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Relative Valuation

Relative valuation is based on the principle that similar assets should sell at similar prices. It involves analyzing the company to be valued, selecting comparable companies, choosing valuation multiples, calculating the multiples for comparable companies, and then using the comparable company multiples to value the company. There are equity valuation multiples like P/E, P/B, and P/S as well as enterprise valuation multiples like EV/EBITDA, EV/EBIT, EV/Sales, and EV/BV. Fundamental formulas for calculating these multiples rely on variables like growth rate, return on equity, cost of equity, and net profit margin.

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342 views22 pages

Relative Valuation

Relative valuation is based on the principle that similar assets should sell at similar prices. It involves analyzing the company to be valued, selecting comparable companies, choosing valuation multiples, calculating the multiples for comparable companies, and then using the comparable company multiples to value the company. There are equity valuation multiples like P/E, P/B, and P/S as well as enterprise valuation multiples like EV/EBITDA, EV/EBIT, EV/Sales, and EV/BV. Fundamental formulas for calculating these multiples rely on variables like growth rate, return on equity, cost of equity, and net profit margin.

Uploaded by

sanket patil
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Relative Valuation

Relative Valuation is based on the principle that :

“Similar assets should sell at similar prices”

DCF approach provides the conceptual foundation for relative valuation metrics.
These two approaches are seen as complementary to each other.
Relative Valuation Process

1. Analyse the company to be valued w.r.t Business model, product profile, Cost of
inputs, trends in turnover, liquidity, leverage, margins, return on investment ,
technological and production capabilities, Customers, competitive features etc.
2. Select comparable companies
3. Select the valuation multiples
4. Determine the valuation multiples for the comparable companies
5. Using the valuation multiples of comparable companies, value the company.

Valuation multiples : Two categories

A. Equity Valuation Multiples


B. Enterprise Valuation Multiples
Equity Valuation Multiples

1. Price Earning Multiple (P/E)

P/E = Market price per share (MPS)


Earning per share (EPS)

The market price is the current market price per share. The EPS may be the trailing EPS ( Based on
previous financial year ) or expected or forward EPS ( Expected EPS for the current year or the
following year)

Benchmark P/E
Average or median P/E for the company’s peer group
Average or median P/E for the company’s industry or sector
The P/E for a representative stock index
Fundamentally P/E = (1-b) = (1-b)
Ke – ROE*b ke-g

Where 1-b = dividend payout, b= retention rate


Ke = Cost of equity, ROE = Return for equity
ROE *b = growth rate

P= D1/ ke-g
P= E1(1-b)/ ke – g
P= E1(1-b)/ke – (ROE*b)
P/E1 = (1-b)/ke-g

A Ltd’s ROE is 18%, ke =15% and dividend payout is 40%. Determine fundamental P/E
2. Price / Book Value multiple ( P/B )

P/B = Market Price per share * Equity shareholders funds/number of o/s equity shares
Book Value per share*

P/B ratio is generally positive even when EPS is negative or zero


BV is more stable than EPS
Companies with liquid assets can be valued using this ratio
Book values are affected by accounting policies
Tangible book value may be calculated by excluding intangible assets which
cannot be separated from the company e.g goodwill on acquisition
Fundamentally P/B = ROE(1+g)(1-b)
Ke-g
V= E(1-b)/ke-g………………….1 (DDM)
ROE = E/B i.e E= B*ROE Substituting in 1

V = B*ROE*(1-b)/ke-g since { b= g/ROE}


V/B = ROE – g/ke-g

If for A, g= 12%, determine fundamental P/B


3. Price /Sales Multiple (P/S)

P/S = Market Price per share =


Revenue per share

Sales are less subject to distortion as compared to EPS or book value and
generally not affected by accounting policies
Sales are more stable than EPS
Mature, cyclical and new companies can be valued using P/S
Does not reflect cost structures of different companies
Sales and equity are not logically linked.
Fundamentally P/S = NPM(1+g)(1-b)
Ke-g

Since P = D(1+g)/r-g and D = E (1-b) substituting

P = [E(1-b)(1+g)]/r-g
Since E = S(NPM) EPS = Sales per share * NPM
P/S = NPM(1-b)(1+g)]/r-g
Critical evaluation of P/E, P/B and P/S multiples

1. Earning power is a major driver of investment. P/E is thus a very popular metric
However the earnings may have non recurring/exceptional components which
has to be adjusted. Reported earnings may be managed/distorted/ manipulated

2. Even if EPS is negative, book value is generally positive and more stable. But
significant drivers of value like human capital, technology, brand etc are not
captured in Balance Sheet.

3. Sales are less prone to distortions and manipulations. Even if Earnings and book
value can be negative, sales are always positive.
P/E = (1-b) = (1-b) key driver = g
Ke – ROE*b ke-g
P/B = ROE(1+g)(1-b) key driver = ROE
Ke-g
P/S = NPM(1+g)(1-b) key driver = NPM
Ke-g

PEG ratio = PE/g


Value ratio = PB/ROE
PSM = PS/NPM
PEG ratio : P/E to Growth multiple

= P/E
Annual expected EPS growth in %

PEG is being increasingly used by financial analyst to discover over valued and under valued stocks. It refers
to P/E per percentage of expected growth

A PEG ratio relates the P/E to future growth in EPS. It refers to

If the P/E multiple = growth rate in EPS i.e. PEG ratio of 1 means that the share is fairly priced in the market.

A PEG ratio <1 indicates that the market is discounting the prospects of future growth= undervalued stocks
A PEG ratio >1 indicates that future growth is factored at a premium = overvalued stocks

However PEG ratio should also be checked with average or median industry PEG ratio
You are analysing Telecom industry for valuation of VCom one of the leading
telecom company. You want to use P/E multiple with median P/E of peer
companies. You collect the following information:
FOR EVERY 1% GROWTH IN EPS, p/e IS 1.95

Trailing P/E Forward P/E 5 year EPS growth Forward Beta


forecast (%) PEG

AT&T 25.73 12.62 6.46 1.95 0.40


BCE 14.49 14.12 3 4.71 0.76
Equinix 18.86 12.04 1.35 8.92 0.89
Windstream 131.28 43.97 25.3 1.74 1.26
Frontier Com 43.3 18.83 21.8 0.86 0.78
Centel 36.91 18.66 -11.55 - 0.89
Mean 50.95 19.23 8 3.27 0.77
Median 36.91 14.40 6.46 1.85 0.78
1. P Ltd , having an issued capital of Rs. 500 lacs ( Rs.10/-), reports PAT of Rs.280
lacs for the year 2018 . The current market price of the stock is Rs.22.40/-. The
company’s profit is expected to grow by 4% next year.
The P/E multiple of four comparable listed companies engaged in similar business is :

2016 2017 2018 Average


Company A 5.7 6.3 7.1 6.37
Company B 5.9 6.5 6.8 6.4
Company C 6.8 7.0 7.4 7.07
Company D 5.0 5.9 6.1 5.67
Industry 6.38X
average

Company’s expected EPS = 291.2/50 = 5.82 ( forward eps)


Value per share = 5.82*6.38 =37.15
2. A ltd’s financial data is given : Total Capital Employed : 7000 crs , Sales ; Rs.8500
crs, EBITDA : 725 crs, PAT : 250 crs, BV/Share : Rs.250/share, EPS : Rs.12.5/share.
Number of shares : 20 crs. Expected growth in EPS 8%. It has identified 3
comparable companies for the purpose of valuation. The details of the same are :
P Ltd Q Ltd R Ltd
MPS 450 550 425
Number of shares 18 crs 22 crs 20 crs
Net worth 6000 crs 6400 crs 5200 crs
Debt 1500 crs 1400 crs 1800 crs
Sales 8900 crs 9500 crs 8400 crs
EBITDA 875 crs 1000 crs 720 crs
PAT 300 crs 465 crs 312 crs

Determine value of A Ltd. using equity and enterprise multiples.


3. P Ltd has 40 lakh equity shares of Rs.10/-.. The company has reported a profit of
Rs.65 lacs after paying a tax of 35%. The current years income includes
extraordinary income of Rs. 10 lacs and extra ordinary expenses of Rs. 3 lacs. The
company’s existing operations will continue in future. The company plans to
launch a new product next year which will generate a additional net revenue of
Rs.28 lacs. The average Industry P/E ratio is 8 times Determine value of the
business using P/E ratio.
Solution

FMP ( 100 -10+3 +28) – tax = 78.65


EPS = 78.65/ 40 = 1.97
MPS= EPS*P/E = 1.97*8 = Rs.15.73/share

Value of business = 15.73 *40 lakhs =Rs. 629.20 lacs


4. The following information is made available

ROE = 20%
Ke= 15%
BV/share = Rs.50/-
Dividend payout = 40%
NPM = 10%

Calculate P/E, P/B, P/S,PEG ratios


Enterprise Valuation Multiples

1. EV/EBITDA multiple : Enterprise Value (EV)


Earnings before interest, taxes, depn and amortization

EV = Market value of equity +market value of interest bearing debt + market value of preferred stock
less cash and cash equivalents

Fundamental multiple: ROCE-g * (1-DA)(1-t) [ DA = depn and amortn as a % of EBITDA]


ROCE* (WACC - g)

2. EV/EBIT multiple : Enterprise Value (EV)


Earnings before interest and tax

3. EV/FCFF multiple : Enterprise Value (EV)


FCFF
4. EV/ Sales multiple : Enterprise Value (EV)
Sales

Fundamental multiple : After tax operating margin(1+g)(1-b)


WACC-g

5. EV/BV multiple : Enterprise Value (EV)


Book Value of assets

Fundamental multiple: ROCE-g


WACC –g
The following details have been compiled for valuation of Asterix Ltd using
EV/Sales multiple and EV/EBITDA. Determine the value of Asterix.
Asterix Stora Ltd EMC Ltd Verizon Ltd avg
Sales 10814.8 9887.5 5200.85 12475.36 95337.25/788.6
0
EBITDA 3244.2 3460.62 1456.22 3992.11 =120.89*0.40
O/s shares 788.60 540.85 389.50 850.00 92637.17/788.6
Debt 4500 3200 2800 5600 =117.47*0.60
Minority 91.5
interest
Cash 1849.23 1422.50 690.45 1925.45
mps 120 130 150 125
EV/SALES 9.24XSA 7.29 11.64 8.81 9.24
Selection of valuation multiple

1. P/E multiple – companies with positive earnings , insignificant non cash expenses
2. P/B multiple – companies whose balance SHEET figures of assets reasonable
reflects the market prices ( banks )
3. EV/EBITDA – companies with substantial non cash expenses ( capital intensive
companies like airlines/telecom)
4. EV/FCFF – companies with stable growth and predictable capex
5. EV/Sales – new companies without positive earnings
6. Other multiples-
 Cement – EV/ MT of production
 Automobile – EV/ No of vehicles
 Power – EV/ Kwh Production
 Hospitality – EV/ Number of rooms in hotel

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