Firm Valuation - Relative Valuation PDF

Section 9
Firm valuation: relative valuation
’A little inaccurancy sometimes saves tons of explanation.’

--H.H. Munro
1
Learning objectives
After studying this section, you will understand
• The process of firm valuation

• How to use price multiples in relative valuation
• Main problems in using price multiples
• Ways to address the problems in using price multiples
• Links between price multiples and firm fundamentals
2
Firm valuation
• The term firm valuation refers to determining the true or
intrinsic value of the firm
– This value may significantly differ from the asset-based book
value of the firm
• Investors and financial analysts conduct firm valuation for
various purposes needed in their decision making
– Investment decisions
– In M&A transactions and IPOs, firm valuation plays a key role
• From firms’ point of view, valuation models help
understanding the key value drivers of the firm
3
Valuation process
Business Analysis
GAAP
Financial Financial Statement Forecast
Statements Analysis Assumptions
Valuation
Time
Historical Periods Valuation Date Forecast Periods
4
Valuation process
1. Business analysis
 Internal and external business analysis
 What are the key business drivers of the firm?
2. Financial statement analysis
 Historical financial statements are analyzed to learn about the
profitability, leverage, growth, etc. of the firm
3. Forecasting
 Future financial statements are projected
4. Valuation
 Valuation models
 Relative valuation
 What is the value of the equity of the firm?
5
Valuation tools
• Two different types of valuation tools are mainly used
– Relative valuation based on price multiples
• P/E-, P/B-, EV/EBIT- etc. ratios
– Valuation models
• Dividend discount model (DDM)
• Free cash flow model (DCF)
• Abnormal earnings model (AE)
• Relative valuation is simple
• Valuation models are more sophisticated
– Infinite forecast horizon
– Risk and time-value of money are taken into account
6
Price multiples
• In Section 2, we calculated P/E- and P/B-ratios from per-

share numbers to
– Show the link between accounting numbers and stock prices
– Calculate the expected return of a stock
• These ratios, also called as price multiples, are used in
relative valuation to determine the intrinsic value of the
firm
• Relative valuation can answer the question, “I want to
buy a stock in a brewing industry, which one should I
buy?”
7
Relative valuation: what does it mean?
• The value of the firm (a target firm) is estimated by

looking at how the market prices similar or comparable
firms
• The value of the firm is whatever the market is willing to
pay for it given its financial characteristics like earnings,
book equity or sales
• Information needed
– A group of similar or comparable firms
– Median value of the price multiples of similar or comparable
firms
– Typically, price multiples like P/E- or P/B-ratio are used
8
Relative valuation: how to do it?
1. Identify comparable firms that have similar operations

to the firm whose value you are calculating
– Operate in the same industry or otherwise have similar
business models
2. Calculate price multiples for the comparable firms by
using their financial statement numbers and current
stock price
– Earnings, book value, sales
3. Apply these multiples to the corresponding measures
for the target to get its intrinsic value
– Example: P(target) = EPS(target) × P/E(comps)
3-9
Example on relative valuation
• Suppose we have identified 5 firms which are similar to

the firm we want to evaluate:
– Firm A P/E –ratio = 16
– Firm B P/E –ratio = 18
– Firm C P/E –ratio = 12
– Firm D P/E –ratio = 14
– Firm E P/E –ratio = 20
 The median P/E –ratio is 16
• Our firm has EPS of 5.00€
• Implied stock price of our firm is 5.00€×16 = 80€
10
Relative valuation: some considerations
• Use financial statement numbers consistently when
calculating price multiples
– Use exactly the same financial statement numbers for target
firm and for all comparable firms
– For example, the same earnings numbers must be used for all
firms when calculating P/E ratio
– What if accounting methods are different for comps and
target?
– What about negative denominators?
• Conceptual problem: circular reasoning
– Firm value is calculated from the market values of the comps
11
Many ways to calculate P/E-ratios
• There are a number of variants on the P/E-ratio based

upon how the price and the earnings are defined
• Price
– Usually the current price (though some like to use average
price over last 6 months or year)
• EPS
– EPS in most recent fiscal year (current)
– EPS in most recent four quarters (trailing)
– EPS expected in next fiscal year or next four quarters (both
called forward)
– EPS in some future year
– EPS in many past fiscal years
– Some combination of all these…
12
Price-Book ratio
• Recall from Section 2 that P/B ratio is calculated by dividing
stock price (P) by the book value of equity per share (BPS):
P/B = P/BPS
• Abnormal earnings model (we will dicuss it in Section 10):


( ROEt  rE ) Bt 1
Equity value  P0  B0  
t 1 (1  rE )t
Bt 1
 ( ROEt  rE )
P0 B0
• Dividing by B0, we get:  1 
B0 t 1 (1  rE )t
13
Price-Book ratio
Implications:
• P/B ratio is directly related to the future abnormal earnings,

i.e. the difference between forecasted ROE and the cost of
equity
• Forecasted ROE equals the cost of equity:

– P = B  P/B = 1
• Forecasted ROE is greater than the cost of equity:
– P > B  P/B > 1
• Forecasted ROE is less than the cost of equity:
– P < B  P/B <1
14
Links between P/E, P/B and ROE
P P E P
PB      ROE
BPS E BPS E
P PB
 
E ROE
• P/B ratio increases with ROE

– P/B as such is not indicative of the firm value without
considering ROE
• P/E ratio is the ratio of P/B ratio to ROE
– P/E ratio indicates the current valuation of the firm relative to
its profitability
15
Links between P/E, P/B and ROE
• Value of the firm having high ROE should be higher than

that of the firm having low ROE
 Simple investment strategy
– Buy firms having low P/B ratios and high ROE
– Sell firms having high P/B ratios and low ROE
• Some empirical evidence from Helsinki Stock Exchange
– P/B vs. ROE calculated by using analysts’ EPS forecasts
– P/B vs. ROE calculated by using EPS from previous year
– What can you learn from these two graphs?
16
Example: P/B-ratio and forecasted ROE for
firms listed in Helsinki Stock Exchange
10,00
9,00
8,00
7,00
6,00
P/B 5,00
4,00
3,00
2,00
1,00
0,00
0,00 10,00 20,00 30,00 40,00 50,00 60,00
ROE
Example: P/B-ratio and previous year’s ROE
for firms listed in Helsinki Stock Exchange
10,00
9,00
8,00
7,00
6,00
P/B 5,00
4,00
3,00
2,00
1,00
0,00
0,00 10,00 20,00 30,00 40,00 50,00 60,00
ROE
Lots of price multiples…
• Denumerator of the multiple can be based on:
• Earnings
– Price/Earnings Ratio (PE) and its variants (PEG)
– Enterprise value/EBIT
– Enterprise value/EBITDA
– Enterprise value/Cash Flow
• Book value of the asset
– Price/Book Value (of Equity) (PB)
– Value/ Book Value of Assets
– Value/Replacement Cost (Tobin’s Q)
• Revenues generated by the asset
– Price/Sales per Share (PS)
– Value/Sales
• Asset or industry specific variables (Price/kwh, Price per
ton of steel ....) 19
Example: Valuation of Securitas based on price
multiples as of July 31, 2017 by Nordea Markets
20
EV/EBIT-ratio
• EV/EBIT = Enterprise value (EV) / Earnings before

interest and taxes (EBIT)
• Enterprise value (EV) = Market value of equity + Net

value of debt
• Net value of debt is calculated as we have done it:

Interest bearing debt
- Financial assets
= Net value of debt
21
Price-Sales Ratio (P/S)
• P/Sales ratio is calculated as follows:
P/S = Stock price / Sales per share

= Market value of equity / Sales
• P/S ratio is commonly used despite its deficiencies

– By relying on sales, it neglects all the costs need to generate
sales
– Firm having a high level of sales can be deeply unprofitable
22
Summary
• Valuation based on price multiples is called relative

valuation
• Price multiples can be defined in numerous ways
• Selection of the group of comparable firms is essential
in relative valuation
• Relative valuation can give very strange results
23

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Section 9

Firm valuation: relative valuation

’A little inaccurancy sometimes saves tons of explanation.’

After studying this section, you will understand

• The process of firm valuation

• In Section 2, we calculated P/E- and P/B-ratios from per-

• The value of the firm (a target firm) is estimated by

1. Identify comparable firms that have similar operations

• Suppose we have identified 5 firms which are similar to

• There are a number of variants on the P/E-ratio based

• Abnormal earnings model (we will dicuss it in Section 10):

• P/B ratio is directly related to the future abnormal earnings,

• Forecasted ROE equals the cost of equity:

• P/B ratio increases with ROE

• Value of the firm having high ROE should be higher than

• EV/EBIT = Enterprise value (EV) / Earnings before

• Enterprise value (EV) = Market value of equity + Net

• Net value of debt is calculated as we have done it:

• P/Sales ratio is calculated as follows:

P/S = Stock price / Sales per share

• P/S ratio is commonly used despite its deficiencies

• Valuation based on price multiples is called relative

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