Presented by SnibdhaTambe,11 Shreeti Daddha,09 (BVIMSR)

Valuation
It is the process of determining the current worth of an

asset or company. There are many techniques that can be used to determine value, some are subjective and others are objective. For example, an analyst valuing a company may look at the company's management, the composition of its capital structure, prospect of future earnings, and market value of assets. Judging the contributions of a company's management would be more of a subjective valuation technique, while calculating intrinsic value based on future earnings would be an objective technique.

What is Relative Valuation? a It is a business valuation method that compares

firm's value to that of its competitors to determine the firm's financial worth. Relative valuation is not as straightforward as it might appear on the surface. Which companies are chosen as comparable companies and which multiples are used to determine value will have a significant outcome on a company's relative valuation. In relative valuation, the objective is to value an asset, based upon how similar assets are currently priced by the market.

 To value assets on a relative basis, prices have to be

standardized, usually by converting prices into multiples of some common variable. Eg. A prospective house buyer decides how much to pay for a house by looking at the prices paid for similar houses in the neighborhood. Embedded in this description are the three essential steps in relative valuation. 1. Finding comparable assets that are priced by the market. All too often, analysts use other companies in the same sector as comparable, comparing a software firm to other software firms.

2. Scaling the market prices to a common variable to generate

standardized prices that are comparable. While this may not be necessary when comparing identical assets, it is necessary when comparing assets that vary in size or units. Eg. A smaller house or apartment should trade at a lower price than a larger residence. 3. Adjusting for differences across assets when comparing their standardized values. Eg. A newer house with more updated amenities should be priced higher than a similar sized older house that needs renovation.

Key Issues in Relative Valuation

Peer selection II. Current Multiples or Forward Multiples III. Adjustments to the Value
I.

Issue 1- Peer Selection

Identification of appropriate peers is a prerequisite. Peers

taken should be as close as possible to the company being valued. It is preferred that the peer companies should have a similar:Business model, Accounting Policies, Growth pattern, Return on Capital Invested and Financial and Operational Risk In case peers in the domestic country are not available, then global peers can also be taken but subject to certain adjustments Therefore, to select the peer group of a company, it is important to understand the business of the company being

Issue 2- Current or Forward Multiples

Generally, to the latest financials of the company, a prevailing

market multiple of the comparable companies is applied to arrive at the value of the company being valued. However while valuing early stage companies whose values of financials in future years are considered as they provide a much better picture of the true potential of the firm. Current Multiples of Peer Companies: In case the peer companies are mature as on the valuation date, their prevailing valuation multiple may be applied to the forward stabilized financials of the company being valued. This will yield value of the company for the year for which earnings are taken..

 Forward Multiples of Peer Companies: Forward Multiples of peer companies are applied when

the entire industry is in evolving stage and no Comparable Mature Company exists on the Valuation date. In this case, there is no need for discounting. Forward looking Earnings are generally preferred for valuation purposes. Valuation is generally done with a forward looking view and the value of a company depends more upon how much in the future could the company/business earn than how much it has earned till date. Therefore, Forward multiples are preferred more than Current Multiples.

Issue 3- Adjustments to the Value

Valuation derived from relative valuation method is based on

certain multiples like EBITDA/Sales or Profits etc. It does not take into consideration other factors which are not reflected by the earnings such as: Surplus/Non-operating Assets: Surplus assets/non-operating assets does not reflect its value in the operating earnings of the company. Therefore , the Fair Market Value of such assets should be separately added to the value derived through other valuation methodologies to arrive at the value of the company. However, it is pertinent to mention herein that the investors may not be willing to pay for these surplus/non-operating assets which may call for reorganization of the company.

 Adjustments for Global Peers:

If the valuation of a company is based on comparison with the global peers, then it should be adjusted for some differences such as :

1. Difference of tax rate in the 2 countries 2. Difference in Growth and Inflation rate of the 2 countries 3. Difference between the levels of competition in the 2 countries, 4. Difference in the country risk of the 2 companies, and 5. Difference of accounting treatment in the 2 companies Thus there are many changes that are required to be made when choosing global peers and therefore domestic peers are always preferred for relative valuations since they are more comparable.

When Relative Valuation Works Best..

This approach is easiest to use when :
There are a large number of assets comparable to the one being valued

These assets are priced in a market

There exists some common variable that can be used to standardize the price

This approach tends to work best for investors : Who have relatively short time horizons Are judged based upon a relative benchmark (the market, other portfolio managers following the same investment style etc.) Can take actions that can take advantage of the

relative mispricing.

Step-by-Step Approach for Relative Valuation

1) Selection of Right Set of Peer Group Companies. 2) Calculation of Enterprise Value. 3) Calculate Multiples.

I.

Selection of Right Set of Peer Group Companies :

The starting point for performing a relative valuation is the

selection of a universe of comparable companies for the target company. One has to gain a sound understanding of the target company to identify the companies with similar and financial characteristics. Further if possible, the companies should be in same subindustry/sector. For example, though both Idea Cellular and BSNL are operating in telecom sector, we cannot compare these two companies as Idea is deriving its revenues only from wireless (mobile) services while BSNL generates maximum revenues from fixed line (land line) mobile services.

Products and Services offered by the company Dell and Microsoft, though are in same industry (Technology),cannot be compared as they offer different set of products and services. Dell is more into hardware while Microsoft is more into software. Geographical Concentration Different countries have different macroeconomic environment, demographics, rules and regulations, and consumers buying behavior, etc. So, the companies in the same geography/country are first taken into consideration before moving the international peers.

II. Calculation of Enterprise Value : Enterprise Value (EV) is a measure of actual economic value of the company at a given point of time i.e. it reflects the actual cost of a company if someone were to acquire it. Enterprise value can be calculated as below :

III. Calculation of Key Multiples :

Valuation multiples are the quickest way to value a

company. There are two basic types of multiples (a) Enterprise Value Multiples and (b) Equity Multiples.
Enterprise value multiples are better than equity value

multiples because EV allows for direct comparison of different firms, regardless of capital structure. Equity value multiples, on the other hand, are influenced by leverage. For example, highly levered firms generally have higher P/E multiples because their expected returns on equity are higher.

Valuation Multiples
Valuation multiples are the quickest way to value a company, and are useful in comparing similar companies (comparable company analysis). They attempt to capture many of a firm's operating and financial characteristics (e.g. expected growth) in a single number that can be mutiplied by some financial metric (e.g. EBITDA) to yield an enterprise or equity value.

Multiples
Relative valuation relies on the use of multiples and a little algebra.

For example: House Prices.

House A B C D E Price $ 110,000 $ 120,000 $ 96,000 $ 99,000 $ 105,000 Sq ft 1,700 1,725 1,500 1,550 1,605
Average What is the price of a 1,650 sq ft house?

Price per sq ft $ 64.71 $ 69.57 $ 64.00 $ 63.87 $ 65.42

$65.51

Answer: 1650 65.51 = $108,092

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Standardized Values and Multiples

Prices can be standardized using a common variable

such as Earnings, Cash flows, Book value or revenues. Earnings Multiples Book Value Multiples Revenue Multiples Industry Specific Variable (Price/kwh, Price per ton of steel ....)

The Four Steps to Understanding Multiples

Define the multiple
Describe the multiple Analyze the multiple Apply the multiple

Basics and Tests

Definitional test:

Is the multiple consistently defined? Is the multiple uniformaly estimated?

Descriptive test:

What is the average and standard deviation for this multiple, across the universe (market)? What is the median for this multiple? The median for this multiple is often a more reliable comparison point. How has this multiple changed over time?

 Analytical test:

What are the fundamentals that determine and drive these multiples? How do changes in these fundamentals change the multiple?
Application test:

Given the firm that we are valuing, what is a comparable firm? Given the comparable firms, how do we adjust for differences across firms on the fundamentals?

 Price-earnings ratio :

Price-earnings ratio = Market Price per Share

Earnings per Share The price-earnings ratio is considered useful in valuation because earnings are a primary driver in a companys value. In cases in which a company does not have positive earnings, the price-earnings ratio cannot be used, and in cases in which a company has volatile earnings, the priceearnings ratio as a multiple may not be very reliable.

There are a number of variants of the basic PE ratio in use. They are based on how the price and earnings are defined.

Price - Current Price - Or average price for the year Earnings - Most recent financial year - Trailing 12 months (Trailing PE) - Forecasted EPS (Forward PE)

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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.

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

Stock D PE=21

The average PE = (14+18+24+21)/4=19.25 Our firm has EPS of $2.25 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

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Example
Australia

20.1 Britain 18.9 Canada 17.2 France 14.9 Germany 14.4

20.56 14.80 19.38 14.04 13.51

-0.46 4.10 -2.18 0.86 0.89

 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.

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.

 PEG Ratio :

The PEG ratio is the ratio of the price-earnings ratio to the

growth rate of earnings: PEG ratio = PE ratio Growth Rate of Earnings The PEG ratio considers the companys expected growth directly by comparing the markets multiple applied to earnings with the growth rate. Though in most applications the PEG ratio is calculated using anticipated growth, in valuation situations of a nonpublicly-traded company it may not be possible to estimate the future growth rate, but rather it may be possible to look at the recent or historical growth rate of the companies.

Relative PE Ratio
.
Relative PE = PE of Firm / PE of Market While the PE can be defined in terms of current earnings,

trailing earnings or forward earnings, consistency requires that it be estimate during the same measure of earnings for both the firm and the market. firm or sector which has historically traded at half the market PE (Relative PE= 0.5) is considered over valued if it is trading at a relative PE of 0.7.

Relative PE ratios are usually compared over time. Thus, a

The relative PE ratio of a firm is determined by two variables. In particular, it will

Increase as the firms growth rate relative to the market increases. The rate of change in the relative PE will itself be a function of the market growth rate, with much greater changes when the market growth rate is higher. In other words, a firm or sector with a growth rate twice that of the market will have a much higher relative PE when the market growth rate is 10% than when it is 5%. Decrease as the firms risk relative to the market increases. The extent of the decrease depends upon how long the firm is expected to stay at the level of relative risk. If the different is permanent, the effect is much greater.
Relative PE ratios seem to be unaffected by the level of rates, which might give them a decided advantage over PE ratios

Value/EBITDA Multiples
The Classic Definition
Value /EBITDA = Market Value of Equity + Market Value of Debt/ Earnings before Interest, Taxes and Depreciation The no cash version Value /EBITDA = Market Value of Equity + Market Value of Debt Cash/Earnings before Interest, Taxes and Depreciation Interest Income

Reasons for increased use

The multiple can be computed even for firms that are reporting net

losses, since earnings before interest, taxes and depreciation are usually positive. For firms in certain industries, such as cellular, which require a substantial investment in infrastructure and long gestation periods, this multiple seems to be more appropriate than the price/earnings ratio. In leveraged buyouts, where the key factor is cash generated by the firm prior to all discretionary expenditures, the EBITDA is the measure of cash flows from operations that can be used to support debt payment at least in the short term. By looking at cash flows prior to capital expenditures, it may provide a better estimate of optimal value, especially if the capital expenditures are unwise or earn substandard returns. By looking at the value of the firm and cash flows to the firm it allows for comparisons across firms with different financial leverage.

Book Value Ratio

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. Price/Book Value = Market Value of Equity/Book Value of Equity

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.

Price Sales Ratio

The price/sales ratio is the ratio of the market value of

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

Choosing between the Multiples

There are dozen of multiples There are three choices Use a simple average of the valuations obtained using a number of different multiples Use a weighted average of the valuations obtained using a number of different multiples (one ratio may be more important than another) Choose one of the multiples and base your valuation based on that multiple (usually the best way as you provide some insights why that multiple is important remember car industry video segment)

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Conclusion
In relative valuation, we estimate the value of an asset

by looking at how similar assets are priced. To make this comparison, we begin by converting prices into multiples standardizing prices and then comparing these multiples across firms that we define as comparable. Prices can be standardized based upon earnings, book value, revenue or sector-specific variables. we need to find truly comparable firms and adjust for differences between the firms on fundamental characteristics

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