Valuation using multiples

Abstract

In the last chapter, we demonstrated how an analyst can estimate the intrinsic value of a firm usingDCF methods like the Free Cash Flowto Firm approach, the Adjusted Present Value method, and the Capital Cash flow methods. Quite often analysts are also interested in knowing whether a stock is over or under-valued vis-a-vis the industry or some peer group. The objective of relative valuation is to find out whether a stock is relatively over or undervalued but not in an absolute sense. That is, it is quite possible for a stock to be relatively undervalued compared to some benchmarks but over valued when compared to its own intrinsic value as estimated using the DCF methodology. Price multiples are a useful way to compare the valuation of a stock over time, against "comparable companies" or the market as a whole. These multiples are a ratio of the stock's current market capitalization to one of its underlying accounting fundamentals such as book value (total owners' equity), sales or net income. Because investors are usually more familiar with share price rather than market capitalization (share price-shares outstanding) the accounting fundamentals are often converted to a per-share basis when using price multiples. Ratios are very popular with investors because they can be calculated easily, and they are readily available from most financial Web sites and newspapers. While valuation ratios have become ubiquitous, it is important to recognize their strengths and weaknesses. Valuation ratios are handy tools to have at your disposal for a quick-and-dirty analysis, but they all require a lot of context to be useful. The most common price multiples are the following: • P/E = (share price)/(earnings per share). Since earnings are meant to approximate the money available to shareholders, the P/E ratio expresses how much the investor pays for each dollar of earnings. This is the most frequently used price multiple. • P/B = (share price)/(book value per share). This compares the value of the firm today with the capital provided to the company over time. • Price to sales (P/S)= (share price)/(sales per share). This ratio can be useful for valuing cyclical companies where earnings tend to be more volatile than sales, or situations in which a firm temporarily has little or no earnings. Exhibit 11.1 presents some commonly used multiples. A high multiple indicates that the market is wiling to pay a high price relative to the underlying fundamental value such as earnings. A company may trade at a high multiple because it has high growth prospects and future earnings are expected to be higher than past earnings. A low multiple indicates that that the stock is not valued highly - perhaps it has low growth prospects, high risk or is simply undervalued by the market. Value investors tend to search for companies trading at lower multiples than peer companies. © 2009 Springer-Verlag Berlin Heidelberg.