This presentation is the property of its rightful owner.
1 / 12

# Valuation: Principles and Practice: Part 1 – Relative Valuation PowerPoint PPT Presentation

Valuation: Principles and Practice: Part 1 – Relative Valuation. 03/03/08 Ch. 12. Valuation techniques. Relative valuation the value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable such as earnings, book value or revenues.

Valuation: Principles and Practice: Part 1 – Relative Valuation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.

- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -

## Valuation: Principles and Practice: Part 1 – Relative Valuation

03/03/08

Ch. 12

### Valuation techniques

• Relative valuation

• the value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable such as earnings, book value or revenues.

• Discounted cash flow valuation

• The value of an asset is the discounted expected cash flows on that asset at a rate that reflects its riskiness.

• Residual Income valuation

• The value of an asset is based on the discounted expected difference between net income and its associated cost of equity.

### Relative valuation

• The value of the firm is determined as:

Comparable multiple * Firm-specific denominator value

where the denominator value can be earnings, book value, sales, etc.

• A firm is considered over-valued (under-valued) if the calculated price (or multiple) is greater (less) than the current market price (comparable firm multiple)

• Assumptions:

• Comparable firms, on average, are fairly valued

• Comparable firms have similar fundamental characteristics to the firm being valued.

### Relative valuation

• Examples of relative valuation multiples

• Price/Earnings (P/E)

• Earnings calculations should exclude all transitory components

• Price/Book (P/BV)

• Book value of equity is total shareholders equity – preferred stock

• Price/Sales (P/S)

• Enterprise Value/EBITDA

• Enterprise Value = Mkt Cap + Debt – Cash

• EBITDA = Earnings before Interest Taxes Depreciation and Amortization

### Advantages and drawbacks of P/E

• Earnings power is the chief driver of investment value

• Main focus of security analysts

• The P/E is widely recognized and used by investors

• Drawbacks

• If earnings are negative, P/E does not make economic sense

• Reported P/Es may include earnings that are transitory

• Earnings can be distorted by management

• Assumption:

• Required rate of return, retention ratio and growth rates are similar among comparable firms

### Advantages and drawbacks of P/BV

• Since book value is a cumulative balance sheet amount, it is generally positive

• BV is more stable than EPS, therefore P/BV may be more meaningful when EPS is abnormally low or high

• P/BV is particularly appropriate for companies with primarily liquid assets (financial institutions)

• Differences in asset age among companies may make comparing companies difficult

• Assumption:

• Required rate of return, return on equity, retention ratio and growth rates are similar among comparable firms

### Advantages and drawbacks of P/S

• Sales are generally less subject to distortion or manipulation

• Sales are positive even when EPS is negative

• Sales are more stable than EPS, therefore P/S may be more meaningful when EPS is abnormally low or high

• High growth in sales may not translate to operating profitability

• P/S does not reflect differences in cost structure

• Assumption:

• Required rate of return, profit margin, retention ratio and growth rates are similar among comparable firms

### Advantages and drawbacks of EV/EBITDA

• This represents a valuation indicator for the overall company and not just equity.

• It is more appropriate for comparing companies that have different capital structures since EBITDA is a pre-interest measure of earnings.

• Appropriate for valuing companies with large debt burden: while earnings might be negative, EBIT is likely to be positive.

• Differences in capital investment is not considered.

• Assumption:

• Required rate of return, growth rates, working capital needs, capital expenditures and depreciation are similar among comparable firms

### Benchmarks for comparison

• Peer companies

• Constituent companies are typically similar in their business mix

• Industry or sector

• Usually provides a larger group of comparables therefore estimates are not as effected by outliers

• Overall market

• Own historical

• This benchmark assumes that the firm will regress to historical average levels

• Considerations: market efficiency, historical trends, comparable assumptions

• Trailing (or current) P/Es is calculated using the firm’s current market price and the four most recent quarters’ EPS.

• Leading P/Es is calculated using the firm’s current market price and next year’s expected earnings.

### PEG Ratio

• “I don’t buy stocks with P/E’s over 30. To our Foolish ear, that sounds identical to: I don't buy hydrogenated milk; I am born in May.” Motley Fool

• When comparable firm P/Es are used to calculate the value of a firm, the assumption is that the firm has characteristics that are similar to that of the average comparable firm.

• However, differences may exist. For example, a higher P/E for a particular firm may be justified because the firm has higher growth.

### PEG Ratio

• The Price/Earnings-to-Growth (PEG) accounts for differences in the growth in earnings between companies.

• PEG is calculated as:

P/E divided by expected earnings growth (%).

• "The P/E ratio of any company that's fairly priced will equal its growth rate." Peter Lynch