Market-Based

Valuation:
Price and Enterprise
Value Multiples
 Valuation Indicators

Enterprise
Price
Value
Multiples
Multiples

Momentum
Indicators
 Methods for Price and Enterprise Value
Multiples
1. Method of Comparables
• Economic rationale is the law of one price

2. Method Based on Forecasted Fundamentals

• Reflects firm fundamentals and future cash flows

Justified Price Multiples

• Can be determined using either method
 Price-to-Earnings Multiple
Rationales and Drawbacks

Rationales Drawbacks
Zero, negative, or very
EPS is driver of value
small earnings

Permanent versus
Widely used
transitory earnings

Management discretion
Related to stock returns
for earnings
 Price-to-Earnings Multiple
Definitions

Forward
Trailing P/E
P/E
Preferred Preferred
Uses last when Uses next when trailing
year’s forecasted year’s earnings are
earnings earnings are earnings not reflective
not available of future
 Issues in Calculating EPS

Underlying
EPS Dilution
Earnings

Differences in
Normalized
Accounting
Earnings
Methods
 Example: Underlying Earnings

Reported EPS from previous four quarters $4.00

Restructuring charges $0.10

Amortization of intangibles $0.15

Impairment charge $0.20

Stock price $50.00

 Example: Underlying Earnings
P/E based on reported earnings  $50  $4.00  12.5

Reported core earnings  $4.00  $0.10  $0.15  $0.20  $4.45

P/E based on reported core earnings  $50  $4.45  11.2

Underlying earnings  $4.00  $0.20  $4.20

P/E based on underlying earnings  $50  $4.20  11.9
Example: Normalized Earnings
Year EPS BVPS ROE
2015 $0.66 $4.11 16.1%
2014 $0.55 $3.67 15.0%
2013 $0.81 $2.98 27.2%
2012 $0.73 $2.12 34.4%
2011 $0.34 $1.61 21.1%

2016 stock price $24.00

 Example: Normalized Earnings

1) Method of historical average EPS

($0.66  $0.55  $0.81  $0.73  $0.34)

Average (normalized) EPS   $0.618
5

P/E  $24.00  $0.618  38.8

 Example: Normalized Earnings
2) Method of average ROE

(16.1%  15.0%  27.2%  34.4%  21.1%)

Average ROE   22.8%
5

Average (normalized) EPS  Average ROE  Current equity book value per share
Average (normalized) EPS  22.8%  $4.11  $0.937

P  E  $24.00  $0.937  25.6

Justified Forward P/E from Fundamentals

D1
V0 
rg
P0 D1 E1

E1 rg
P0 1 b

E1 rg
Justified Trailing P/E from Fundamentals
D 0 (1  g )
V0 
rg
P0 D 0 (1  g ) E0

E0 rg
P0 (1  b)(1  g )

E0 rg
 Example: Justified Forward P/E
from Fundamentals

Retention ratio 0 .36

Dividend growth rate 4.0%

Required return on stock 10.0%

Example: Justified Forward P/E
from Fundamentals

P0 1 b
=
E1 rg
P0 1  0.36
= =10.7
E1 0.10  0.04
 Example: Justified P/E from
Regression on Fundamentals
Predicted P/E 
11.5   2.2  DPR  +  0.03  Beta  + 16.2  EGR 
Values for Subject Firm

Dividend payout ratio 0.40

Beta 1 .20
Earnings growth rate 6.00%
Actual P/E 15 .0
 Example: Justified P/E from
Regression on Fundamentals
Predicted P/E 

11.5   2.2  DPR    0.03  Beta   16.2  EGR 

 11.5   2.2  0.4  +  0.03 1.2   16.2  0.06 

 13.3
 Method of Comparables

Benchmark Value of the

Multiple Choices

Industry Broad Firm’s

Industry
or sector market historical
peers
index index values
 Method of Comparables
Using Peer Company Multiples

 Law of one price

 Risk and earnings growth adjustments
 PEG limitations:
 Assumes linear relationship
 Does not account for risk
 Does not account for growth duration
 Example: Method of Comparables
Using P/E and PEG

Values for subject firm

Five-year EPS growth rate 8.0%
Consensus EPS forecast $4.50
Current stock price $28.00

Values for peer group

Median P/E 9 .00
Median PEG 1 .60
Example: Method of Comparables
Using P/E and PEG

P/E  $28.00  $4.50  6.2

PEG  6.2  8.0  0.78

Intrinsic value  9.0  $4.50  $40.50

 Method of Comparables
Using Industry and Market Multiples
 Industry or Sector Index
 Mean vs. median
 Check industry valuation against market

 Broad Market Index

 Adjust for differences in fundamentals
and size
 Use relative values on a historical basis
 Method of Comparables
Valuing the Market

 Fed Model: Earnings Yield vs. T-Bond Yield

 Does not account for inflation correctly
 Relationship between earnings yield and interest
rates is nonlinear
 Small rate changes → large changes in P/E

 Yardeni Model
 The Yardeni Model incorporates both the bond yield and the
growth rate. The model’s results are that higher growth rates
should result in higher justified price multiples and higher bond
yields should result in lower multiples.
 Method of Comparables
Using Own Historical Multiples
 Rationale: Regression to the Mean
 Approaches:
 Average of four middle values over past 10 years
 Five-year average trailing P/E
 Potential Problems from Changes in
 firm business
 firm financial leverage
 interest rate environment
 economic fundamentals
 inflationary environment
Using P/Es for Terminal Value
P/E Based
on
Justified P/E
Comparable
s
P/E = Grounded in market
(D/E)/(r – g) data

If comp is mispriced,
Sensitive to required
terminal value will
inputs
be mispriced
Example: Using P/Es for Terminal Value

Values for subject firm

Required rate of return 11.0%
EPS forecast for Year 3 $2.50

Values for peer group

Mean dividend payout ratio 0 .40
Mean ROE 8.0%
Median P/E 9 .00
Example: Using P/Es for Terminal Value
Using Gordon Growth Model
D3  EPS3  Dividend payout ratio
D3  $2.50  0.40  $1.00

Retention ratio  1  Dividend payout ratio

Retention ratio  1  0.40  0.60

g  Retention ratio  ROE

g  0.60  8%  4.8%

D3 1  g  $1.00 1  0.048 
V3    $16.90
rg 0.11  0.048
Example: Using P/Es for Terminal Value
Using Comparables

V3  P/E  EPS3

 9.0  $2.50  $22.50

 Price-to-Book Value Multiple
Rationales

Book Value Is Usually Positive

More Stable than EPS

Appropriate for Financial Firms

Appropriate for Firms that Will Terminate

Can Explain Stock Returns

 Price-to-Book Value Multiple
Drawbacks
Does Not Recognize Nonphysical Assets

Misleading when Asset Levels Vary

Can Be Misleading Because of Accounting Practices

Less Useful when Asset Age Differs

Can Be Distorted Historically by Repurchases

 Adjustments to Book Value
Intangible Inventory
Assets Accounting

Off-Balance-
Fair Value
Sheet Items
 Justified P/B

P0 ROE  g

B0 rg

P0 PV  Expected future residual earnings 

 1
B0 B0
 Price-to-Sales
Multiple Rationales

Sales Less Easily Manipulated

Sales Are Always Positive

P/S Appropriate For Mature, Cyclical, and Distressed Firms

P/S More Stable Than P/E

Can Explain Stock Returns

 Price-to-Sales
Multiple Drawbacks

Sales ≠ Earnings and Cash Flow

Numerator and Denominator Not Consistent

P/S Does Not Reflect Cost Differences

P/S Can Be Misleading Because of Accounting Practices

 Justified P/S
P0 (E0 /S0 )(1  b)(1  g )

S0 rg

g  b  ROE

 Sales   Total assets 

g  b  PM 0      
 Total assets   Shareholders’ equity 
Example: Calculating the Actual and Justified
P/E, P/B, and P/S

Stock price $50 .00

EPS $2 .00
Dividends per share $1 .20
Book value of equity per share $6 .25
Sales per share $15 .00
ROE 22.5%
Required return on stock 12.0%
Example: Calculating the Actual
P/E, P/B, and P/S
P0 $50
Actual   25.0
E0 $2

P0 $50
Actual   8.0
B0 $6.25

P0 $50
Actual   3.3
S0 $15
Example: Calculating the Inputs for the Justified
P/E, P/B, and P/S

Dividend payout ratio  $1.20  $2.00  0.60

Retention ratio (b)  1  0.60  0.40

Growth rate in dividends (g )  0.40  22.5%  9.0%

 Example: Calculating the Justified
P/E, P/B, and P/S
P0 (1  b)(1  g ) (1  0.60)(1  0.09)
   21.8
E0 rg 0.12  0.09

P0 ROE  g 0.225  0.09

   4.5
B0 rg 0.12  0.09

P0 (E0  S0 )(1  b)(1  g ) ($2  $15)(0.6)(1.09)

   2.9
S0 rg 0.12  0.09
 Price-to–Cash Flow
Multiple Rationales

Cash Flow Less Easily Manipulated

Ratio More Stable Than P/E

Ratio Addresses Quality of Earnings Issue with P/E

Ratio Can Explain Stock Returns

Price-to–Cash Flow
Multiple Drawbacks

Cash Flow Can Be

Distorted

FCFE More Volatile and

More Frequently Negative

Cash Flow Increasingly

Managed by Firms
 Definitions of Cash Flow
CF • Earnings + Depreciation +
Amortization + Depletion

CFO • From statement of cash flows

FCFE • Most valid but volatile

EBITDA • Best used with enterprise value

 Justified P/CF

FCFE 0 (1  g )
V0 
rg
 Dividend Yield
Rationales and Drawbacks

Rationales Drawbacks
It is only one
Component of return component of return

Dividends may displace

future earnings
Dividends less risky than
future capital gains Market may not favor
dividends
Justified Dividend Yield

D0 rg

P0 1 g
 Inverse Price Ratios
Price Ratio Inverse Price Ratio

Price-to-earnings (P/E) Earnings yield (E/P)

Price-to-book (P/B) Book-to-market (B/P)

Price-to-sales (P/S) Sales-to-price (S/P)

Price-to-cash-flow (P/CF) Cash flow yield (C/P)

Price-to-dividends (P/D) Dividend yield (D/P)

 Enterprise Value/EBITDA Multiple
Rationales and Drawbacks

Rationales Drawbacks
Useful for comparing firms
of different leverage Exaggerates cash flow

Useful for comparing firms

of different capital utilization
FCFF more strongly
Usually positive grounded
 Issues in Using Enterprise Value Multiples
EV = Market value of stock + Debt – Cash – Investments

Justified EV/EBITDA
• Positively related to FCFF growth
• Positively related to ROIC
• Negatively related to WACC

Comparables May Use Total Invested Capital

Other EV Multiples
• EV/FCFF
• EV/EBITA
• EV/EBIT
• EV/S
 Cross-Country Comparisons
US GAAP • Net income higher under IFRS
• Shareholder's equity lower under IFRS
vs. IFRS • ROE higher under IFRS

Valuation • P/CFO and P/FCFE most comparable

Multiples
• P/B, P/E, and EBITDA multiples least comparable

• Higher inflation  Lower justified price multiples

Inflation • Higher pass-through rates  Higher justified
price multiples
 Momentum Indicators:
Earnings Surprises

UEt  EPSt  E  EPSt 

EPSt  E  EPSt  UEt

SUEt  
σ  EPSt  E  EPSt  σ UEt 
Momentum Indicators:
Relative Strength

Past Performance

Relative to an Index

Inherently Self-
Destructing
 Valuation Indicators in Practice:
Averaging Multiples
Arithmetic
Mean and • Overestimate of index P/E
Weighted
Mean

Harmonic • Closer to index P/E but is

Mean influenced by small outliers

Weighted
Harmonic • Equal to index P/E
Mean
 Valuation Indicators in Practice:
Stock Screens

Database Limitations
• Variables are predetermined
• Does not contain qualitative data

Look-Ahead Bias
• Assumes investor has info not yet available

Sector Rotation
 Summary
Price and Enterprise Value Multiples
• Method of comparables
• Method based on forecasted fundamentals

Price-to-Earnings Rationales and Drawbacks

• Rationales: EPS  Driver of value, widely used, and related
to stock returns
• Drawbacks: Zero, negative, or very small earnings;
transitory components; management discretion for earnings
• Trailing and forward P/Es
 Summary
Issues in Calculating EPS
• EPS dilution
• Underlying earnings
• Normalized earnings
• Differences in accounting methods

Method of Comparables
• Industry peers
• Industry or sector index
• Broad market index
• Own historical values
 Summary
Price-to-Book Rationales and Drawbacks

• Rationales: Book value usually > zero, more stable than EPS,
appropriate for financial firms and firms that will terminate, and
explains stock returns
• Drawbacks: Doesn’t recognize nonphysical assets, misleading if
asset levels vary or differ from accounting practices, less useful
when asset age differs, and can be distorted by repurchases

Issues in Calculating Book Value

• Intangible assets
• Inventory accounting
• Off-balance-sheet items
• Fair value
 Summary
Price-to-Sales Rationales and Drawbacks
• Rationales: Sales less easily distorted, sales always positive, P/S
more stable than P/E, appropriate for many firms, and explains
stock returns
• Drawbacks: Sales ≠ Earnings and Cash flow, numerator and
denominator not consistent, does not reflect cost differences,
and can be distorted

Price-to-Cash-Flow Rationales and Drawbacks

• Rationales: CF less easily manipulated, more stable than P/E,

addresses quality of earnings issue, and explains stock returns
• Drawbacks: can be distorted, FCFE more volatile and more
frequently negative, and increasingly managed by firms
 Summary
Measures of Cash Flow
• CF: Earnings + Depreciation + Amortization + Depletion
• CFO: From statement of cash flows
• FCFE: Most valid but volatile
• EBITDA: Best used with enterprise value

Dividend Yield Rationales and Drawbacks

• Rationales: A component of return, dividends less risky than

future capital gains
• Drawbacks: Only one component of return, dividends may
displace future earnings, and market may not favor dividends
 Summary
Inverse Price Ratios

• Useful when denominators are small, low, or negative (e.g.,

earnings)
• Earnings yield, book-to-market, sales-to-price, cash flow
yield, and dividend yield

Enterprise Value Multiples

• EV = Market value of stock + Debt – Cash – Investments

• Rationales: Useful for comparing firms of different leverage
and capital utilization, usually positive
• Drawbacks: Exaggerates cash flow, FCFF more strongly
grounded
 Summary
Justified Multiples

• P/E: + related to g, – related to r

• P/B: + related to ROE, – related to r
• P/S: + related to g and PM, – related to r
• P/CF: + related to g, – related to r
• D/P: – related to g, + related to r
• EV/EBITDA: + related to g and PM,
– related to WACC
 Summary
Cross-Country Comparisons

• IFRS ROE higher than GAAP ROE

• P/CFO and P/FCFE most comparable
• P/B, P/E, and EBITDA multiples least
comparable
• Higher inflation  Lower justified price
multiples
• Higher pass-through rates  Higher
justified price multiples
 Summary
Momentum Indicators

• Unexpected earnings (UE)

• Standardized unexpected earnings (SUE)
• Relative strength

Stock Screens

• Database limitations
• Potential look-ahead bias
• Used in sector rotation