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A relative valuation model estimates an assets value relative to that of another asset.
Relative valuation is typically implemented using price multiples (ratios of stock price to a
fundamental such as cash flow per share) or enterprise multiples (ratios of the total value of
common stock and debt net of cash and short term investments to certain of a companys
operating assets to a fundamental such as operating earnings).
Relative Valuation
Framework of relative valuation: Key questions to be answered:
What accounting issues affect particular price/ enterprise value multiples and how to address
them
How do price multiples relate to fundamentals, such as earnings growth rates, and how can
this information be used when making valuation comparisons among stocks?
Method of Comparables:
Multiply the companys fundamentals like earnings, EBIDTA etc with the benchmark, or
compare the multiple with the benchmark multiple.
Compute a justified multiple and compare with the multiple based on current market price.
Relative Valuation
Price Multiples:
Price to Earnings:
Why P/E?
Earnings are chief drivers of investment value and P/Es may reflect differences in growth
and return on investment
Key considerations:
Consider the potential dilution in EPS so use diluted EPS, (eg. BFSI, IT/ITES, Pharma,
Construction & Real estate)
HDFC
EARNINGS PER SHARE
Bank
Basic EPS (Rs.) 57.18 48.84 42.00 35.47 28.49
Diluted EPS (Rs.) 56.43 48.26 42.00 35.21 28.18
EARNINGS PER SHARE Dr. Reddys
Basic EPS (Rs.) 83.05 79.42 99.00 114.00 75.00
Diluted EPS (Rs.) 82.88 79.14 98.00 113.00 74.00
Relative Valuation: P/E ratio
Trailing P/E ratio
Annual
Year 31 March 30 June 30 September 31 December
Estimate
2013 0.21 0.24 0.25 0.18 0.88
2014 0.20 0.19
On 9 August 2014, ANZ closed at $12.20. ANZs fiscal year ends on 31 December. As of 9 August 2014, solve the
following problems by using the information
1. Calculate trailing P/E based on the past four quarters of EPS.
2. Calculate BYDs TTM P/E.
3. Calculate BYDs trailing P/E based on a fiscal-year definition.
Identify core earnings for the company: Adjust for non-recurring components
Eg. Gains and losses from sale of assets, asset write downs, goodwill impairment, provisions
for future losses, changes in accounting estimates. Eg Tata Motors
Relative Valuation: P/E ratio
Relative Valuation: P/E ratio
Moldovosky effect
Normalize EPS: Use historical average over the most recent full cycle, use average ROE and multiply it with
current book value per share.(using recent book value reflects to effect of EPS growth or shrinkage on
companys size)
Do adjustments to earnings:
For zero earnings, P/E ratio cannot be calculated, for negative or low earnings use Normalized EPS or inverse
P/E
High leverage
Relative Valuation: P/E ratio
Calculating P/E
You are calculating a trailing P/E for American Electric Power (NYSE: AEP) as of November 9, 2001, when the share
price closed at $44.50. In its fiscal year ended December 13, 2000, AEP recorded EPS of $0.83 that included an
extraordinary loss of 0.11. Additionally, AEP took an expense of $203 million for merger costs during that calendar
year, which are not expected to recur, and had unusual deficits in two out of four quarters. As of November 2001, the
trailing 12 months EPS was $2.16, including three quarters in 2001 and one quarter in 2000. The fourth quarter of
calendar year 2000 had $0.69 per share in nonrecurring expenses. (Assume the charges are post tax)
PHG, Europes largest electronics company, as of the beginning of November 2001. On November 8, 2001, PHG stock closed at
$25.72. PHG experienced a severe cyclical contraction in its Consumer Electronics division in 2001, resulting in a loss of $1.94 per
share; you thus decide to normalize earnings. You believe the 19952000 period (which excludes 2001) reasonably captures average
profitability over a business cycle. Table 4-1 supplies data on EPS, book value per share (BVPS), and return on equity (ROE).
Annual
Year 31 March 30 June 30 September 31 December
Estimate
2013 0.01 0.00 E(0.01) E(0.05) (0.05)
2014 E0.07 E0.08 E0.03 E(0.03) 0.15
On 9 August 2013, BYD closed at $13.50. BYDs fiscal year ends on 31 December. As of 9 August 2013, solve the
following problems by using the information
1. Calculate BYDs forward P/E based on the next four quarters of forecasted EPS.
2. Calculate BYDs NTM P/E.
3. Calculate BYDs forward P/E based on a fiscal-year definition and current fiscal year (2013) forecasted EPS.
4. Calculate BYDs forward P/E based on a fiscal-year definition and next fiscal year (2014) forecasted EPS.
Relative Valuation: P/E ratio
Valuation based on fundamentals
FPL Group (NYSE: FPL) is a southeastern U.S. utility. Jan Unger, a utility analyst, forecasts a long-term earnings
retention rate (b) of 50 percent and a long-term growth rate of 5 percent. Unger also calculates a required rate of return
of 9 percent. Based on Ungers forecasts of fundamentals and the equation above, FPLs what is its justified leading
P/E?
Relative Valuation: P/E ratio
P/E based on cross sectional regression
Regress past P/E with Dividend Payout Ratio, Beta, Expected Growth Rate
Sector Benchmark (median, including the average P/E of the subject company)
If subject company has higher than average earnings growth, it may have a higher P/E than benchmark which is justified eg
Asian Paints, Kajaria ceramics Avenue supermart (P/E growth)
If subject company has higher than average risk, it may have a lower P/E than benchmark which is justified
https://in.investing.com/indices/cnx-high-beta-components
G P/E PEG
In most accounting standards book value reflects the historical price net of accumulated depreciation.
Misleading when the level of assets differ among the companies or companies follow different business models.
Certain intangible assets like human capital may be more important but not reflected in balance sheet.
Intangible assets generated internally may not be shown in the balance sheet of the company.
Relative Valuation: Price/Book value
Share repurchases or issuance can distort historical comparison, make the stock appear more expensive than historical.
Be careful while using P/B ratios compare P/BV w.r.t differences in ROE and growth
Drawbacks
Sales may be there but no cash flows or earnings
Price-post financing, sales pre-financing; logical mismatch.
P/S does not reflect differences in cost structures
Distorted by revenue recognition practices.
Justified P/Sales
Relative Valuation: EV/EBIDTA
EV defined
Drawbacks:
FCFF may be better than EBIDTA as EBIDTA does not reflect working capital
expenditure.
Does not directly reflect capex and only covers it to the extent of depreciation
Hotels: Rooms
FIs: NAV, BV
Power: EV/MW
Using Multiples for Valuation
Case of Talbros