Relative Valuation

A relative valuation model estimates an assets value relative to that of another asset.

Similar assets should sell at similar prices,

Relative valuation is typically implemented using price multiples (ratios of stock price to a
fundamental such as cash flow per share) or enterprise multiples (ratios of the total value of
common stock and debt net of cash and short term investments to certain of a companys
operating assets to a fundamental such as operating earnings).
 Relative Valuation
Framework of relative valuation: Key questions to be answered:

What are the major price/enterprise valuation multiples.

What accounting issues affect particular price/ enterprise value multiples and how to address
them

How do price multiples relate to fundamentals, such as earnings growth rates, and how can
this information be used when making valuation comparisons among stocks?

For which types of valuation problems is a particular price multiple appropriate or

inappropriate?

What challenges arise in applying price multiples internationally?

 Relative Valuation
Methods of using price and enterprise value multiples:

Method of Comparables:

Valuation of an asset based on multiples of comparable (similar) assets also called

comparable (comps) or guideline assets.

Multiply the companys fundamentals like earnings, EBIDTA etc with the benchmark, or
compare the multiple with the benchmark multiple.

Method of forecasted fundamentals:

Compute a justified multiple and compare with the multiple based on current market price.
 Relative Valuation

Price Multiples:

Price to Earnings:

Trailing P/E vs Forward P/E or Leading P/E

Why P/E?

Earnings are chief drivers of investment value and P/Es may reflect differences in growth
and return on investment

Can be used across all sectors

Relative Valuation: P/E ratio

Trailing P/E ratio:

Based on past year, past 12 months, past 4 quarters EPS.

Key considerations:

Consider the potential dilution in EPS so use diluted EPS, (eg. BFSI, IT/ITES, Pharma,
Construction & Real estate)

HDFC
EARNINGS PER SHARE
Bank
Basic EPS (Rs.) 57.18 48.84 42.00 35.47 28.49
Diluted EPS (Rs.) 56.43 48.26 42.00 35.21 28.18
EARNINGS PER SHARE Dr. Reddys
Basic EPS (Rs.) 83.05 79.42 99.00 114.00 75.00
Diluted EPS (Rs.) 82.88 79.14 98.00 113.00 74.00
Relative Valuation: P/E ratio
Trailing P/E ratio

Annual
Year 31 March 30 June 30 September 31 December
Estimate
2013 0.21 0.24 0.25 0.18 0.88
2014 0.20 0.19

On 9 August 2014, ANZ closed at $12.20. ANZs fiscal year ends on 31 December. As of 9 August 2014, solve the
following problems by using the information
1. Calculate trailing P/E based on the past four quarters of EPS.
2. Calculate BYDs TTM P/E.
3. Calculate BYDs trailing P/E based on a fiscal-year definition.

Ans. 12.20/0.82, 12.20/0.83, 12.20/0.88

Relative Valuation: P/E ratio

Identify core earnings for the company: Adjust for non-recurring components

Examine income statement, footnote, MDA to identify non-recurring components.

Eg. Gains and losses from sale of assets, asset write downs, goodwill impairment, provisions
for future losses, changes in accounting estimates. Eg Tata Motors
Relative Valuation: P/E ratio
Relative Valuation: P/E ratio

Adjust the EPS for business cycle influences

Moldovosky effect

Normalize EPS: Use historical average over the most recent full cycle, use average ROE and multiply it with
current book value per share.(using recent book value reflects to effect of EPS growth or shrinkage on
companys size)

Do adjustments to earnings:

Adjust for differences in capitalization, leases, inventory valuation

Dealing with extremely low or zero or negative earnings

For zero earnings, P/E ratio cannot be calculated, for negative or low earnings use Normalized EPS or inverse
P/E
High leverage
Relative Valuation: P/E ratio

Calculating P/E

You are calculating a trailing P/E for American Electric Power (NYSE: AEP) as of November 9, 2001, when the share
price closed at $44.50. In its fiscal year ended December 13, 2000, AEP recorded EPS of $0.83 that included an
extraordinary loss of 0.11. Additionally, AEP took an expense of $203 million for merger costs during that calendar
year, which are not expected to recur, and had unusual deficits in two out of four quarters. As of November 2001, the
trailing 12 months EPS was $2.16, including three quarters in 2001 and one quarter in 2000. The fourth quarter of
calendar year 2000 had $0.69 per share in nonrecurring expenses. (Assume the charges are post tax)

What is the core EPS?

Relative Valuation: P/E ratio

PHG, Europes largest electronics company, as of the beginning of November 2001. On November 8, 2001, PHG stock closed at
$25.72. PHG experienced a severe cyclical contraction in its Consumer Electronics division in 2001, resulting in a loss of $1.94 per
share; you thus decide to normalize earnings. You believe the 19952000 period (which excludes 2001) reasonably captures average
profitability over a business cycle. Table 4-1 supplies data on EPS, book value per share (BVPS), and return on equity (ROE).

2001 2000 1999 1998 1997 1996 1995

EPS (1.94) 2.11 1.15 0.87 1.16 0.55 1.14
BVPS 13.87 16.62 9.97 11.68 6.57 6.43 6.32
ROE NA 0.129 0.104 0.072 0.168 0.083 0.179

Using the data in Table

1. Calculate a normal EPS for PHG based on the method of historical average EPS, and then calculate the P/E based on that estimate
of normal EPS.
2. Calculate a normal EPS for PHG based on the method of average ROE and the P/E based on that estimate of normal EPS.
3. Explain the source of the differences in the normal EPS calculated by the two methods, and contrast the impact on the estimate of
a normal P/E
Relative Valuation: P/E ratio
Forward P/E ratio

Annual
Year 31 March 30 June 30 September 31 December
Estimate
2013 0.01 0.00 E(0.01) E(0.05) (0.05)
2014 E0.07 E0.08 E0.03 E(0.03) 0.15

On 9 August 2013, BYD closed at $13.50. BYDs fiscal year ends on 31 December. As of 9 August 2013, solve the
following problems by using the information
1. Calculate BYDs forward P/E based on the next four quarters of forecasted EPS.
2. Calculate BYDs NTM P/E.
3. Calculate BYDs forward P/E based on a fiscal-year definition and current fiscal year (2013) forecasted EPS.
4. Calculate BYDs forward P/E based on a fiscal-year definition and next fiscal year (2014) forecasted EPS.
Relative Valuation: P/E ratio
Valuation based on fundamentals

Fundamental/Justified P/E ratio

Justified P/E based on retention and growth

FPL Group (NYSE: FPL) is a southeastern U.S. utility. Jan Unger, a utility analyst, forecasts a long-term earnings
retention rate (b) of 50 percent and a long-term growth rate of 5 percent. Unger also calculates a required rate of return
of 9 percent. Based on Ungers forecasts of fundamentals and the equation above, FPLs what is its justified leading
P/E?
Relative Valuation: P/E ratio
P/E based on cross sectional regression

Regress past P/E with Dividend Payout Ratio, Beta, Expected Growth Rate

Benchmark for comparison

Sector Benchmark (median, including the average P/E of the subject company)

If subject company has higher than average earnings growth, it may have a higher P/E than benchmark which is justified eg
Asian Paints, Kajaria ceramics Avenue supermart (P/E growth)

If subject company has higher than average risk, it may have a lower P/E than benchmark which is justified
https://in.investing.com/indices/cnx-high-beta-components

EBIDTA ROE P/E

Hindustan Unilever 19 67 45
Britannia 14 37 42
Colgate 23 64 40
NHPC 60 10 10
Infosys 27 22 15
ONGC 30 10 9
Relative Valuation: P/E ratio

G P/E PEG

Asian Paints 17.80% 65.28 3.66

Berger Paints 20.70% 59.66 2.88

Kansai Nerolac 14.7% 52.07 3.53

Akzo Nobel 3% 39.86 13.2

Relative Valuation: Price/Book value

Can be used when:

EPS is zero or negative

EPS is abnormally high or low
For finance, investment, insurance and banking institutions
For companies on verge of liquidation

Drawbacks of P/B ratio

In most accounting standards book value reflects the historical price net of accumulated depreciation.

Different average age of assets of the firm.

Misleading when the level of assets differ among the companies or companies follow different business models.

Certain intangible assets like human capital may be more important but not reflected in balance sheet.

Intangible assets generated internally may not be shown in the balance sheet of the company.
Relative Valuation: Price/Book value
Share repurchases or issuance can distort historical comparison, make the stock appear more expensive than historical.

Be careful while using P/B ratios compare P/BV w.r.t differences in ROE and growth

P/B NPM ROE BV M.Price Intrinsic price

HDFC Bank 5.33 3.83 16.26 346.22 1846 1334.6781
IndusInd Merger with Bharat
Bank 4.98 3.39 14.14 338.44 1687 1304.6862 Financial inclusion
Axis Bank 2.11 3 6.59 232.57 458.75 896.55735
watch list, extent of
ICICI Bank 1.67 2.81 10.11 151.01 257.95 582.14355 undervaluation is low
Kotak
Mahindra 4.5 3.75 12.78 145.04 1078.45 559.1292Merger synergies to start
Yes Bank 3.21 2.69 15.09 96.28 356.4 371.1594stock split in September
3.855
Relative Valuation: Price/Book value

Calculation of book value

=Shareholders equity Preferred stock dividends on preferred stock

Tangible Book value per share

Adjust for off balance sheet items

Fundamental P/BV ratio

Relative Valuation: Price/Sales
Sales are less subject to manipulation
Sales are positive even when EPS is negative.
Sales are more stable than EPS and not affected by leverage.
No accounting adjustments are required.
P/S can be used for valuing the stocks of mature, cyclical or zero income stocks

Drawbacks
Sales may be there but no cash flows or earnings
Price-post financing, sales pre-financing; logical mismatch.
P/S does not reflect differences in cost structures
Distorted by revenue recognition practices.
Justified P/Sales
Relative Valuation: EV/EBIDTA

EV defined

EV/EBIDTA is useful for comparing companies with different financial leverage.

Incorporates depreciation and amortization in contrast to NI.. So frequently used in
valuation of capital intensive companies.
Can be positive when EPS is negative

Drawbacks:
FCFF may be better than EBIDTA as EBIDTA does not reflect working capital
expenditure.
Does not directly reflect capex and only covers it to the extent of depreciation

Other ratios: EV/Sales, EV/CFO

Relative Valuation: EV/

Telecom: Subscribers, towers, ARPU

Retail: Square footage

Hotels: Rooms

FIs: NAV, BV

Oil: Reserves, EBITDAX

Real estate: EV/FFO (NI+Dep-Gain/loss on sale) (AFFO: maintenance capex)

Power: EV/MW
Using Multiples for Valuation

Comparable company Valuation

Comparable transaction valuation

Case of Talbros