Relative Valuation Models

Relative Valuation Models

1. Price-to-Earnings Ratio (PE Ratio)
2. Price-to-Cash-flow Ratio (P/CF Ratio)
3. Price-to-Sales Ratio
 Price-to-earnings Ratio (PE Ratio)

 The price to earnings ratio (PE Ratio) is the measure

of the share price relative to the annual net income
earned by the firm per share.

 PEratio shows current investor demand for a

company share. A high PE ratio generally indicates
increased demand because investors
anticipate earnings growth in the future.
Price-to-earnings ratio

 The price-to-earnings ratio (P/E) is one of the most

widely used metrics for investors and analysts to
determine stock valuation.

 In addition to showing whether a company's stock

price is overvalued or undervalued, the P/E can
reveal how a stock's valuation compares to its
industry group or a benchmark like the S&P 500 index.
 However, companies that grow faster than average
typically have higher P/Es, such as technology companies.

 A higher P/E ratio shows that investors are willing to pay a

higher share price today because of growth expectations
in the future.
 The average P/E for the S&P 500 has historically ranged
from 13 to 15.

 For example, a company with a current P/E of 25, above

the S&P average, trades at 25 times earnings. The high
multiple indicates that investors expect higher growth
from the company compared to the overall market.
Relative Valuation Models
Price-to-earnings ratio indicates how
aggressively the market values the firm.
 Investors not only use the P/E ratio to
determine a stock's market value but also
in determining future earnings growth.

 For example, if earnings are expected to

rise, investors might expect the company
to increase its dividends as a result. Higher
earnings and rising dividends typically
lead to a higher stock price.
 The P/E ratio helps investors determine the
market value of a stock as compared to
the company's earnings.

 Inshort, the P/E shows what the market is

willing to pay today for a stock based on its
past or future earnings.
 A highP/E could mean that a stock's price is
high relative to earnings and possibly
overvalued. Conversely, a low P/E might
indicate that the current stock price is low
relative to earnings.
Price-Earnings Ratio and Growth
Price-Earnings Ratio and Growth

 The ratio of PVGO to E/r is the ratio of firm value due to growth
opportunities to value due to assets already in place (i.e., the no-
growth value of the firm, E / k ).
 
EPS1 P0 1 PVGO  P0 1 PVGO
P0 = + PVGO → = 1+ → = +
r EPS1 r  EPS1  EPS1 r EPS1
 r 
Price-Earnings Ratio and Growth

 WhenPVGO=0, P0=E1/r. The stock is valued like a non-growing

perpetuity.

 P/E rises dramatically with PVGO.

 When future growth opportunities dominate the estimate of
total value, the firm will command a high price relative to
current earnings.
 High P/E indicates that the firm has ample growth
opportunities.
Price-Earnings Ratio and Growth
 P/E increases:
 As ROE increases
 As plowback increases, as long as ROE > r
E1 (1 − b) P0 1− b
P0 = =
r − ROE x b E1 r − ROE x b
 TheP/E ratio can be precisely defined as
the ratio of today’s price to the trend
value of future earnings.
Effect of ROE and Plowback on Growth and
the P/E Ratio
Definition
 Return on equity (ROE) is a measure of financial performance calculated
by dividing net income by shareholders' equity. Because shareholders'
equity is equal to a company's assets minus its debt, ROE could be
thought of as the return on net assets.

 Plow Back.
 To reinvest a company's earnings into its operations. A high growth
company often plows back the majority of its earnings rather than pays
out dividends in order to maintain its high growth rate
 Effect of ROE and Plowback on Growth and the
P/E Ratio

 When the expected ROE is less than the required return,

 assuming a required return r of 12%, the investors prefer that
the firm pay out earnings as dividends rather than reinvest
earnings in the firm at an inadequate rate of return (ROE).

Investors want more dividend

not reinvest
 Effect of ROE and Plowback on Growth and the
P/E Ratio
 That is for ROE lower than r, the value of the firm falls as
plowback increases.

 Conversely for ROE higher than r, the firm offers attractive

investment opportunities, so the value of the firm is
enhanced as those opportunities are more fully exploited.
 Effect of ROE and Plowback on Growth and the
P/E Ratio

 Thehigher the plowback, the higher the growth rate,

but a higher plow back does not necessarily mean a
higher P/E ratio.

 Otherwiseincreasing plowback hurts investors

because more money is sunk into projects with
inadequate rates of return.
P/E and Growth Rate
 Wall Street rule of thumb: The growth rate is roughly equal to the P/E ratio.

 “The P/E ratio of any company that is fairly priced will

equal its growth rate (i.e. the growth rate of earnings). If
the P/E ratio of Coca Cola is 15, you’d expect the company
to be growing at about 15% per year, etc. But if the P/E
ratio is less than the growth rate, you may have found
yourself a bargain.”

Quote from Peter Lynch in One Up on Wall Street.

P/E and Growth Rate
 The importance of growth opportunities is most evident in the
valuation of start-up firms.
 For example, in the dot-com boom of the late 1990s, many companies
that had yet to turn a profit were valued by the market at billions of
dollar.
 The online auction firm eBay had 1998 profits of $2.4 million, far less
than the $45 million profit earned by the traditional auctioneer
Sotheby’s: yet eBay’s market value was more than 10 times greater:
$22 billion versus $1.9 billion.
 As it turns out, the market was quite right to value eBay so much more
aggressively than Sotheby’s
 P/E Ratios and Stock Risk
 When risk is higher, r is higher; therefore, P/E is lower.

P 1− b
=
E r−g

 One’s
judgement about the performance of small, risky firms is a
matter of the trade-off between high risk and high expectation of
growth rates of those companies.
Limitations to the P/E Ratio

 The first part of the P/E equation or price is

straightforward as the current market price of the
stock is easily obtained.

 On the other hand, determining an appropriate

earnings number can be more difficult.
 Investors must determine how to define earnings and
the factors that impact earnings.
Limitations to the P/E Ratio

 As a result, there are some limitations to the P/E

ratio as certain factors can impact the P/E of a
company. Those limitations include:
 Volatile market prices

 The earnings makeup of a company are often

difficult to determine. The P/E is typically calculated
by measuring historical earnings not future earnings.
Limitations to the P/E Ratio
 Forward earnings or future earnings are based on the opinions of
analysts. Analysts can be overoptimistic in their assumptions
during periods of economic expansion and overly pessimistic
during times of economic contraction.
 Earnings growth is not included in the P/E ratio. The biggest
limitation to the P/E ratio is that it tells investors little about the
company's EPS growth prospects.
 If the company is growing quickly, an investor might be
comfortable buying it at a high P/E ratio
expecting earnings growth to bring the P/E back down to a
lower level.

 If earnings are not growing quickly enough, an investor might

look elsewhere for a stock with a lower P/E. In short, it
is difficult to tell if a high P/E multiple is the result of
expected growth or if the stock is simply overvalued.
Relative Valuation Models
1. Price-to-Earnings Ratio (PE Ratio)
2. Price-to-Cash-flow Ratio (P/CF Ratio)
3. Price-to-Sales Ratio
Price-to-Cash-flow Ratio (P/CF Ratio)
Price-to-cash-flow ratio is better in the case of
improper earnings forecast
 Price-to-Cash-flow Ratio (P/CF Ratio)
 Theprice-to-cash flow (P/CF) ratio is a stock
valuation indicator or multiple that measures the
value of a stock's price relative to its operating cash
flow per share.

 Theratio uses operating cash flow which adds back

non-cash expenses such as depreciation and
amortization to net income.
 Price-to-Cash-flow Ratio (P/CF Ratio)

 Itis especially useful for valuing stocks that have

positive cash flow but are not profitable because of
large non-cash charges.
 The price-to-cash flow ratio measures how much cash a
company generates relative to its stock price, rather
than what it records in earnings relative to its stock
price, as measured by the price-earnings ratio.
 The price-to-cash flow ratio is said to be a better
investment valuation indicator than the price-earnings
ratio, due to the fact that cash flows cannot be
manipulated as easily as earnings, which are affected
by depreciation and other non-cash items.
 Some companies appear unprofitable because of large,
non-cash expenses even though they have positive cash
flows.
Formula
Limitations of Price-to-cash-flow ratio
 Different Types of Cash Flow
 Several approaches exist to calculate cash flow.
 When performing a comparative analysis between the relative values of
similar firms, a consistent valuation approach must be applied across the
entire valuation process.

 For example, one analyst might calculate cash flow as simply adding back
non-cash expenses such as depreciation and amortization to net income,
while another analyst may look at the more comprehensive free cash flow
figure.

 Furthermore, an alternative approach to determining cash flow would be to

simply sum the operating, financing and investing cash flows found within
the cash flow statement.
Limitations of Price-to-cash-flow ratio

 While the free cash flow approach is the most time intensive, it
typically produces the most accurate results, which can be
compared between companies. Free cash flows are calculated as
follows:

 FCF = [Earnings Before Interest Tax * (1 – Tax Rate) +

Depreciation + Amortization – Change in Net Working Capital –
Capital Expenditures]

 Most of these inputs can be quickly pulled (sometimes with some

minor calculations) out of the firm's financial statements.
Price-to-Sales Ratio (P/S Ratio)
 Price-to-Sales Ratio (P/S Ratio)

 The price-to-sales ratio (Price/Sales or P/S) is

calculated by taking a company's market
capitalization (the number of outstanding shares
multiplied by the share price) and divide it by the
company's total sales or revenue over the past 12
months.
 The lower the P/S ratio, the more attractive the
investment.
Relative Valuation Models
Price-to-sales ratio is better for start up firms.
 Comparing the Valuation Models
 In practice
 Values from these models may differ
 Analysts are always forced to make simplifying
assumptions
Examples, how long will it take the firm to enter a
constant growth stage?
How should the depreciation best be treated?
What is the best estimate of ROE?
Market Valuation Statistics
P/E Ratios of the S&P 500 Index and
Inflation

Inflation spikes in
the beginning of
1970s
Earnings Growth for Two Companies
Earnings Growth for Two Companies
P/E Ratios for Different Industries, 2007
The End
This video is provided to you as part of your online learning during the
Movement Control Order in Malaysia.

The University requests that you do not share this video on any other
platform besides eLearn.

This includes all social media platforms, distribution through email or

other web-links, downloaded and distributed via other platforms, or any
other method other than eLearn.

Students who are caught violating this request will be in breach of

University conduct and will be subjected to disciplinary action.

Thanks you