Section 9
Firm valuation:
Price multiples
’A little inaccurancy sometimes saves tons of explanation.’
--H.H. Munro
1
Learning objectives
After studying this chapter, you will understand
•
•
•
•
How to use price multiples in firm valuation
Main problems in using price multiples
Ways to address the problems in using price multiples
Links between price multiples and firm fundamentals
2
Price multiples
• In Section 2, we calculated P/E- and P/B-ratios from pershare numbers to
– Show the link between accounting numbers and stock prices
– Calculate the expected return of a stock
• Price multiples are many, and they can be used for
more comprehensive valuation analysis
• Price multiples are also linked to valuation models
• Valuation based on price multiples is called relative
valuation
3
Relative valuation: what does it mean?
• Definition
– The value of the firm (a target firm) is estimated by looking at
how the market prices similar or comparable firms
• Philosophical basis
– The value of the firm is whatever the market is willing to pay for
it given its financial characteristics like earnings, book equity or
sales
• Information needed
– A group of similar or comparable firms
– Average (median) value of the price multiples of similar or
comparable firms
4
– Typically, price multiples
like P/E- or P/B-ratio are used
Relative valuation: how to do it?
1. Identify comparable firms that have similar operations
to the firm whose value you are calculating
– Operate in the same industry or otherwise have similar
business models
2. Calculate price multiples for the comparable firms by
using their financial statement numbers and current
stock price
– Earnings, book value, sales
3. Apply these multiples to the corresponding measures
for the target to get its intrinsic value
– Example: P(target) = EPS(target) × P/E(comps)
3-5
Example on relative valuation:
Dell, Hewlett Packard, and Lenovo, 2008
Relative valuation: some considerations
• Use financial statement numbers consistently when
calculating price multiples
– Use exactly the same financial statement numbers for target
firm and for all comparable firms
– For example, the same earnings numbers must be used for all
firms when calculating P/E ratio
– What if accounting methods are different for comps and
target?
– What about negative denominators?
• Conceptual problem: circular reasoning
– Firm value is calculated from the market values of the comps
7
Many ways to calculate P/E-ratios
• There are a number of variants on the P/E-ratio based
upon how the price and the earnings are defined
• Price
– Usually the current price (though some like to use average
price over last 6 months or year)
• EPS
– EPS in most recent fiscal year (current)
– EPS in most recent four quarters (trailing)
– EPS expected in next fiscal year or next four quarters (both
called forward)
– EPS in some future year
– EPS in many past fiscal years
– Some combination of all these…
8
Price-Book ratio
• Recall from Section 2 that P/B ratio is calculated by dividing
stock price (P) by the book value of equity per share (BPS):
P/B = P/BPS
• Abnormal earnings model (we will dicuss it in Section 10):

( ROEt  rE ) Bt 1
Equity value  P0  B0  
t
(
1

r
)
t 1
E
• Dividing by B0, we get:
9
Bt 1
(
ROE

r
)
t
E

B0
P0
 1 
B0
t 1
(1  rE )t
Price-Book ratio
Implications:
•
P/B ratio is directly related to the future abnormal earnings,
i.e. the difference between forecasted ROE and the cost of
equity
•
Forecasted ROE equals the cost of equity:
– P = B  P/B = 1
Forecasted ROE is greater than the cost of equity:
– P > B  P/B > 1
Forecasted ROE is less than the cost of equity:
– P < B  P/B <1
•
•
10
Links between P/E, P/B and ROE
P
P
E
P
PB 
 
  ROE
BPS E BPS E
P
PB
 
E ROE
• P/B ratio increases with ROE
– P/B as such is not indicative of the firm value without
considering ROE
• P/E ratio is the ratio of P/B ratio to ROE
– P/E ratio indicates the current valuation of the firm relative to
its profitability
11
Links between P/E, P/B and ROE
• Value of the firm having high ROE should be higher than
that of the firm having low ROE
 Simple investment strategy
– Buy firms having low P/B ratios and high ROE
– Sell firms having high P/B ratios and low ROE
• Some empirical evidence from Helsinki Stock Exchange
– P/B vs. ROE calculated by using analysts’ EPS forecasts
– P/B vs. ROE calculated by using EPS from previous year
– What can you learn from these two graphs?
12
Example: P/B-ratio and forecasted ROE for
firms listed in Helsinki Stock Exchange
10,00
9,00
8,00
7,00
6,00
P/B 5,00
4,00
3,00
2,00
1,00
0,00
0,00
10,00
20,00
30,00
ROE
40,00
50,00
60,00
Example: P/B-ratio and previous year’s ROE
for firms listed in Helsinki Stock Exchange
10,00
9,00
8,00
7,00
6,00
P/B 5,00
4,00
3,00
2,00
1,00
0,00
0,00
10,00
20,00
30,00
ROE
40,00
50,00
60,00
Lots of price multiples…
• Denumerator of the multiple can be based on:
• Earnings
–
–
–
–
Price/Earnings Ratio (PE) and its variants (PEG)
Enterprise value/EBIT
Enterprise value/EBITDA
Enterprise value/Cash Flow
• Book value of the asset
– Price/Book Value (of Equity) (PB)
– Value/ Book Value of Assets
– Value/Replacement Cost (Tobin’s Q)
• Revenues generated by the asset
– Price/Sales per Share (PS)
– Value/Sales
• Asset or industry specific variables (Price/kwh, Price per
ton of steel ....)
15
Example: Valuation of Novo Nordisk based on
price multiples as of May 5, 2014 by Nordea
16
EV/EBIT-ratio
• EV/EBIT = Enterprise value (EV) / Earnings before
interest and taxes (EBIT)
• Enterprise value (EV) = Market value of equity + Net
value of debt
• Net value of debt is calculated as we have done it:
Interest bearing debt
- Financial assets
= Net value of debt
17
Price-Sales Ratio (P/S)
• P/Sales ratio is calculated as follows:
P/S = Stock price / Sales per share
= Market value of equity / Sales
• P/S ratio is commonly used despite its deficiencies
– By relying on sales, it neglects all the costs need to generate
sales
– Firm having a high level of sales can be deeply unprofitable
18
Summary
• Valuation based on price multiples is called relative
valuation
• Price multiples can be defined in numerous ways
• Selection of the group of comparable firms is essential
in relative valuation
• Relative valuation can give very strange results
19