Basics: Relative Valuation (Price Multiples)

In contrast to the discounted cash flow valuation, relative valuation contends that it is possible to determine the value of a company by comparing with similar companies on the basis of several relative ratios¹. Relative valuation (also called price-multiples) is one of the most widely used valuation tool. Intuition behind the price-multiples is that we cannot judge whether a stock is undervalued, overvalued, or fairly valued without knowing what a share buys in terms of some other measure of valuation such as earning, assets, sales². Price-multiples ratio measures what a share can buy in comparison to other per share value measure such as earnings per share. There are different valuation ratios. I will discuss mostly used price/earnings, price/cash flow, price/book value, and price/sales ratios.

Price-to-earnings ratio is popular in the investment community. Earnings power is the primary determinant of investment value. Price-to-earnings ratio is using earnings per share (EPS)³. Some companies have basic and diluted earnings per share in the income statement. Diluted earnings take account of the possibility that some convertible securities could increase the number of common shares outstanding.⁴ Diluted earnings per share should be used. There are two version of P/E ratio as trailing and leading P/E ratio. The P/E ratio has a disadvantage. Because, earnings are prone to manipulation.

Price to cash flow ratio is generally less prone to manipulation. Cash flows is important to the valuation and critical for credit analysis. EBITDA is typically use as a specific measure of Cash flow. However, depending on the nature of the industry different cash flow measures can be used such as Free Cash Flow. Cash flow per share should be expected for the next period.

Price to book value ratio is a widely used ratio. There is a excess relationship between the P/BV ratios and excess rates of returns⁵. It is necessary to estimate the end-year-book value per share for the next period. This can be derived from the historical growth rate by the sustainable growth formula (g=ROE*retention rate).

Price to sales ratio is relatively volatile in comparison to other ratios. This ratio is suitable for growth companies. A requirement for a growth company is strong consistent sales growth.

References:

1 Investments, brawn, page 388

2 Equity asset valuation, cfa, page 166

3 Equity asset valuation, cfa, page 166

4 How to think like benjamin graham and invest like waren buffet, page 138

5 Eugene Fama, Kenneth French, “The Cross section of expected returns” journal of finance 47, no.2,june 1992

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