RELATIVE VALUATION DEFINED

In discounted cash flow valuation, the objective

is to find the value of assets given their cash
flows, growth and risk characteristics

In relative valuation the objective is to value

assets based on how similar assets are
currently priced in the market. Relative value
reflects both theoretical value and market
sentiments.

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 STANDARDIZED VALUES OF MULTIPLES

• Prices get tampered by capitalisation changes such as stock splits,

stock dividends, rights issues etc.

• Valuation multiples are useful for inter-firm comparison.

TYPES OF MULTIPLES
• Earnings multiples

• Book value or replacement value multiples

• Revenue multiples

• Sector-specific multiples

2
 THE FOUR BASIC STEPS IN USING MULTIPLES
I. Definitional tests
Consistency
Uniformity

II. Distributional tests

Descriptive statistics
• Since the valuation multiples are generally positive, their distributions are
positively skewed.
• Median P/E ratio is preferred to mean P/E ratio as the latter is higher in
positively skewed distributions.
• Measures of central tendency and dispersion should be estimated both on
sectoral as well as overall market basis.

Outliers
They should be omitted or capped.

Negative P/E ratios

• Ignore them
• Use aggregate P/E
• Use E/P ratio

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III. Analytical Tests
DPS1
Value of equity P0 = ----------
Kc – gN
P Payout ratio x (1 + gN)
Price Earning or P/E ratio ------ = ----------------------------
EPS0 Ke – gN
+ - -
P/E = f (payout, growth, risk)
P ROE x Payout ratio x (1 + gN)
Price to book or P/E ratio ------ = --------------------------------------
BV0 K c – gN
+ + + -
P/B = f (ROE, payout, growth, risk)
P Net profit margin x Payout ratio x (1 + gN)
Price to sales (P/S) ratio ------ = -----------------------------------------------------
S0 Kc – gN

P/S = f (Net profit margin, payout ratio, growth, risk)

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IV. APPLICATION TESTS

Comparable company

• Company in the same business

• Company of the same size
• Company with the same fundamental characteristics such as payout,
growth and risk

Sector regression

P/E ratio as a function of its determinants for a given sector. The data
range is low on multi-sectoral basis for most countries.

Market regression

Multiple regression on overall market basis.

• Wider range
• Each Euro is competing for each company.
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 EARNINGS MULTILPLES
Estimating value of equity
Market price per share
P/E = -----------------------------
Net Earnings per share

• P/E ratios can be trailing P/E, current P/E and forward P/E.

• P/E ratios of technology firms are generally higher than P/E ratios for
other firms, owing to
- their strong growth potential through mergers and acquisitions
- valuation of R&D processes.

• Greater management options in case of technology firms, warrants

market use of diluted EPS instead of primary EPS.

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 DETERMINANTS OF P/E
Whibeck and Kisor Model

P/E = r0 + r1 (expected growth rate) + r2 (Beta) + r3 (payout) + e

Estimation procedure
• Multiple regression (cross-sectional)
• Panel data regression

Forward P/E

P0 Payout ratio
--- = ---------------
E1 Kc - gN

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The price-Earnings to Growth or PEG ratio
• Most investment analysts combine P/E ratio with expected growth rates
for comparable firms to detect under (over) valuation.
Payout ratio x (1 + g)
PEG = ------------------------------
g(ke – g)
• A low PEG ratio generally implies undervaluation.

• The PEG matrix

High Over
valued
stocks
P/E
Under
valued
Low stocks
Low g High

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CASE STUDY
Comparing PE Ratios and Growth Rates Across Firms
Table summarizes the PE ratios and expected growth rates in EPS
over the next five years, based on consensus estimates from analysts,
for the firms that are categorized as comparable to Cisco because
they are in a similar business.
Company Name BETA PE Projected PEG
Growth
3 Com Corp. 1.35 37.20 11.00% 3.38
ADC Telecom 1.4 78.17 24.00% 3.26
Alcatel ADR 0.9 51.50 24.00% 2.15
Ciena Corp. 1.7 94.51 27.50% 3.44
Cisco 1.4 133.76 35.20% 3.80
Converse Technology 1.45 70.42 28.88% 2.44
E-TER Dynamics 1.85 295.56 55.00% 5.37
JDS Uniphase 1.6 296.28 24.00% 2.36
Lucent Technologies 1.3 54.28 24.005 2.26
Nortel Networks 1.4 104.18 25.50% 4.09
Tellabs, Inc. 1.75 52.37 22.00% 2.39 9
Average 115.31 30.64% 3.38
Is Cisco under-or overvalued on a relative basis? A simple view of
multiples would lead you to conclude that it is highly overvalued
because its PE ratio of 133.76 is higher than the average for the
industry.

In making this comparison, you assume that Cisco has a growth

rate similar to the average for the sector. One way of bringing
growth into the comparison is to compute the PEG ratio, which is
reported in the last column. Based on the average PEG ratio of 3.38
for the sector and the estimated growth rate for Cisco, you obtain
the following values for the PE ratio for Cisco:

Based on this adjusted PE, Cisco is overvalued compared to its its

current PE ratio of 133.76. While this may seem like an easy
adjustment to resolve the problem of differences across firms, the
conclusion holds only if these firms are of equivalent risk.
Implicitly, this approach assumes a linear relationship between
growth rates and PE.
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Case Study II
Revisiting the Cisco Analysis: Sector Regression

The price-earnings ratio is a function of the expected growth rate,

risk, and the payout ratio. None of the firms in Cisco’s comparable
firm list pays significant dividends, but they differ in terms of risk.
Table summarises the price-earnings ratios, betas, and expected
growth rates for the firms on the list.

since these firms differ on both risk and expected growth, you would
run a regression of PE ratios on both variables.

PE = 35.08 – 65.73 Beta + 573.10 Expected Growth R2 = 92.63%

(0.56) (-1.67) (11.93)

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The numbers in parenthesis are t-statistics and suggest that the
relationships between PE ratios and the variables in the regression
are statistically significant. R2 indicates the percentage of the
differences in PE ratios that is explained by the independent
variables. Finally, the regression itself can be used to get predicted
PE ratio for the companies in the list. Thus, the predicted PE ratio
for Cisco, based on its beta of 1.40 and the expected growth rate of
35.2%, would be:

Predicted PECisco = 3.08 – 65.73 (1.40) + 573.10 (.352) = 144.79

Since the actual PE ratio for Cisco was 133.76, this result would
suggest that the stock is undervalued.

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Estimating Firm Value

Enterprise value
-------------------
EBITDA

where

Enterprise value = market value of equity + market value of debt – any

cash outstanding

EBIDTA = Earnings before interest, taxes, depreciation and amortization

The ratio can be used to compare firms with

• different financial leverage

• Different accounting policies

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 BOOK VALUE MULTILPLES
Valuing Equity
P/B ratio = Price to book value of equity
Constant growth assumption

ROEX Payout ratio x (1 + gN)

P/B = -----------------------------------
Ke – gN
Modified P/B ratio = P/B ROE

High Over
valued

P/B
Under
valued
Low
Low ROE High

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 REVENUE MULTIPLES
Valuing Equity
Constant growth assumption

P0 Net profit margin x payout ratio x (1 + gN)

------- = ----------------------------------------------------
Sales0 Ke – gN

Modified price to sales ratio = P/S  Net profit margin

High Over
valued

P/S
Under
valued
Low
Low NPM High

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 FINDING PE RATIO

EXAMPLE 4

The dividend pay out ratio of XYZ Ltd. is 40%. The growth rate of the firm
is 10%. The cost of equity is 14%. Find PE ratio of XYZ Ltd.

Payout ratio x (1 + g)
PE ratio = ----------------------------
Ke - g

.40 x 1.10 .44

= ------------- = ------ = 11
.14 - .10 .04

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FIND PRICE TO BOOK VALUE RATIO OF THE FIRM

EXAMPLE 5

The dividend pay out ratio of XYZ Ltd. is 40%. The growth rate of the firm
is 10%. The cost of equity is 14%. Return on Equity (RoE) of the firm is
16.67%. Find P/B ratio of XYZ Ltd.

RoE x [Payout ratio x (1 + g)]

P/B ratio = ----------------------------------------
Ke - g

.1667 x [.40 x 1.10] .1667 x .44 0.0733

= ---------------------- = -------------- = --------- = 1.83
.14 - .10 .04 .04

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 FIND PRICE TO SALES RATIO

EXAMPLE 6

The dividend pay out ratio of XYZ Ltd. is 40%. The growth rate of the firm
is 10%. The cost of equity is 14%. Net profit margin is 10%. Find Price to
Sales (P/S) ratio of XYZ Ltd.

Net profit margin x [Payout ratio x (1 + g)]

P/S ratio = -----------------------------------------------------
Ke - g

.10 x [.40 x 1.10] .10 x .44 .044

= ----------------------- = ------------ = ------- 1.1
.14 - .10 .04 .04

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CASE STUDY: Calcualting EV/EBITDA multiples

Daniel, Inc., is a manufacturer of small refrigerators and other

appliances. The following figures are from Daniel’s most recent
financial statements except for the market value of long-term debt,
which has been estimated from financial market data.

Stock price $30.00

Shares outstanding 300,000
Market value of long-term debt $800,000
Book value of long-term debt $1,100,000
Book value of total debt $2,600,000
Cash and marketable securities $300,000
EBITDA $1,200,000

Calculate the EV/EBITDA multiple.

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Answer:

First, we must estimate the market value of the firm’s short-term

debt and liabilities. To do so, subtract the book value of long-term
debt from the book value of total debt: $2,600,000 - $1,100,000 =
$1,500,000. This is the book value of the firm’s short-term debt.
We can assume the market value of these short-term items is close
to their book value. (As we will see in the Study Session on fixed
income valuation, the market values of debt instruments approach
their face values as they get close to maturity).

Add the market value of long-term debt to get the market value of
total debt:
$800,000 + $1,500,000 = $2,300,000.

The market value of equity is the stock price multiplied by the

number of shares:
$30 x 300,000 = $9,000,000.
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The enterprise value of the firm is the sum of debt and equity minus
cash:
$2,300,000 + $9,000,000 - $300,000 = $11,000,000.

EV/EBITDA = $11,000,000/$1,200,000 = 9.2

If the competitor or industry average EV/EBITDA is above 9.2,

Daniel is relatively undervalued. If the competitor or industry
average EV/EBITDA is below 9.2, Daniel is relatively overvalued.

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Explain asset-based valuation models and demonstrate the use of
asset-based models to calculate equity value.

Asset-based models are based on the idea that equity value is the
market or fair value of assets minus the market or fair value of
liabilities. Possible approaches to valuing assets are to value them at
their depicted values, inflation-adjusted depreciated values, or
estimated replacement values.

Applying asset-based model is especially problematic for a firm that

has a large amount of intangible assets, on or off the balance sheet.

Asset-based model valuations are most reliable when the firm has
primarily tangible short-term assets, assets which with ready market
values (e.g., financial or natural resource firms), or when the firm
will cease to operate and is being liquidated. Asset-based models are
often used to value private companies but may be increasingly useful
for public firms as they move toward fair value reporting on the
balance sheet. 22
CASE STUDY: Using an asset-based model for public firm
Williams Optical is a public traded firm. An analyst estimates
that the market value of net fixed assets is 120% of book value.
Liability and short-term asset market values are assumed to equal
their book values. The firm has 2,000 shares outstanding.
Using the selected financial results in the table, calculate the value of
the firm’s net assets on a per-share basis.

Cash $10,000
Accounts receivable $20,000
Inventories $50,000
Net fixed assets $120,000
Total assets $200,000
Accounts payable $5,000
Notes payable $30,000
Term loans $45,000
Common stockholder equity $120,000
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Total assets $200,000
Answer:
Estimate the market value of assets, adjusting the fixed assets for
the analyst’s estimates of their market values:

$10,000 + $20,000 + $50,000 + $120,000(1.20) = $224,000

Determine the market value of liabilities:

$5,000 + 30,000 + $45,000 = $80,000

Calculate the adjusted equity value:

$224,000 - $80,000 = $144,000

Calculate the adjusted equity value per share:

$144,000/2,000 = $72 24
CHAOS THEORY AND CAPITAL
MARKETS

A Presentation
by
Prof. Sanjay Sehgal
Department of Financial Studies
University of Delhi, India
sanjayfin15@yahoo.co.in

25
 Chaos Theory and Financial
Markets
What is Chaos?

- Chaotic systems are apparently random but inherently deterministic

- The system exhibits a long memory process which is born because

of combination of trend with noise

- System outcomes are highly sensitive to initial conditions

- Chaos are non linear dynamical systems which are graphed using
fractal geometry

- Chaos is observed in natural as well as economic phenomenon

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 Review of Literature
(Mishra, Sehgal and Bhanumurthy (2011)

• Broadly, the literature on chaos could be divided into two parts (see Savit, 1988 &
1989; Hinich and Patterson, 1985 for comprehensive RoLit):

1. Theoretical studies (contributions of Mandelbrot).

2. Empirical studies

• Mandelbrot highlighted the weak foundations of the linear paradigm (IID/NID, finite
variance, volatility scales with square root of time similar to a particle under Brownian
motion, price distribution follows a continuous time process, dimensionality of random
walk series is 2).

• Mandelbrot (1963, 1969, 1971 & 1972) demonstrates that time series of various
assets returns are:

– Not normally distributed – the problem of fat tail.

– Price distributions are non-normal
– Not IID - strong evidence of long-memory.
– Evidence of non-periodic cycles.
– High probability of outlier events, discontinuities and sudden change
transmitted by crisis – indicative of nonlinearity and chaos (see Mouck, 1998).

27
• Following this, a number of studies investigated the issue – covering different sample
periods and markets.

• First evidence of nonlinear dependence and chaos is provided by Hinich and

Patterson (1985) – stock returns and Frank and Stengos (1989) for Gold and silver.

• In general, studies have consistently documented evidence of nonlinearity in the

returns of various assets.

• For example, Scheinkman and LeBaron (1989), Brock et al. (1992); Kyrtsou and
Serletis, 2006; Kyrtsou and Terraza, 2003; Cajueiro and Tabak, 2008 :
• Found that residuals of filtered stock returns are not IID and,
• Market returns, therefore, do not follow random walk process.

• Other studies, such as Helms et al., 1984; Panas and Ninni, 2000; Sarkar, 2005;
Souza and Tabak, 2008; Cajueiro & Tabak, 2009; Kyrtsou and Terraza, 2010:
• reported strong evidence of long-range dependence in the returns of various
assets.
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• Howe et al. (1999):
• Strong evidence of deterministic structure in returns (stock).
• Cycle length ranging from 3 to 4 years.

• Contrary to these findings, Lo (1991), Cheung and Lai (1995), Jacobsen (1996),
Serletis & Shintani (2006):
• Failed to find any evidence of long-range dependence in stock returns for
some European countries, the United States and Japan.

• Similarly, evidence on chaotic structures in market returns is also somewhat mixed.

• For example, studies such as Frank and Stengos (1989), Hsieh (1991), Blank
(1991) and DeCoster, Labys, and Mitchell (1992) Cajueiro & Tabak (2009); Kyrtsou
and Terraza (2010):
• Have found strong evidence of dependence and chaotic structure.
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• Kosfeld and Robe (2001) for German bank stock returns and Opong, Mulholland,
Fox, and Farahmand (1999) for London Financial Times Stock Exchange:

• Found that low order GARCH models are sufficient to explain the existing
nonlinearity in the data.

• Mishra, Sehgal and Bhanumurthy (2011) reported strong evidence of nonlinearity

in Indian stock market, but failed to find significant evidence of chaos.

• Nevertheless, some other studies have documented encouraging evidence of

chaos for exchange rates. For example, Serletis and Gogas (1997) and Scarlat,
Stan, and Cristescu (2007).

• Most recently, Aviral Kumar Tiwari and Rangan Gupta (2019) investigated chaos
in the stock returns for G7 countries and concluded that chaos is observed for all
countries using the denoised data.

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 Research Issues
• Do financial time series exhibit deterministic chaos?

• What are the more sophisticated tools to test Chaos?

• How should financial time series be forecasted in the

presence of Chaos?

• Can Chaos theory be used to explain economic and

market collapse?

• Previous studies have mainly focused on mature markets,

and emerging markets have received very less attention.
31