Valuation Methods

Introduction
Fundamental valuation helps us in finding the Intrinsic Value (IV) or True Value of the
company. Share market demand & supply generates the Current Market Price (CMP).

Decision Making criteria:

If Intrinsic Value (IV) > Current Market Price (CMP): Under Valued :: BUY

If Intrinsic Value (IV) < Current Market Price (CMP): Over Valued :: Sell

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Relative valuation measures

What is Relative Valuation?

It answers the following question

“How does the value of an asset compare with the values assessed by the market

for similar or comparable assets”

● Multiples

► Absolute values of comparable assets are standardized for the purpose of

comparison

► Standardized values are called multiples

● Valuation Multiples

► Multiples used in Valuation process

►They are the ratios with equity value (Price) or enterprise value (EV) in the
numerator and a standardizing factor (Earnings, Sales, Book Value, etc.) in the denominator

Popular Valuation Multiples used extensively:

► EV Multiples

► EV/Revenue

► EV/EBITDA

► EV/EBIT

► Equity Multiples

► Price/Earnings (P/E)

► Price/Book Value (P/B)

● Both the value (the numerator) and the standardizing factor ( the denominator) in
multiples represent the same claimholders in the firm

► E.g. Value of equity is standardized with equity earnings, and enterprise value
(value of entire firm) is standardized with EBITDA or Sales

● In order to use a multiple effectively to pass judgment on valuation of a firm

► Know how the multiple was computed

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 ► Define the comparable asset universe of the multiple

► Understand the fundamentals (growth, risk, profit margin, etc. ) that drive the
multiple

► Know the cross sectional distribution of the multiple across comparables

● Meaning of a Comparable Firm:

► Any firm – in same or different business – that has same fundamental

characteristics (risk, growth, cash flows, etc.) as the firm being valued

► In practice, it is very rare to find an exactly identical firm to the one you are valuing

► The key to sound Relative Valuation is be able to adjust for differences across
‘comparable’ firms

Steps to do Relative Valuation - Trading Comparable Analysis or Comparable Company

Analysis

Choose the set of appropriate Comparable Firms (Comps)

► In practice, Market Research databases such Capital IQ, Reuters, etc are used

► Screening criteria are selected such as

- Business Description

- Geographical Regions

- Financial Parameters such as range of Sales, EBITDA, etc

- Exclusion of outliers such EV/EBITDA > 15x

► It is suggested to select at least five Comps

● Choose the Multiple to be used

► EV Multiple or Equity Multiple ?

► Mean Multiple or Median Multiple ?

● EV is calculated as Metric * Multiple.

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Price multiple

 Dividend discount model is very sensitive to its inputs, many investors rely on other
methods.

 In a price multiple approach, an analyst compares a stock’s price multiple to a

benchmark value based on an index, industry group of firms, or a peer group of firms
within an industry.

 Common price multiples used for valuation includes:

 Price-to-earnings (P/E),

 Price-to-cash flow,

 Price-to-sales, and

 Price-to-book value ratios

 Price multiples are widely used by analysts and readily available in numerous media
outlets.

 Price multiples are easily calculated and can be used in time series and cross-
sectional comparisons.

Price multiples used for valuation include:

Price-earnings (P/E) ratio: The P/E ratio is a firm’s stock price divided by earnings per share
and is widely used by analysts and cited in the press.

Price-sales (P/S) ratio: The P/S ratio is a firm’s stock price divided by sales per share.

Price-book value (P/B) ratio: The P/B ratio is a firm’s stock price divided by book value of
equity per share.

Price-cash flow (P/CF) ratio: The P/CF ratio is a firm’s stock price divided by cash flow per
share, where cash flow may be defined as operating cash flow or free cash flow.

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Other multiples can be used that are industry specific. For example, in the cable television
industry, stock market capitalization is compared to the number of subscribers.

Multiples based on fundamentals

 Gordon growth valuation model:

 If we divide both sides of the equation by next year’s projected earnings, E1, we get
which is the leading P/E for this stock if it is valued in the market according to the
constant growth DDM.

 This P/E based on fundamentals is also referred to as a justified P/E. It is “justified”

because, assuming we have the correct inputs for D1, E1, ke, and g, the previous
equation will provide a P/E ratio that is based on the present value of the future cash
flows. We refer to this as a leading P/E ratio because it is based on expected earnings
next period, not on actual earnings for the previous period, which would produce a
lagging or trailing P/E ratio.

Example

 The firm’s P/E ratio should be related to its fundamentals. It illustrates that the P/E
ratio is a function of:

 D1 / E1 = expected dividend payout ratio.

 k = required rate of return on the stock.

 g = expected constant growth rate of dividends.

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Enterprise value (EV)

 It measures total company value. EV can be viewed as what it could cost to acquire
the firm. It is calculated as:

Market value of common and preferred stock

Add: Market value of debt

Less: Cash and short-term investments

 Cash and short-term investments are subtracted because an acquirer’s cost for a
firm would be decreased by the amount of the target’s liquid assets.

 Although an acquirer assumes the firm’s debt, it also receives the firm’s cash and
short-term investments.

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  Enterprise value is appropriate when an analyst wants to compare the values of
firms that have significant differences in capital structure.

EBITDA

 EBITDA: Earnings Before Interest, Tax, Depreciation and Amortization

 It’s the most frequently used denominator for EV multiples; operating income can
also be used.

 Because the numerator represents total company value, it should be compared to

earnings of both debt and equity owners.

 An advantage of using EBITDA instead of net income is that EBITDA is usually positive
even when earnings are not.

 When net income is negative, value multiples based on earnings are meaningless.

 A disadvantage of using EBITDA is that it often includes non-cash revenues and

expenses.

EV/EBITDA

● EV Ratios

► While Price earnings ratios look at the market value of equity relative to earnings to
equity investors, Enterprise Value ratio look at total value of the firm relative to total
operating earnings or free cash flows

● EV/EBITDA Ratio

– It can be computed even for firms that are reporting net losses

– For firms in certain industries, such as cellular, which require a substantial

investment in infrastructure and long gestation periods

– Useful in LBO’s where cash generated by the firms is the key factor

– Allows for comparisons across firms with different financial leverage

Other EV Ratios

EV/Sales: Ratio of the market value of the firm to the sales

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► Useful where EBITDA is negative

► Useful for young start ups where EBITDA is either negative or not stabilized yet

● EV/EBIT: Ratio of the market value of the firm to the Operating Income

Precedent Transaction Analysis OR Comparable Transaction Analysis

 This approach utilizes recent merger transactions involving comparable companies

to determine a fair acquisition price (directly) for the target company.

 Comparable transaction analysis entails the following steps:

1. Identification of relevant merger transactions: The sample of transactions used should

include mergers involving companies from the same (or closely related) industry as the
target.

2. Based on completed deals and transaction prices, relative valuation metrics are calculated
for the companies in the sample: Relative valuation multiples (e.g., P/E, P/B, P/CF, industry‐
specific ratios, etc.) are calculated based on acquisition prices in comparable transactions
(not based on market prices of comparable companies that were used to estimate target
market price under comparable company analysis).

3. Apply multiples to the target company: The target’s estimated acquisition price is
determined by multiplying its valuation metrics by corresponding relative valuation

REMEMBER: In comparable company analysis multiples are derived from stock prices,
while in precedent transaction analysis multiples are derived from merger transactions.