes PEG ratio more suitable for valuing high growth companies.

• PEG ratio is less useful for assessing• Cyclical Industries• Assets value based Industries

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Enterprise Value Multiple• EV/EBITDA = Enterprise Value / EBITDA• Indicate the value of overall company not just equity.• Unaffected by differences in Depreciation Policy.• Unaffected by differences in Capital Structure.• Affected by a firm’s level of capital intensity(measured as

depreciation as a percentage of EBITDA).• Higher Capital intensity results in a lower EV/EBITDA

multiple• Most useful in comparing companies with a selected peer

group that has a comparable level of capital untensity.

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Used in which Sector?• It can be used for relative valuation of :• Oil Companies• Auto Companies• Capital Intensive Business with high levels of depreciation

& amortization• It can’t be used when current cash flow is negative,

instead we should use normalized EBITDA or a forward multiple.

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Enterprise Value to Sales• EV/Sales = Enterprise Value/ Total Sales

• Equivalent to its equity counterpart, price to sales , where company has no sales.

• EV/Sales is important because :a) Least susceptible to accounting differencesb) Useful when accounting differences are extreme.c) Profits or Cash flow figures are unrepresentative or

negative.

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Enterprise Value to EBIT• EV/EBIT = Enterprise Value / EBIT• EBIT is a better measure of “free” cash flow than EBITDA.• EV/EBIT is more comparable where capital intensities

differ.• EBIT affected by accounting policy differences for

depreciation.• EV/EBIT is most useful where there are relatively small

differences in accounting treatment of depreciation among comparable.

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Enterprise Value to FCF• EV/FCF = Enterprise Value / Free cash Flow • EV/FCF is preferable to EV/EBITDA foe comparing

companies within a sector.• Comparing across sectors or markets where companies

have widely varying degrees of capital intensities.• Can’t be used when current cash flow is negative.• Use of historic FCF can be problematic because of

fluctuations in cash flow items can cause it to be highly volatile , making EV/FCF a less useful multiple.

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Example: Valuing using value/FCFF

• Industry average is 20• Firm has FCFF of $2,500• Shares outstanding of 450• MV of debt = $30,000

• Using Value/FCFF=20 value = FCFF*20 MV equity + MV debt = FCFF*20 MV equity = FCFF*20 – MV debt Price = (FCFF*20-MV debt)/Shares

Price = ($2,500*20-$30,000)/450 = 44.44

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Enterprise Value to Capacity• EV/ Capacity = Core EV / Units of capacity( such as

tonnes of cement capacity).• Compare the implied value of productive assets ( tonnes

of cement capacity, fixed telephone lines) to enable comparison across firms operating within the same industry.

• Value can be compared to the cost of replacing the asset on a gross basis or after factoring in depreciation to adjust for the remaining life of the assets in use.

• Implied market value can be calculated for each revenue generating units such as subscribers.

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Used in which Sector?• EV/Capacity useful for- • Oil companies (EV/boe)• Telecom companies (EV/subscriber)• Cement companies (EV/per ton of cement capacity)

• But it does not tell us nothing about the relative underlying profitability of the assets.

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Multiples can be misleading

To use a multiple inelegantly you must: • Know what are the fundamentals that determine the

multiple.• Know how changes in these fundamentals change the

multiple.• Know what the distribution of the multiple looks like.• Ensure that both the denominator and numerator

represent claims to the same group• - OK: P/E – Price equityholders, EPS equityholders• - Not OK: P/EBIT – Price equityholders, EBIT All claimants• Ensure that firms are comparable.

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THANK YOU

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