Relative Valuation: Introduction

Concept
In relative valuation, the value of an asset is compared to the

values assessed by the market for similar or comparable assets.

To do relative valuation, you need to:
Identify similar assets and obtain market values for these assets.
Convert these market values into standardized values. This process
of standardizing creates price multiples (or value ratios).

Compare the standardized value (or multiple) for the asset being
analyzed to the standardized values for comparable assets to
determine the market value of the asset.

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Relative Valuation: Introduction

The use of relative valuation is widespread
Most valuations on Wall Street are relative valuations.
Almost 85% of equity research reports are based upon multiples.
More than 50% of all acquisition valuations are based upon multiples.
Rules of thumb based on multiples are not only common but are often
the basis for final valuation judgments.

While there are more discounted cash flow valuations in consulting

and corporate finance, they are often relative valuations

masquerading as DCF valuations.
The objective in many DCF valuations is to back into a number that has
been obtained by using a multiple.
The terminal value in discounted cash flow valuations is often estimated
using a multiple.
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Multiples: Standardized Estimates of Price

Market value for the firm (E+D)

Multiple =

Firm revenues

Market value of enterprise (E+D-Cash)

Market value of equity (E)

Numerator = What you are paying for the asset (market value)
Denominator = What you are getting in return (financial variable)

Earnings
Firm: EBITDA, EBIT
Equity: Net income, EPS

Cash flow
Firm: FCF
Equity: CFE

Book value
Firm: BV(E)+ BV(D)
Equity: BV(E)

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Relative Valuation: Multiples

Four steps to understanding multiples
Define the multiple: In use, the same multiple can be defined in

different ways by different users. When comparing and using multiples,

it is critical that we understand how the multiples have been estimated.
Describe the multiple: Without knowing the cross-sectional distribution

of a multiple, it is difficult to look at a number and pass judgment on

whether it is too high or low.
Analyse the multiple: We need to understand the fundamentals that

drive each multiple, and the nature of the relationship between the
multiple and each variable.
Apply the multiple: Defining the comparable universe and controlling

for differences is far more difficult in practice than it is in theory.

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Relative Valuation: Multiples

Define the multiple
Is the multiple consistently defined?
Both the value (the numerator) and the standardizing variable ( the
denominator) should be to the same claimholders in the firm.
In other words, the value of equity should be divided by equity earnings
or equity book value, firm value should be divided by firm earnings or
firm book value.

Is the multiple uniformly estimated?

The variables used in defining the multiple should be estimated
uniformly across assets in the comparable firm list.
For instance, if earnings-based multiples are used, the accounting rules
to measure earnings should be applied consistently across assets.
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Relative Valuation: Multiples

Describe the multiple
Examine the distribution of the multiple
What is the average for this multiple, across the universe (market)?
What is the standard deviation for this multiple?
How asymmetric is the distribution?

Are there any outliners, and how do we deal with the outliers?
While true outliers do occur, a mistake in the data can also lead to outliers.
One approach: throw out the outliers, which can lead to a biased estimate.
Another approach: cap the outliers.

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Relative Valuation: Multiples

Analyse the multiple
What are the fundamentals that drive these multiples?
Embedded in every multiple are all of the variables that drive every
discounted cash flow valuation growth, risk and cash flow patterns.

The relationship between a fundamental factor (such as growth) and a

multiple (such as PE) is almost never linear.
Why do we need to worry about how a multiple change with the

fundamentals?
There are no identical firms as ideal comparables.
Different fundamentals between the asset and the comparables can
lead to substantially different, non-comparable multiples.

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Relative Valuation: Multiples

Apply the multiple
For the firm that we are valuing, what is a comparable firm?
Traditional analysis: firms in the same sector are comparable firms.

Valuation theory: a comparable firm is one which is similar to the

one being analysed in terms of fundamentals.

A firm can be compared with another firm in a different business, if the
two firms have the same risk, growth and cash flow characteristics.
As long as we can adjust multiples for differences across firms on the
fundamentals, we can expand our comparable universe.
How many comparable firms are enough?
There is no clear rule on this, and it is typically a judgement call.

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Price Earnings Ratio

Price earnings ratio (PE)
Market price per share
PE =
Earnings per share

MV of E
=
Earnings

Price: the current price (P0)

EPS: in most recent financial year (EPS0)
Primary, diluted or partially diluted

Before or after extraordinary items

Measured using different accounting rules (options expensed or not,
pension fund income counted or not )

Can EPS be negative?

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Price Earnings Ratio

More variants on the basic PE ratio in use, depending on the

time period chosen in the calculation of price and earnings.

Time variants in the measure of price
Usually the current price;
Some use the average price over last 6 months or year.

Time variants in the measure of EPS

Of most recent financial year (referred to as current, EPS0);
Of most recent four quarters (referred to as trailing, EPS-1);
Expected EPS in next fiscal year, or next four quartes, or in some

future year (referred to as forward, EPS1).

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Skewed Distributions
PE Ratios for US Companies (January 2012)

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PE Ratios
US Companies (January 2012)

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Current PE Ratio
A Global Comparison (January 2012)
Mean

Median 25th

75th

Australia, NZ and Canada

43.13

11.85

6.66

22.64

Developed Europe

42.40

12.67

6.97

24.19

Emerging markets

62.76

12.40

7.03

23.42

Japan

49.07

12.32

7.34

23.99

U.S.

45.01

12.45

6.69

25.84

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Price Earnings Ratio

Example: Use PE to determine an investments (current) value
A project is expected to generate net income (NI) of $1.2 million.
The comparable firms stock price, total number of shares
outstanding and earnings are $21.51, 5.5 million, and $11 million,
respectively. Use comparable firms PE ratio to determine the value
of this project.
PriceComparable=$21.51 and EPSComparable=$11/5.5 = $2
PEComparable = $21.51 / $2 = 10.755

(MV of equity / NI)Project = 10.755

Equity valueProject = 10.755(1.2) = $12.906 million

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Price Earnings Ratio

PE ratio and fundaments
Suppose dividends (DIV) per share follows perpetual growth, g n
DIV1
,
E gn

P0 = R

DIV1 = DIV0 1 + g n , DIV = EPS Payout ratio

Therefore: PE =

P0
EPS0

(Payout ratio)(1+gn )
RE gn

The partial effects of fundamentals on PE

Higher growth higher PE
Higher business risk lower PE
Higher financial leverage lower PE
Higher payout higher PE
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Price Earnings Ratio

About regressions of the PE ratio
Example:
PE = 6.37 + 83.56 Expected growth rate + 5.05 Beta + 5.83 Payout ratio
(5.9) (16.9)
(8.2)
(4.3)

How to understand it?

How to use it?

Potential problems

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Firm Value to Earnings

Value to EBITDA multiples
The classic definition:

Value
EBITDA

MV of equity E + MV of debt (D)

EBITDA

The non-cash version:

EV
EBITDA

E + D Cash
EBITDA

Both focus on the value of the operating assets of the firm.

both numerator and demoninator

Alternative common earnings measures include:

Operating income, EBIT
After-tax operating income: EBIT 1
Free cash flow, FCF

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Skewed Distributions
EV to Earnings for US Companies (January 2012)

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EV/ EBITDA
A Global Comparison (January 2011)
Mean

Median 25th

75th

Australia, NZ and Canada

26.94

10.17

6.07

18.45

Developed Europe

37.25

10.28

6.08

19.26

Emerging markets

40.59

10.04

6.12

18.54

Japan

26.54

9.93

6.02

19.04

U.S.

54.80

10.04

6.22

19.29

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Firm Value to Earnings

Example: Use EV/EBITDA to determine terminal value
The CFO of HT Inc. has estimated the firms EBITDA in year 10 at
$19.765 million. The EV/EBITDA ratio for peer companies in the
same industry is currently averaged at 8. If we expect HTs cash
flows since year 10 to be comparable to the industry peers cash
flows since now, estimate HTs value in year 10 (terminal value).
EV/EBITA(t=0)Comparables = 8

EV/EBITDA(t=10)HT = 8

EV(10)HT = EBITDA(10) EV/EBITDA(0)

= 19.765(8)
= $158.12 million

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Firm Value to Earnings

Value-to-earnings multiples and fundaments
Suppose FCF follows perpetual growth:
EV0 =

FCF1
,
WACC g n

FCF1 = FCF0 1 + g n

FCF0 = EBITDA0 1 t + Dep0 t NCS0 NWC0

Then:

EV0
EBITDA0

1+g

n
= WACCg
1t+
n

Dep0 tNCS0 NWC0

EBITDA0

EV0
FCF0

1+g

n
= WACCg

The partial effects of fundamentals

Higher growth Higher both multiples
Higher WACC Lower both multiples
Higher reinvestment need Lower EV/EBITDA

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Firm Value to Earnings

Reasons for increased use of V/EBITDA, V/EBIT
Since EBITDA is usually positive, the multiple V/EBITDA can be

computed even for firms that are reporting net losses.

By looking at the value and cash flows of the entire business (before

payments to creditors), V/EBITDA and V/EBIT allow for comparisons

across firms with different financial leverage.
Don't worry financial leverage

Because depreciation methods affect operating income and net

income but not EBITDA, the value to EBITDA multiples are less
sensitive to assets depreciation and hence more useful for firms in
capital intensive industries.

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A Further Example
Happy Times Inc., wants to expand its party stores into the Southeast. In order to
establish an immediate presence in the area, the company is considering the
purchase of the privately held Joes Party Supply. Happy Times currently has debt
outstanding with the market value of $140 million and a YTM of 6%. The companys
market capitalization is $380 million, and the required return on equity is 11%. Joes
currently has debt outstanding with a market value of $30.5 million. The EBIT for
Joes next year is projected to be $12.5 million. EBIT is expected to grow at 10% per
year for the next five years before slowing to 3% in perpetuity. Net working capital
investment, capital spending, and depreciation as a percentage of EBIT are
expected to be 9%, 15% and 8% respectively. Joes has 1.85 million shares
outstanding and the tax rate for both companies is 38%.
(a) What is the maximum price that Happy Times should be willing to pay for Joes?
(b) After examining your analysis the CFO of Happy Times is uncomfortable using
perpetual growth rate in cash flows. Instead, she feels that the terminal value
should be estimated using the industrys current EV/EBITDA multiple. If the
EV/EBITDA multiples is 8, what is your new estimate of the maximum share
price for the purchase?

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A Further Example
(a) Suppose the two companies will have the same cost of capital (more
assumptions would be needed otherwise), we obtain the cost of capital from
Happy Times:
WACC=(380/(380+140)(11%)+(140/(380+140)(6%)(1-38%) = 9.04%

We then obtain the enterprise value of Joes (with no excess cash, this is
also its firm value) in DCF at $119.97 million (upper panel of next slide)
Value of equity = 119.97 30.5 = $89.47 (note: use Joes debt)
Equity per share: 89.47/1.85 = $48.36 per share
(b) For Joes in year 5: EBITDAt=5=18.301+1.464=$19.765 million. Then,
TVt=5 = 19.765(8) = $158.12 million
Replacing 143.562 by 158.12 gives firm value of $129.42 million
(lower panel of next slide)
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A Further Example
WACC
gn
Shares outstanding (million)
EBIT growth
EBIT ($million)
Taxes
Depreciation
CapEx
DNWC
FCF
TV
Discount factor
PV of CF
Firm value
Value of debt
Value of equity
Equity value per share

TV
PV of CF
Firm value
Value of debt
Value of equity
Equity value per share

12.50
4.75
1.00
1.88
1.13
5.75

10%
13.75
5.23
1.10
2.06
1.24
6.33

0.92
5.27

0.84
5.32

Year
3

10%
15.13
5.75
1.21
2.27
1.36
6.96

10%
16.64
6.32
1.33
2.50
1.50
7.65

3%
18.85
7.16
1.51
2.83
1.70
8.67

0.77
5.37

0.71
5.41

10%
18.30
6.95
1.46
2.75
1.65
8.42
143.56
0.65
98.60

5.41

158.12
108.04

9.04%
3%
1.85

38%
8%
15%
9%

119.97
30.50
89.47
$48.36

5.27

5.32

5.37

129.42
30.50
98.92
$53.47
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Book Value Multiples

Price-to-Book (P/B) ratio
Total value or value per share:

Market value of equity

Book value of equity

Consistency in estimation
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 than one class of common stock outstanding, the
market values of all classes (even the non-traded classes) needs to
be factored in.

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Price-to-Book ratio for US Companies in January 2011

Returned earning is negative. 14%

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Book Value Multiples

Value-to-Book (V/B) ratios
Value to book =

MV of euqity + MV of debt
BV of equity + BV of debt

MV of euqity + MV of debt Cash

EV to invested capital =
BV of equity + BV of debt Cash

Note the following:

Invested capital BV of equity + BV of debt Cash
When the market value of debt is unavailable, the book value of
debt can be used in the numerator as well.

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V/B and EV/Invested Capital

for US Companies in January 2011

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Revenue Multiples
Price-to-sales ratios
An internally inconsistent yet more popular revenue multiple (since

the market value of equity is divided by the total revenues of the firm):
MV of euqity
Price/Sales =
Revenues

An alternative, more consistent revenue multiple:

Value/Sales =

MV of euqity + MV of debt Cash

Revenues

Accounting standard across different sectors and markets are fairly

similar when it comes to how revenues are recorded.

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Revenue Multiples for US Companies in January 2011

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Relative Valuation vs. DCF Valuation

Strengths of relative valuation
It is easy, involving fewer assumptions and requires far less

information than a discounted cash flow valuation.

A relative valuation is simpler to understand and easier to present

to clients than a DCF valuation. So your findings/recommendations

will reach a receptive audience.
A relative valuation is much more likely to reflect the current mood

of the market, since it is an attempt to measure relative market

value and not intrinsic value.

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Relative Valuation vs. DCF Valuation

Weaknesses of relative valuation
It can be easily misused either because of inadequate comparable

firms or inconsistent estimates of multiples.

Being subject to the market mood, a relative valuation can result in

values that are too high when the market is overvaluing

comparable firms, or too low when it is undervaluing these firms.
Due to the lack of explicit modeling for risk or other important

fundamentals, relative valuation is not as useful, as a discounted

cash flow valuation, in performing sensitivity analysis and
deepening our understanding of the drivers and risks of the
investment.

Relative valuation 33