MODULE IN

VALUATION CONCEPTS & METHODS II

ACELEC 331
FACILITATORS
Maybel Lee Kua, CPA, MSBA in progress
Ma. Jennifer R. Marquez CPA,
Joseph R. Mendoza CPA, MBA

Department of Accountancy

SAMCIS

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 Module 3: RELATIVE VALUATION

FUNDAMENTAL PRINCIPLES OF RELATIVE VALUATION

The objective is to value assets, based upon how similar assets are currently priced in the market.
Relative valuation uses multiples, averages, ratios, and benchmarks to determine a firm’s value. A
benchmark may be selected by finding an industry-wide average, and that average is then used to
determine a relative value.

Two components of relative valuation

1. To value assets on a relative basis, prices have to be standardized, usually by converting prices
into multiples of earnings, book values or sales.
2. Looking for similar firms or comparable companies.

Reasons for Popularity

1. A valuation based upon a multiple and comparable firms can be completed with far fewer
assumptions and far more quickly than a discounted cash flow valuation.
2. A relative valuation is simpler to understand and easier to present to clients and customers than
a discounted cash flow valuation.
3. A relative valuation is much more likely to reflect the current mood of the market. Thus, relative
valuations will generally yield values that are closer to the market price than discounted cash
flow valuations.

Potential Pitfalls
The strengths of relative valuation are also its weaknesses.
the more na 1. The ease with which a relative valuation can be put together, pulling together a multiple and
madaming multiple
mas inconsistent a group of comparable firms, can also result in inconsistent estimates of value where key
variables such as risk, growth or cash flow potential are ignored.
values are too high 2. The fact that multiples reflect the market mood also implies that using relative valuation to
estimate the value of an asset can result in values that are too high, when the market is over
when market is over
too low kapag under
valuing comparable firms, or too low, when it is under valuing these firms.
3.
lack of transparency,
While there is scope for bias in any type of valuation, the lack of transparency regarding the
kasi namimili yung
analyst
underlying assumptions in relative valuations make them particularly vulnerable to
manipulation. A biased analyst who is allowed to choose the multiple on which the valuation
is based and to choose the comparable firms can essentially ensure that almost any value can
be justified.

Steps on relative valuation:

1. Identify an appropriate set of comparable assets and companies. Such “comps” maybe
chosen based on geography, industry and financial “size” Comparable companies should
have similar risks and potential returns.
2. Determine the metrics and multiples to be used.
3. Determine the relative value of the firm based on multiple of comparable companies.

Standardized Values and Multiples

Values can be standardized relative to the earnings firms generate, to the book value or
replacement value of the firms themselves, to the revenues that firms generate or to measures that
are specific to firms in a sector.

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 1. Earnings Multiples
One of the more intuitive ways to think of the value of any asset is the multiple of the
earnings last 4 quarters earnings that asset generates. When buying a stock, it is common to look at the price paid as
a multiple of the earnings per share generated by the company. This price/earnings ratio can
result ttm

be estimated using current earnings per share, yielding a current PE, earnings over the last 4
quarters, resulting in a trailing twelve months (TTM) PE, or an expected earnings per share in
the next year, providing a forward PE. It is important that when using P/E, for relative
valuation, the same earnings definition is used. If one uses a specific industry as “comps” the
industry average P/E is oftentimes used in computing for a relative value. For example, a
assume Company A trades for P50 in the stock market and has an EPS of P2. The P/E ratio is
computed by dividing P50 by P2, which is 25X. This is higher than the industry average of 20X,
which means Company A is overvalued. If Company A were trading at 20X its EPS, the
industry average, it would be trading at a price of P40, which is the relative value.

When buying a business, as opposed to just the equity in the business, it is common to
examine the value of the firm as a multiple of the operating income or the earnings before
interest, taxes, depreciation and amortization (EBITDA), thus the formula price per share
/EBITDA per share

2. Book Value or Replacement Value Multiples

Book value is determined by accounting rules and is heavily influenced by the original
price paid for assets and any accounting adjustments (such as depreciation) made since.
Investors often look at the relationship between the price they pay for a stock and the book
value of equity (or net worth) as a measure of how over- or undervalued a stock is; the
price/book value ratio that emerges can vary widely across industries, depending upon the
growth potential and the quality of the investments in each. When valuing businesses, you
estimate this ratio using the value of the firm and the book value of all assets (rather than just
the equity).

3. Revenue Multiples
Both earnings and book value are accounting measures and are determined by
advantage: accounting rules and principles. An alternative approach, which is far less affected by
nacocompare mo
agad sa market accounting choices, is to use the ratio of the value of an asset to the revenues it generates.
For equity investors, this ratio is the price/sales ratio (PS), where the market value per share is
divided by the revenues generated per share. For firm value, this ratio can be modified as the
value/sales ratio (VS), where the numerator becomes the total value of the firm. This ratio,
again, varies widely across sectors, largely as a function of the profit margins in each. The
advantage of using revenue multiples, however, is that it becomes far easier to compare
firms in different markets, with different accounting systems at work, than it is to compare
earnings or book value multiples.

4. Sector-Specific Multiples
While earnings, book value and revenue multiples are multiples that can be
computed for firms in any sector and across the entire market, there are some multiples that
are specific to a sector. For instance, when Internet firms first appeared on the market in the
later 1990s, they had negative earnings and negligible revenues and book value. Analysts
looking for a multiple to value these firms divided the market value of each of these firms by
the number of hits generated by that firm’s web site. Firms with a low market value per
customer hit were viewed as more undervalued. More recently, e-tailers have been judged
by the market value of equity per customer in the firm, regardless of the longevity and the
profitably of the customers. While there are conditions under which sector-specific multiples
can be justified, they are dangerous for two reasons. First, since they cannot be computed for
other sectors or for the entire market, sector-specific multiples can result in persistent over or
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 under valuations of sectors relative to the rest of the market. Thus, investors who would never
consider paying 80 times revenues for a firm might not have the same qualms about paying
$2000 for every page hit (on the web site), largely because they have no sense of what high,
low or average is on this measure. Second, it is far more difficult to relate sector specific
multiples to fundamentals, which is an essential ingredient to using multiples well. For instance,
does a visitor to a company’s web site translate into higher revenues and profits? The answer
will not only vary from company to company, but will also be difficult to estimate looking
forward.

Illustrative Example: The following information were gathered from the financials sector of the
Philippine stock exchange. The market prices of shares were the closing prices on July 5, 2021. All
other information is from the audited annual reports for the year ending December 31, 2020
submitted by the companies to the PSE.

FINANCIALS
Source: edge.pse.com.ph
MARKET
SHARES BOOKVALUE
PRICE REVENUE EPS (basic)
OUTSTANDING per SHARE
07/05/21
BDO 114.30 4,384,578,215.00 212,241,000,000.00 6.37 88.11
BPI 89.40 4,513,101,605.00 101,923,000,000.00 4.74 62.01
CHINA BANK 25.55 2,685,899,812.00 43,853,635,000.00 4.49 39.08
EAST WEST 10.66 2,249,975,411.00 33,383,355,000.00 2.89 24.89
METROBANK 49.50 4,497,415,555.00 121,900,000,000.00 3.08 72.10
PNB 22.75 1,525,764,850.00 57,665,597,000.00 1.71 100.44
RCBC 21.00 1,935,628,896.00 37,913,000,000.00 2.43 44.89
SECURITY BANK 124.00 753,538,887.00 50,372,594,000.00 9.86 163.50
UNION BANK 77.00 1,219,362,818.00 38,577,694,000.00 9.48 86.31

Assuming that all the nine banks listed in the financials sector of the PSE are “comps”, compute for the
relative value of BDO under the following independent cases. Based on the computed relative value,
determine if an investor should buy BDO at the closing price on July 5, 2021.

Case 1: Price/Earnings ratio

Company PRICE EPS (basic) P/E ratio
BPI 89.40 4.74 18.86
CHINA BANK 25.55 4.49 5.69
EAST WEST 10.66 2.89 3.69
METROBANK 49.50 3.08 16.07
PNB 22.75 1.71 13.30
RCBC 21.00 2.43 8.64
SECURITY BANK 124.00 9.86 12.58
UNION BANK 77.00 9.48 8.12

AVERAGE 10.87

MEDIAN 10.61

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 The price per share is divided by the TTM EPS to compute for the P/E ratio for each company. After
which, an average P/E ratio is computed. Some analysts prefer to use the median ratio to lessen the
impact of outliers. For this example, the average P/E ratio is used. Such ratio is called a “fair ratio” which
is then used to compute for a relative value.

EPS of BDO 6.37

Multiply by: fair ratio 10.87
Relative value of BDO 69.24

To compute for the relative value of BDO, the EPS is multiplied by the “fair ratio” which results to a
relative value of P69.24 per share. This computed relative value is then compared to the current share
price, which in this case is P114.30. Since the current price of P114.30 is higher than the relative value
of P69.24, then BDO shares are deemed to be overvalued. This means that an investor should not buy
BDO shares at P114.30.

Another way of looking at the “fair ratio” is to compare it to the P/E ratio of BDO.

BDO Price/share 114.30

Divide by: EPS 6.37
P/E ratio of BDO 17.94

The “fair ratio” of comparable companies (or industry average) is 10.87 while the P/E of BDO is 17.94.
The higher P/E ratio of BDO means that it’s shares are more expensive than that of the comps. Hence,
an investor should not buy at P114.30.

Case 2: Price/Book value ratio

BOOKVALUE
Company PRICE per SHARE P/B ratio
BPI 89.40 62.01 1.44
CHINA BANK 25.55 39.08 0.65
EAST WEST 10.66 24.89 0.43
METROBANK 49.50 72.10 0.69
PNB 22.75 100.44 0.23
RCBC 21.00 44.89 0.47
SECURITY BANK 124.00 163.50 0.76
UNION BANK 77.00 86.31 0.89

AVERAGE 0.69

MEDIAN 0.67

The price to book ratio for each company is computed by dividing the price per share by the book
value per share. An average “fair ratio” is then computed for the sector. Just like the P/E ratio, analyst
may use the median rather than the average PB ratio. For this example, the average PB ratio is used
for relative value computation.

Bookvalue/share of BDO 88.11

Multiply by: fair ratio 0.69
Relative value of BDO 61.18
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 Using the “fair ratio”, the relative value of BDO is computed by multiplying it by the book value per
share of BDO to arrive at P61.18. This relative value is less than the current market price, thus BDO shares
are overvalued. On that basis, an investor should not buy BDO shares at P114.30. If a specific relative
value is not needed, a simple comparison between the P/B ratio of BDO as against the “fair ratio” of
the sector may be done to over/undervaluation.

BDO Price/share 114.30

Divide by: Bookvalue/share 88.11
P/B ratio of BDO 1.30

The computed P/B ratio of BDO is 1.30 which is higher than the “fair ratio” of 0.69. This indicates an
overvaluation; thus, an investor should not buy BDO shares at P114.30. It is interesting to note that the
“fair ratio” is below 1 which may mean market prices in the sector are generally undervalued. On the
other hand, this may lead back to a limitation in the use of book values because of its dependence
on historical costs.

Case 3: Price/Sales ratio

SHARES MARKET REVENUE
REVENUE
Company PRICE OUTSTANDING CAPITALIZATION PER SHARE P/S ratio
BPI 89.40 4,513,101,605.00 403,471,283,487.00 101,923,000,000.00 22.58 3.96
CHINA BANK 25.55 2,685,899,812.00 68,624,740,196.60 43,853,635,000.00 16.33 1.56
EAST WEST 10.66 2,249,975,411.00 23,984,737,881.26 33,383,355,000.00 14.84 0.72
METROBANK 49.50 4,497,415,555.00 222,622,069,972.50 121,900,000,000.00 27.10 1.83
PNB 22.75 1,525,764,850.00 34,711,150,337.50 57,665,597,000.00 37.79 0.60
RCBC 21.00 1,935,628,896.00 40,648,206,816.00 37,913,000,000.00 19.59 1.07
SECURITY BANK 124.00 753,538,887.00 93,438,821,988.00 50,372,594,000.00 66.85 1.85
UNION BANK 77.00 1,219,362,818.00 93,890,936,986.00 38,577,694,000.00 31.64 2.43

AVERAGE 1.75

MEDIAN 1.70

The price to revenue ratio is computed by dividing the price per share by the revenue per share OR
dividing market capitalization by the total revenue of a company. Either way, the resulting P/S ratio
will be the same. In the example, the individual P/S ratio of the “comps” are computed. Then an
average (or median depending on the analyst) P/S is computed for the sector. The resulting “fair ratio”
is used to compute to the relative value of BDO. Note that the average P/S ratio will be used in this
illustration.

Revenue/share of BDO 48.41

Multiply by: fair ratio 1.75
Relative value of BDO 84.90

The computed relative value of BDO is P84.90 which is lower than the current price of P114.30. Hence,
the investor should not buy the BDO share at the current price. This recommendation is also supported
when the P/S ratio of BDO is compared to the “fair ratio.”

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 BDO Price/share 114.30
Divide by: Revenue/share 48.41
P/S ratio of BDO 2.36

The P/S ratio of BDO is higher than the “fair ratio” which indicates that BDO is more expensive that the
shares of comparable companies.

Overall Analysis:
The illustrative problem considered the different cases as independent of each other, however, it is
noteworthy that the 3 multiples resulted to the same recommendation, and that is, that the current
share price of BDO is expensive. Not included in the example are sector specific multiples. For the
banking industry, the ratios that include size of loans of the size of deposits can be used in relative
valuation.

Key Takeaways:

It is important to bear in mind that relative valuation, whatever multiples are used, has its limitations.

• First and foremost, would be the definition of multiples. In the foregoing example, the price
used is the closing price on July 5, 2021 and all other information came from the annual report
for the year ending December 31, 2020. This is a difference of six months where other factors in
the companies or economic developments may have been “priced in” by the market through
the share price but understandably not part of the historical information. The historical data
were used for purposes of uniformity.

• Comparable companies must be comparable. It is easy enough to expect that a bank is

comparable to another bank. This, however, is not always true. Choosing or looking for true
“comps” to the subject company is a real challenge. In the example, the “comps” were
considered such because they are all listed as representatives of the financial sector in the PSE.
Under closer scrutiny, the risks and growth rate of those banks as compared to the subject
company for valuation were not included as criteria. This “oversight” may easily be reason
enough to say that the results of valuation is wrong and worthless.

• Another concern is the source of information. In the example, all information came from PSE
edge since all of the “comps” and even the subject company, BDO, are all listed in the
Philippine Stock Exchange. Even so, information may vary depending on the source. At times,
even if the same source is used, information may have discrepancy because of factors that
are not fully disclosed in the reports.

• Consistency is key. With the multitude of sources of information and the countless ways of
considering the factors of multiples, consistency or lack thereof is likely to have a profound
effect on the results of relative valuation.

• Relative valuation is not true value. It does not purport to measure or give the true value of a
firm. It is after all susceptible to the biases of the market (because of the use of share prices)
and even the biases of the analyst (because of the selection of the “comps” and multiples)
undertaking the valuation. Be that as it may, relative valuation gives a context to the
expectations of stakeholders from a company. When the “results” of a company is compared
to that of its peers, this gives a clearer picture of the value of a firm to its stakeholders.

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