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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 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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