Post on 04-Feb-2023
Relative Valuation
Lecture 9 Relative Valuation
Diem Nguyen
diem.nguyen@handels.gu.se
Spring 2020
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Relative Valuation
Multiple Basics
Outline
1 Multiple Basics
2 Multiples and Firm Fundamentals
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Relative Valuation
Multiple Basics
Relative Valuation
Relative valuation → the value of an asset is derived from themarket pricing of comparable assets.
Price standardized (e.g., by earnings, sales, book value) →multiples
Applying relative valuation:1 Method of comparables:
→ value �rms based on comparable �rms' multiplesSimilar �rms should trade at similar price.Value = Multiple of comparables × Firm-speci�c variable.
2 Screening on multiples:
→ buy/sell recommendations based on relative multiplesFirms with relatively extreme multiples may be mispriced
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Relative Valuation
Multiple Basics
The Steps
Method of comparables:1 Identify comparable �rms
Similar risk, growth potential and cash �ows
2 Calculate relevant multiples for the comparable �rms3 Apply these multiples to the corresponding measures for the
target �rm
Screening on multiples:1 Identify a multiple on which to screen stocks2 Rank stocks on that multiple3 Buy stocks with the lowest multiples and short stocks with the
highest ones
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Relative Valuation
Multiple Basics
Popularity
Most equity valuations on Wall Street are relative valuations
Almost 85% of equity research reports are based upon amultiple and comparables.More than 50% of all acquisition valuations are based uponmultiples.
Terminal value in discounted cash�ow valuations is quite oftenestimated using a multiple.
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Relative Valuation
Multiple Basics
Relative Valuation: Pros and Cons
Advantages:Summarizes complex data in easily understandable multiple.
Multiples summarize multiple pieces of �nancial information
Generally requires less explicit assumptions and informationthan discounted cash �ow valuation.More likely to re�ect the market perception and mood.
Disadvantages:Simple, but minimalistic
Multiples summarize and reduce multiple pieces of information
Multiples incorporate accounting limitations
Could even worsen limitations from biases in both numeratorand denominator of multiple
Anchors valuation on other �rms' market values, not on �rmfundamentals
Implicitly assumes comparables to be valued e�ciently
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Relative Valuation
Multiple Basics
Guidelines
Use the right peer group
Di�erences in multiples could be result of di�erences in �rmfundamentals (e.g., growth) rather than mispricing.De�ning the comparable universe and controlling fordi�erences is far more di�cult in practice than it is in theory.
Use forward-looking multiples
Consistent with the principles of valuation
Calculate multiples in a consistent manner
Di�erences in multiples could be result of di�erences inmeasurement or accounting distortion rather than mispricing
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Relative Valuation
Multiple Basics
Selecting Comparable Firms
A comparable �rm is one with cash �ows, growth protentialand risk similar to the �rm being valued.
Start with
Competitors/comparable �rms listed in the �rm's annualreports, analyst reports, credit rating agencies' reports,industry publicationsIndustry classi�cation system (e.g., SIC, GICS)Similar business model
Match on valuation fundamentals such as growth, ROIC, riskand cash �ow pro�le
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Relative Valuation
Multiple Basics
Forward Multiples
Forward-looking multiples are consistent with the principles ofvaluation
A company's value equals the present value of future cash�ow, not sunk costs.
Forward-looking earnings are typically normalized → theybetter re�ect long-term cash �ows by avoiding one-time pastcharges.
To build a forward-looking multiple:
Choose a forecast year for earnings that best represents thelong-term prospects of the business.Firms in periods of stable growth and pro�tability → nextyear's estimate.Firms generating extraordinary earnings (either too high or toolow) or for companies whose performance is expected tochange → use projections further out.
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Relative Valuation
Multiple Basics
Forward Multiples
Empirical evidence → forward-looking multiples are betterpredictors of value than historical multiples.
Liu et al. (2002), Equity valuation using multiples, Journal ofAccounting Research
Historical earnings-to-price (E/P) ratios had much higherstandard deviation compared to one-year forward E/P ratios(6.0 percent versus 3.7 percent).
Kim & Ritter (1999), Valuing IPOs, Journal of FinancialEconomics
Moving from multiples based on historical earnings tomultiples based on one- and two-year forecasts, the averagepricing error fell from 55.0 percent to 43.7 percent to 28.5percent, respectively, and the percentage of �rms valuedwithin 15 percent of their actual trading multiple increasedfrom 15.4 percent to 18.9 percent to 36.4 percent.
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Relative Valuation
Multiple Basics
De�ning Multiples
Consistency in calculating both the numerator anddenominator of the multiple
Both the value (the numerator) and the standardizing variable( the denominator) should be to the same claimholders in the�rm.Equity value should be divided by equity earnings, e.g., P/E,Firm value should be divided by �rm earnings, e.g.,EV/EBITDA
Multiples must be de�ned uniformly across all peers
If earnings based (book-value based) multiples are used, theaccounting rules to measure earnings (book value) should beapplied consistently across �rms.
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Relative Valuation
Multiples and Firm Fundamentals
Outline
1 Multiple Basics
2 Multiples and Firm Fundamentals
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Relative Valuation
Multiples and Firm Fundamentals
Multiples and Firm Fundamentals
Multiples are determined by �rm fundamentals:
variables that drive discounted cash �ow valuation: growth,risk and cash �ow patterns.
How do changes in these fundamentals change the multiple?
The relationship between a fundamental (like growth) and amultiple (such as P/E) is usually not linear.It is not possible to properly compare �rms on a multiple, if wedo not know how fundamentals and the multiple move.
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Relative Valuation
Multiples and Firm Fundamentals
Price-Earnings Ratio
P/E = Market price per share/Earnings per share
Deriving fundamentals:
P0 =Div1rE − g
(DDM)
→ P0
EPS1=Div1/EPS1rE − g
=Payout ratio
rE − g(1)
Determinants of P/E:
Growth → P/E increases with growth rateRisk → P/E decreases with riskPayout ratio → P/E increases with payout ratio
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Relative Valuation
Multiples and Firm Fundamentals
Price-Earnings Ratio
P0
EPS1=
Payout ratio
rE − g
g = (1− Payout ratio)ROE → Payout ratio = 1− g/ROE
→ P0
EPS1=
1− g/ROE
rE − g(2)
P/E increases as ROE increases
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Relative Valuation
Multiples and Firm Fundamentals
Pitfalls in P/E Analysis
P/Es mix capital structure and nonoperating items withexpectations of operating performance
Earnings include nonoperating items, such as restructuringcharges and write-o�s. Since many nonoperating items areone-time events, multiples based on P/Es can be misleading.
Large amount of discretion in managing earnings
Practice of using �exibility in accounting rules to improveapparent pro�tability of �rm
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Relative Valuation
Multiples and Firm Fundamentals
Price-to-Book
P/B = Market value of equity/Book value of equity
Determinants: ROE, growth rate, rE , payout ratio
P0 =EPS1 × Payout ratio
rE − g
=ROE × BV0 × Payout ratio
rE − g
→ P0
BV0=ROE × Payout ratio
rE − g
=ROE − g
rE − g
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Relative Valuation
Multiples and Firm Fundamentals
Enterprise Value to EBITDA
EV/EBITDA = (Market value of equity + Market value ofdebt - Cash)/EBITDA
Deriving fundamentals:
V0 =FCFF1
WACC − g
FCFF =EBIT (1− t)− (CAPEX − DA + ∆Working capital)
=(EBITDA− DA)(1− t)− (CAPEX − DA + ∆Working capital)
=EBITDA(1− t)− DA(1− t)− Reinvestment
→ V0
EBITDA=
(1− t)− DAEBITDA(1− t)− Reinvestment
EBITDA
WACC − g(3)
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