Relative Valuation

RT
 Relative valuation model
• Relative valuation model
– Asset valued based on market pricing of similar
assets
• Most widely adopted valuation model in
practice
– Easy to use, but also easy to misuse!
– Most investment thumb rules based on multiples
– Less time and resource intensive
– Reflects current market sentiments
 Contd...
• Relative valuation technique
– Find comparable assets that are priced by market
• Comparable in terms of risk, growth and cash flow potential
• Common proxies ~ firm size, life cycle, sector / industry
– Scale market prices to a common variable to generate
standardized prices that are comparable
• Equity values for equity multiples
• Firm values for value multiples
– Adjust for differences across assets
• Accounting differences; differences in fundamentals
Standardized Values and Multiples
• Earnings multiples
– Price-earnings (current P/E, trailing P/E, forward P/E)
• Book value or replacement value multiples
– Price-to-book ratio, Tobin’s Q
• Revenue multiples
– Price-to-Sales ratio
• Sector specific multiples
– Price-to-hits ratio, Price-to-subscriptions ratio
 Issues in Multiples Based Valuation

• Consistency in using multiples for valuation

– If numerator is equity value, denominator should
also be equity value
• Numerator ~ Share price or market value of equity
• Denominator ~ EPS, net income, book value of equity
– If numerator is firm value, denominator should
also be firm value
• Numerator ~ Enterprise value or firm value
• Denominator ~ EBIT, EBITDA, book value of capital
 Contd...
• Differences in accounting standards
– May affect earnings and book value numbers
differently even for similar firms
• Differences in depreciation, expense or revenue recognition
• Effect of outliers
– Positively skewed distributions ~ mean > median
• Biases in multiples estimation
– Negative P/E ratios not meaningful, hence ignored
– Upward bias in average P/E ratio due to elimination
 Scaling Variables for Equity Multiples

• Equity earnings variables

– Net Income, Earnings Per Share
• Equity cash flow measures
– Dividends, Free Cash Flow to Equity
• Equity book value measures
– Book value of equity
• Revenue measures
– Sales
 Common Equity Multiples
• Price-Earnings Ratio (P/E)
– P/E = Market value of equity / Net income
– P/E = Share price / Earnings per share
– Current P/E, trailing P/E, forward P/E
– Skewed distribution of P/E ratios
• Negative P/E ratios not meaningful, hence ignored
• PEG Ratio
– PEG Ratio = P/E ratio / Expected earnings growth rate
– Helps portfolio manager to identify undervalued stocks
 Contd...
• Price-to-Book Ratio
– P/B ratio = Market value of equity / BV of equity
– Affected by accounting conventions
• Price-to-Sales Ratio
– Price-to-Sales ratio = Market value of equity / revenues
– Widely used, although inconsistent
– Revenues almost always positive, easily available
• Price-to-Cash Flow Ratio
• Price/FCFE = Market value of equity / FCFE
 Example 1
• XYZ company’s current net income is $25m.
Comparable firms in the same industry are
trading at an average current P/E ratio of 15x.
The company currently has 2,50,000 shares
outstanding. Calculate value of equity.
 Answer
• Value of equity
P/E = Price / EPS
P/E = Equity value / Net Income
=> 15 = Equity value / 25000000
=> Equity value = 15 x 25000000 = 375000000
=> Equity value per share = 375000000 /250000
= $1500/share
 Example 2
• XYZ company’s current net income is $25m.
Comparable firms in the same industry are
trading at an average trailing P/E ratio of 12x.
The company currently has 2,50,000 shares
outstanding. Calculate value of equity.
 Answer
• Value of equity
P/E = Price / EPS
P/E = Equity value / Net Income
=> 12 = Equity value / 25000000
=> Equity value = 12 x 25000000 = 300000000
=> Equity value per share = 300000000/250000
= $1200/share
 Example 3
• XYZ company’s management has forecasted
the net income of the firm as $10m in the next
financial year. Comparable firms in the same
industry are trading at an average P/E ratio of
25x. The company currently has 2,50,000
shares outstanding. Calculate valuation of
equity.
 Answer
• Value of equity
P/E = Price / EPS
P/E = Equity value / Net Income
=> 25 = Equity value / 10
=> Equity value = 25 x 10000000 = 250000000
=> Equity value per share = 250000000/250000
= $1000/share
 Venture Capital Method of Valuation
• Venture Capital Method
– Commonly used in private equity industry
– Uses multiple at a future time, to arrive at exit value
– Exit (or terminal) value discounted back to present
value
• Hurdle rates ~ 40% – 75%, reflecting riskiness of
investment
– Discounted terminal value and size of proposed
– investment gives desired ownership interest in
company
 Contd...
• 1. Calculate Terminal Value
– Equity or Value multiples
• P/E ratio X Projected net income in exit year
– Discounted Cash Flow (DCF) method
• 2. Calculate Discounted Terminal Value
– Use hurdle rate for discounting
• Yield required by VC for compensation of risk and effort
– DTV = Terminal Value / (1 + hurdle rate)yrs
 Example 4
• Vijay is a partner in a venture capital firm. He is
planning to invest $5m in a tech start up firm.
The company management has forecasted the
net income of the firm as $20m in year 7. Few
profitable tech firms are trading at an average
P/E ratio of 15x. The company currently has
500,000 shares outstanding. Vijay believes that
hurdle rate of 50% is required for a venture of
this risk. Calculate value of equity.
 Answer
• Discounted Terminal Value (DTV)
Terminal value = P/E x Forecasted net earnings
= 15 x $20m = $300m
Current value = Terminal Value / (1 + Target)^yrs
= 300 / (1 + 50%)^7 = $17.5m
• Reqd. % Ownership = Investment / DTV
= 5 / 17.5 = 28.5%
 Common Value Multiples
• EV/EBITDA
– EV/EBITDA = Enterprise Value / EBITDA
• EV/EBIT
– EV/EBIT = Enterprise Value / EBIT
• EV/Book Value of Capital
– Enterprise Value / Book Value of Capital
• EV/Sales
– Enterprise Value / Sales
• EV = (Market Value of Equity + Market Value of
Debt) – Non-Operating Cash + Market value of
minority interests

• Approximation:-
• EV = (Market Value of Equity + Market Value of
Debt) – Non-Operating Cash
 Determinants of Equity multiples
• P/E ratio: Exp. Growth rate, payout, risk

• P/BV ratio: Exp. Growth rate, payout, risk, ROE

• P/S ratio: Exp. Growth rate, payout, risk, net

margin
 Estimating P/E of target company using
regression
Sl. Company P/E ratio Exp. Growth Risk (Beta) Payout ratio
No. rate (%) (%)

1 Accenture ltd 16.12 19.34 1.2 40

2 Adobe systems 13.68 25.62 1.5 30

.. ............. ... ... ... ...

.. ............. ... ... ... ...

50 BearingPoint 27.34 30.25 1.65 50

• P/E = 6.75 + 113.10*EGR – 0.919*Beta +
7.33*POR

• For instance, a firm with an EGR of 12%, a beta

of 1.2, and a payout ratio of 20% will have a
predicted P/E ratio:-
= 6.75 + 113.1*0.12 – 0.919*1.2 + 7.33*0.2
= 20.68
• If the net income is $100m
• Value of equity = P/E * NI
= 20.68 * $100m
= $2068m
If outstanding shares are 500000
Price/share = 2068000000 / 500000
= $4136
Say, current price = $3500
• Thank you