Valuation principles and practice part 1 relative valuation
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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.

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Valuation principles and practice part 1 relative valuation

Valuation: Principles and Practice: Part 1 – Relative Valuation

03/03/08

Ch. 12


Valuation techniques

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

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 valuation1

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

Advantages and drawbacks of P/E

  • Advantages:

    • 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

Advantages and drawbacks of P/BV

  • Advantages

    • 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)

  • Disadvantages

    • 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

Advantages and drawbacks of P/S

  • Advantages

    • 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

  • Disadvantages

    • 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

Advantages and drawbacks of EV/EBITDA

  • Advantages

    • 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.

  • Disadvantages

    • 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

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


Leading and trailing p e

Leading and trailing P/E

  • 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

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 ratio1

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


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