Ch9 Relative Valuation

Question 1

Relative Valuation Essence

Answer 1

The value of an asset is found by using values placed on similar, or comparable, assets by other market participants

Question 2

Process of Relative Valuation

Answer 2

1. Identify comparable assets and get their market values.
2. Convert market values to standardized values (price multiples).
3. Compare the standardized value/multiple of the asset being analyzed to comparables, adjusting for differences, to judge if it’s under or over valued.

Question 3

Reasons for Popularity of Relative Valuation

Answer 3

1. Low information requirements.
2. Easy to communicate.
3. Identifies potentially mispriced securities (under/over-valued).

Question 4

Multiples - Standardized Estimates of Price

Answer 4

Multiples standardize value by dividing a numerator (equity value or asset value) by a denominator.
* Numerators: (i)
Equity value or (ii) Asset value.
* Denominators:
Earnings:
Book Values
Revenues
Industry-Specific Variables

Question 5

Steps for Correctly Using Multiples

Answer 5

1. Define the multiple: Understand how the multiple is calculated (e.g., past, current, or expected variables). Different definitions exist (e.g., PE ratio based on trailing vs. forward EPS)
2. Describe the multiple: Know the typical range or cross-sectional distribution of the multiple to judge if a value is high or low. (Example shown for PE ratio distributions).
3. Analyze the multiple: Understand the fundamental drivers that influence the multiple and the relationship between the multiple and these variables
4. Apply the multiple: Accurately define the universe of comparable firms and control for differences between the firms and the asset being valued. This is challenging in practice.

Question 6

Earnings Multiples

Answer 6

Price/Earnings Ratio (PE)
Value/EBIT
Value/EBITDA
Value/Cash Flow

Question 7

Book Values Multiples

Answer 7

Price/Book Value (PBV)
Value/Book Value of Assets
Value/Replacement Cost (Tobin’s Q)

Question 8

Revenues Multiples

Answer 8

Price/Sales per Share (PS)
Value/Sales

Question 9

Industry-Specific Multiples

Answer 9

Price/kwh
Price per ton of steel
Price per customer
price per click

Question 10

Earnings Multiples: Price-to-Earnings Ratio (PE Ratio)

Answer 10

Market Price per Share / Earnings per Share
Price: Usually current price, sometimes average

◦ Growth (g): Higher growth firms tend to have higher PE ratios (all else equal).
◦ Risk (r, cost of equity): Higher risk firms tend to have lower PE ratios (all else equal).
◦ Reinvestment Needs (related to payout ratio): Firms with lower reinvestment needs (higher dividend payouts) tend to have higher PE ratios (all else equal)

Question 11

Revenue Multiples: Price-to-Sales Ratio (PSR) and Value-to-Sales Ratio (VSR)

Answer 11

Consistency Issue: The PSR is considered internally inconsistent because it divides an equity value measure (market value of equity) by a firm-level cash flow measure (total revenues).

• PSR Determinants: Derived from a valuation model, PSR is influenced by:
  ◦ Payout Ratio.
  ◦ Net Profit Margin [(Net Profit after Taxes)/Sales].
  ◦ Growth Rate (g).
  ◦ Cost of Equity (r).
  ◦ Higher Net Profit Margins lead to higher PSRs (all else equal).

Question 12

Value-to-Sales Ratio (VSR): Market Value of the Firm / Total Revenues

Answer 12

Market Value of the Firm = (Market Value of Equity) + (Market Value of Debt) - Cash. The VSR is considered more consistent than PSR as it relates the total firm value to total firm revenue.

Question 13

Industry-Specific Multiples

Answer 13

Value can be standardized using multiples specific to an industry’s key drivers.
- Value per Subscriber
- Value per Customer
- Value per Site Visitor
- Value per commodity unit

Question 14

Choosing Among Multiples

Answer 14

Multiple potential multiples can be used. Relative valuation can be compared to a sector or the entire market

Question 15

Methods for choosing/combining multiple valuations:

Answer 15

1. Use a simple average.
2. Use a weighted average based on precision (e.g., 1/Standard Error).
3. Choose one multiple based on:
   ▪ Industry standard.
   ▪ Statistical fit (e.g., R-squared in regressions on fundamentals).
   ▪ Highest correlation with market values (e.g., in the social media example, number of users showed high correlation with market cap and enterprise value)

Question 16

Caveats when using relative valuation:

Answer 16

◦ Check for consistency between the numerator (equity vs. entity) and denominator.
◦ Check for consistency in computation (past, current, forward values).
◦ Account for fundamental drivers (risk, growth, etc.) when comparing.
◦ Don’t choose multiples randomly; use information on estimation precision or statistical fit.