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RELATIVE VALUATION
Presented By : Jai Kumar MBA IV Sem.

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.

Why Relative Valuation

Most 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.

How to do Relative Valuation

There 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.

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 Profits d) Mispricing

Types of Multiple
EV/Sales EV/EBITDA EnterpriseValue Multiple EV/EBIT EV/FCF

Multiple

EV/Capacity P/E P/BV Equity Value Multiple 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 Availability b) Use for comparison of companies within the sectors

c) Earnings are representative of future earnings.

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?

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?

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

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
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Limitation of using P/E

Earnings are subject to different accounting policies. Cant 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 stocks 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 firms 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 cant 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 differences b) 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. Cant 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.

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.

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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