Investment Analysis

&
Portfolio Management

LECTURE 12
26/12/2022 Syed Muhammad Ali Raza
 The method of Comparables (Price Multiples)

Price multiples are among the most widely used tools for valuation of equities. Comparing stocks price multiple
can help an investor judge whether a particular stock is overvalued, undervalued, or fairly valued in terms of
measures such as earnings, sales, cash flow, or book value per share.

The method of comparables values a stock based on the average price multiple of the stock of similar
companies. The economic rationale for the method of comparables is Law of One Price, which asserts that two
similar asset should sell at comparable price multiples. This is a relative valuation model, so we can only assert
that stock is over undervalued relative to benchmark value.

Some of the examples of comparables will be discussed in detail:

• Price to Earning
• Price to Book Value
• Price to Sales
• Price to Cash Flow

26/12/2022 Syed Muhammad Ali Raza

 The method of Comparables (Price Multiples)

The price-to-earnings ratio is the ratio for valuing a company that measures its current share price relative to
its earnings per share (EPS). The price-to-earnings ratio is also sometimes known as the price multiple or the
earnings multiple.

P/E ratios are used by investors and analysts to determine the relative value of a company's shares in an
apples-to-apples comparison. It can also be used to compare a company against its own historical record or to
compare aggregate markets against one another or over time.
P/E may be estimated on a trailing (backward-looking) or forward (projected) basis.

P/E Ratio Formula and Calculation

The formula and calculation used for this process are as follows.

P/E Ratio= Market value per share / Earnings per share

26/12/2022 Syed Muhammad Ali Raza

 The method of Comparables (Price Multiples)

The price-to-earnings ratio or P/E is one of the most widely used stock analysis tools by which investors and
analysts 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.

In essence, the price-to-earnings ratio indicates the dollar amount an investor can expect to invest in a
company in order to receive $1 of that company’s earnings. This is why the P/E is sometimes referred to as the
price multiple because it shows how much investors are willing to pay per dollar of earnings. If a company was
currently trading at a P/E multiple of 20x, the interpretation is that an investor is willing to pay $20 for $1 of
current earnings.

The P/E ratio helps investors determine the market value of a stock as compared to the company's earnings. In
short, the P/E ratio shows what the market is willing to pay today for a stock based on its past or
future earnings. A high P/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.

26/12/2022 Syed Muhammad Ali Raza

 The method of Comparables (Price Multiples)

The price-to-earnings ratio or P/E is one of the most widely used stock analysis tools by which investors and
analysts 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.

In essence, the price-to-earnings ratio indicates the dollar amount an investor can expect to invest in a
company in order to receive $1 of that company’s earnings. This is why the P/E is sometimes referred to as the
price multiple because it shows how much investors are willing to pay per dollar of earnings. If a company was
currently trading at a P/E multiple of 20x, the interpretation is that an investor is willing to pay $20 for $1 of
current earnings.

The P/E ratio helps investors determine the market value of a stock as compared to the company's earnings. In
short, the P/E ratio shows what the market is willing to pay today for a stock based on its past or
future earnings. A high P/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.

26/12/2022 Syed Muhammad Ali Raza

 The method of Comparables (Price Multiples)

Example:

MK Technologies shares are selling for $ 50. Earnings for the last months were $2 per share. The average
trailing P/E ratio for the firm in MK’s industry is 32 times. Determine whether MK is over or undervalued using
the method of comparables.

Limitations of P/E Ratio:

• Earnings can be negative, which produces a meaningless P/E ratio

• The volatility and transition portion of earnings make the interpretation of P/Es difficult to analyze.
• Management discretion within allowed accounting practices can distort reported earnings, thereby
lessening the comparability of P/Es across the firm.

26/12/2022 Syed Muhammad Ali Raza

 The method of Comparables

Price-to-book value (P/B) is the ratio of the market value of a company's shares (share price) over its book value of
equity. The book value of equity, in turn, is the value of a company's assets expressed on the balance sheet. The
book value is defined as the difference between the book value of assets and the book value of liabilities.

Investors use the price-to-book value to gauge whether a stock is valued properly. A P/B ratio of one means that
the stock price is trading in line with the book value of the company. In other words, the stock price would be
considered fairly valued, strictly from a P/B standpoint. A company with a high P/B ratio could mean the stock price
is overvalued, while a company with a lower P/B could be undervalued.

However, the P/B ratio should be compared with companies within the same sector. The ratio is higher for some
industries than others. So, it's important to compare it to companies with a similar makeup of assets and liabilities.

P/B = Market price per share / book value per share

26/12/2022 Syed Muhammad Ali Raza

 The method of Comparables

The price-to-sales (P/S) ratio is a valuation ratio that compares a company’s stock price to its revenues. It is an
indicator of the value that financial markets have placed on each dollar of a company’s sales or revenues.

• The price-to-sales (P/S) ratio shows how much investors are willing to pay per dollar of sales for a stock.
• The P/S ratio is calculated by dividing the stock price by the underlying company's sales per share.
• A low ratio could imply the stock is undervalued, while a ratio that is higher than average could indicate that the
stock is overvalued.
• One of the downsides of the P/S ratio is that it doesn’t take into account whether the company makes any
earnings or whether it will ever make earnings.

26/12/2022 Syed Muhammad Ali Raza

 The method of Comparables

P/CF multiples are calculated with a similar approach to what is used in the other price-based metrics. The P, or
price, is simply the current share price. The CF, or cash flow, found in the denominator of the ratio, is obtained
through a calculation of the trailing 12-month cash flows generated by the firm, divided by the number of shares
outstanding.

• Price to free cash flow is an equity valuation metric that indicates a company's ability to continue operating. It is
calculated by dividing its market capitalization by free cash flow values.
• Relative to competitor businesses, a lower value for price to free cash flow indicates that the company is
undervalued and its stock is relatively cheap.
• Relative to competitor businesses, a higher value for price to free cash flow indicates a company's stock is
overvalued.
• The price-to-free cash flow ratio can be used to compare a company's stock value to its cash management
practices over time.

26/12/2022 Syed Muhammad Ali Raza

 Derivatives

Introduction
A derivative is a financial instrument that derives its value from the economic performance of the underlying
(stocks, interest rate etc.). Options are contingent-claim derivatives. The two main types of options are call options
and put options.
• A call option gives the holder a right but not the obligation to buy the underlying
asset at a particular price.
• Similarly, a put option gives the holder a right but not the obligation to sell the
underlying asset at a particular price.

Synthetic Forward Position: Synthetic positions are used:

1. To exploit arbitrage opportunities, when the actual forward contract is over or undervalued as compared to the
implied synthetic contract.
2. When it is difficult to buy an actual forward contract.

Synthetic Long Position: Buying a call and writing a put on the same underlying with the same strike price and
expiration creates a synthetic long position (or, a synthetic long forward position). This can be demonstrated by
looking at the payoffs of the three alternatives:
1) Buy a call and write a put. Both options have the same expiration date and the same exercise price of $50.
2) Buy a stock for $50.
3) Buy forward/futures at 50.
26/12/2022 Syed Muhammad Ali Raza
 Derivatives

The table above shows that all three alternatives have the same payoff (value). Hence, we
can conclude that: Long call + Short put = Long stock = Long forward/futures

26/12/2022 Syed Muhammad Ali Raza