Security Valuation

Session 21 & 22

Relative Valuation [Chapter 17 ]

RV- Earnings Multiples [Chapter 18]

RV- BK Value Multiples [Chapter 19]

RV- Revenue Multiples [Chapter 20]

 II. Relative Valuation (RV)
 What is it?: The value of any asset can be estimated by looking at how the
market prices value “similar” or ‘comparable” assets.

 Philosophical Basis: The intrinsic value of an asset is impossible (or close to

impossible) to estimate. The value of an asset is whatever the market is
willing to pay for it (based upon its characteristics)

 Information Needed: To do a relative valuation, you need

• an identical asset, or a group of comparable or similar assets
• a standardized measure of value (in equity, this is obtained by dividing the
price by a common variable, such as earnings or book value)
• and if the assets are not perfectly comparable, variables to control for the
differences

 Market Inefficiency: Pricing errors made across similar or comparable assets

are easier to spot, easier to exploit and are much more quickly corrected.
Multiples are just standardized estimates of price
Multiples are just standardized estimates of price
• The distinction between
– Price (representing Equity Value)
– Firm Value (representing the combined market value of equity and
debt) and
– Enterprise Value (representing firm value - cash and marketable
securities) should be noted.

• Why is Cash netted out ? EV/EBITDA - Since interest income from cash is
not counted as part of EBITDA, not netting it out will result in an
overstatement of the multiple.

• Note that the denominator can be a number from the income statement
(revenues, earnings) or one from the balance sheet (book value). It can
even be a non-financial input (number of employees or units of the product
produced).
 4 Steps to Using / Understanding Multiples
1. Definitional Tests - Define the multiple - In use, the same multiple can be
defined in different ways by different users. When comparing and using multiples,
estimated by someone else, it is critical that we understand how the multiples have
been estimated.

PE = Market Price or CMP / EPS

– (Current price is conventionally used in the numerator, there are some analysts who use the
average price over the prior six months or year.
– The earnings per share in the denominator can be the earnings per share from the most
recent financial year (yielding the current PE), the last four quarters of earnings (yielding the
trailing PE), or expected earnings per share in the next financial year (resulting in a forward
PE).

2. Descriptional Tests-
How large are the outliers to the distribution, and how do we deal with the outliers?

What is the average and standard deviation for this multiple, across the universe (market)?

3. Analytical Tests - It is critical that we understand the fundamentals that drive each
multiple, and the nature of the relationship between the multiple and each variable.

4. Application Tests - Defining the comparable universe and controlling for

differences is far more difficult in practice than it is in theory.
 Need for Standardization of Values
 Two components to RV :
1) To Value assets on relative basis – Prices have to be standardized – How ?
By converting Prices into Multiples of Earnings, Book Value or Sales.

Need to Standardize values and Multiples:

Price of a stock is a function of Both Value of the Equity in a company & No of shares O/S in the
firm.

Eg . 2-for-1 stock split that doubles the number of units will approximately half the stock price.

Since stock prices are determined by the number of units of equity in a firm, stock prices cannot be
compared across different firms.

To compare the values of similar firms in the market- Need to standardize the values in some
way.

Values can be standardized : Relative to the

1) Earnings generated
2) Book value or replacement value of the assets employed,
3) Revenues generated, or
4) To measures that are specific to firms in a sector
 Comparable Firms
 Two components to RV :

2) To find similar firms – difficult to do – since no firms are identical – firms

in the same business can still differ on risk, growth potential and cash flows.

 Comparable Firms:

i. General View/ Conventional practice and Not always True : Firms in the same
business/industry as the firm being valued are called comparable.

ii. Ideal View - A Comparable firm is one with cash flows, growth potential, and risk
similar to the firm being valued.

iii. Telecommunications firm can be compared to a software firm if the two are identical in
terms of cash flows, growth, and risk.

iv. Analysts define comparable firms to be other firms in the firm's business or
businesses. - Implicit assumption being made here is that firms in the same sector
have similar risk, growth, and cash flow profiles and therefore can be compared with
much more legitimacy
 Comparable Firms
 The key question faced in coming up with the list of comparable firms

1. How narrowly you define a comparable firm - If you define it as a firm that
looks just like the firm you are valuing on every dimension (risk, growth, and
cash flows) may find only a handful of comparable firms.

2. How broadly you define a comparable firm - If you define it more broadly
and are willing to accept differences on one or all of the dimensions -
comparable firm list will be longer.

No matter how carefully you construct your list of comparable firms - End up with
firms that are different from the firm you are valuing.

The differences may be small on some variables and large on others, and
you will have to control for these differences in a relative valuation.
Comparable Firms- Controlling for Differences
Question is

How to control for these differences, when comparing pricing across

several firms?

You will get more reliable estimates of relative value using a larger sample of
less comparable firms than a very small sample of more comparable ones.

There are three ways of controlling for these differences

I. Subjective adjustments
II. Modified multiples
III. Sector regressions
IV. Market regressions
 Companion Variables
II. Modified Multiples

In this approach, you modify the multiple to take into account the most important
variable determining it—the companion variable.

There is one variable that dominates when it comes to explaining each multiple.
This variable, which is called the companion variable, can usually be identified by
looking at how multiples vary across firms in a sector or across the entire market.

DCF - value of a firm is a function of three variables—its capacity to generate cash

flows, its expected growth in these cash flows, and the uncertainty associated with these
cash flows.

Every multiple, whether it is of earnings, revenues, or book value, is a function of the

same three variables—risk, growth, and cash flow generating potential.

Firms with higher growth rates, less risk, and greater cash flow generating potential
should trade at higher multiples than firms with lower growth, higher risk, and less cash
flow potential.
 What to control for…

RV Multiple Companion Variables that determine it…

EQ Multiple
PE Ratio Expected Growth, Risk, Payout Ratio

PBV Ratio Return on Equity, Expected Growth, Risk, Payout

PS Ratio Net Profit Margin, Expected Growth, Risk, Payout Ratio

Firm or EV Multiple
EV/EBITDA Expected Growth, Reinvestment rate, Cost of capital
EV/IC Return on Capital, Expected Growth, Cost of capital, Reinvestment
EV/ Sales After-tax Operating Margin (ATOM), Expected Growth, Risk, Reinvestment
 Valuation Models
Objective of DCF: To find the value of assets,
given their CF, Growth & Risk characteristics
Dividend
Equity Valuation
models
FCFE
I. Discounted Cash
flow
(DCF)Model COC approach

Firm Valuation
APV approach
models

Excess Return III. Contingent

(EVA) model Claim Valuation
Valuation Models
Earnings PE IV. Asset- Based
Multiples EV/EBITDA Valuation Model

Book Value PBV

II. Relative Valuation Multiples EV/IC
(RV) Model
Revenue PS
Multiples EV/Sales

Sector specific
Multiples

Objective of RV: Value of an assets is based on how

Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved.
similar assets are currently priced in the market.
Multiples are just standardized estimates of price
Price Earnings Ratio = PE Ratio (Equity Multiple)
• Earnings multiples – most commonly used measure of RV
• There are a number of variants on the basic PE ratio in use (PEG ratio &
Relative PE). They are based upon how the price and the earnings are
defined.
• PE is measure of Equity Earnings or an Equity Multiple

PE = Market Price per Share / Earnings per Share

• Price (numerator):
– is usually the Current Market Price (CMP) or Some like to use average
market price over last 6 months or year)
EPS (denominator):
– Time variants:
i. EPS in most recent financial year (current) – Current EPS
ii. EPS in most recent four quarters (trailing) – Trailing EPS
iii. EPS expected in next fiscal year or next four quarters (both called
forward) or EPS in some future year – Forward EPS
 Price Earnings Ratio = PE Ratio
When you are negotiating with someone else and you are both using PE
ratios to make your case, the first step is to make sure that you are using the
same PE ratio.

PE is measure of Equity Earnings or an Equity Multiple

1. Current PE = Market Price per Share or CMP / Current EPS

2. Forward PE = CMP / Forward EPS or Forward Earnings
3. Trailing PE = CMP / Trailing EPS or Trailing Earnings

Current PE > Forward PE > Trailing PE

Skewed Distributions: PE ratios for US
companies in January 2012
PE Ratio: Understanding the Fundamentals
Determinants of the PE Ratio
• PE is an Equity Multiple of RV & can be analyzed using Equity
Valuation model.

• RV Multiple Companion Variables that determine it

PE Ratio Expected Growth, Risk, Payout Ratio

• Conventional usage…
Sector Multiple Used Rationale
Cyclical PE Often with
Manufacturing normalized earnings
Note on Normalized Earnings for PE ratio :

The dependence of PE ratios on current earnings makes them particularly

vulnerable to the year-to-year swings that often characterize reported earnings.

In making comparisons, therefore, it may make much more sense to use

normalized earnings.

The process used to normalize earnings varies widely, but the most common
approach is a simple averaging of earnings across time.

For a cyclical firm, for instance, you would average the earnings per share
across a cycle. In doing so, you should adjust for inflation.

If you do decide to normalize earnings for the firm you are valuing,
consistency demands that you normalize them for the comparable firms in the
sample as well.
To get to the heart of equity multiples (PE Ratio), we start with an Equity
DCF model. In this case, we consider the simplest equity valuation model
- a stable growth dividend discount model. Restated in terms of the PE
ratio, we find that the PE ratio for a stable growth firm can be written in
terms of three variables:
1.The expected growth rate in earnings per share
2.The riskiness of the equity, which determines the cost of equity
3.The efficiency with which the firm generates growth, which is measured
by how much the firm can pay out or afford to pay out after reinvested
to create the growth.

In the simplest DCF model for equity, which is a Stable growth DDM :

Value of equity = P0 = DPS1 / (Ke – gn)

= DPS0 (1+ g) / (Ke – gn)

Where :

DPS1 = Expected Dividend in the next year

Ke = COE or cost of Equity
 PE – Equity Multiple (Stable Growth Firm)
Value of equity = P0 = DPS1/ (Ke – gn)
= DPS0 (1+ g)/(Ke – gn)

Dividing both sides by Earnings or EPS we get:

P0 = DPS0 (1+ g)/(Ke – gn)

P0 / EPS0 = [DPS0 (1+ g)/(Ke – gn) ] / EPS0

Dominating
Variable is
P0 / EPS0 = Dividend Payout Ratio (1+ gn) / (Ke – gn)
Expected
Current PE = Payout Ratio (1+ gn) / (Ke – gn)
Growth

P0 / EPS1 = Dividend Payout Ratio / (Ke – gn)

Forward PE = Payout Ratio / (Ke – gn)

Note : Payout ratio = DPS/ EPS

Payout ratio = Total dividend paid / Net Income or PAT
 PE – Equity Multiple (Stable Growth Firm)

Current PE = Payout Ratio (1+ g n) / (Ke – gn)

PE is a Decreasing
PE is an function of COE or
Increasing Riskiness of equity
function of
Payout ratio
and Growth
rate
Expected growth or g = b* ROE
g= Retention Ratio *ROE
g=(1-payout ratio)* ROE
g / ROE= 1-payout ratio Payout ratio
Payout ratio = 1 – (g/ROE) expressed as a
Payout Ratio = 1- (expected growth rate/ ROE ) function of expected
= 1- (gn/ ROEn ) growth and ROE
 PE – Equity Multiple (Stable Growth Firm)
Payout Ratio = 1- (expected growth rate/ ROE ) Payout ratio
= 1- (gn/ ROEn ) expressed as a
function of expected
growth and ROE

P0 / EPS1 = Dividend Payout Ratio / (Ke – gn)

Forward PE = Payout Ratio / (Ke – gn)

Substitute Payout ratio in terms of ROE , we get :

Forward PE = [1- (gn / ROEn )] / (Ke – gn)

 PE Ratio: Determinants to Recap

• Proposition: Other things held equal, higher growth firms

will have higher PE ratios than lower growth firms.
• Proposition: Other things held equal, higher risk firms will
have lower PE ratios than lower risk firms
• Proposition: Other things held equal, firms with lower
reinvestment needs or higher payout ratio will have
higher PE ratios than firms with higher reinvestment rates.
• Of course, other things are difficult to hold equal since high
growth firms, tend to have risk and high reinvestment rates.
 Estimate PE For a High Growth Firm
• The PE ratio for a high growth firm can also be related to
fundamentals. In the special case of the two-stage dividend
discount model, this relationship can be made explicit fairly
simply:

– For a firm that does not pay what it can afford to in dividends,
substitute FCFE/Earnings for the payout ratio.

• Dividing both sides by the earnings per share (EPS):

 Expanding the Model
Payout ratio of High High growth rate Stable
growth phase growth
rate

COE of stable
growth phase
COE of high
growth phase Payout ratio of Stable growth phase

• In this model, the PE ratio for a high growth firm is a function of

growth, risk and payout, same variables that it was a function of for
the stable growth firm.
• The only difference is that these inputs have to be estimated for
two phases - the high growth phase and the stable growth
phase.
• Expanding to more than two phases, say the three-stage model, will
account for risk, growth and cash flow patterns in each stage.
 Problem 1
• Assume that you have been asked to estimate the PE
ratio for a firm which has the following characteristics:
Variable High Growth Phase Stable Growth Phase

Expected Growth Rate 25% 8%

Payout Ratio 20% 50%
Beta 1.00 1.00
Number of years 5 years Forever after year 5
• Riskfree rate = T.Bond Rate = 6%; Market Risk Premium = 5.5
• Required rate of return or COE = 6% + 1(5.5%)= 11.5%

= 1.427 + 27.321 = 28.7483 = 28.75 times

 Problem 1
• Assume that you have been asked to estimate the PE
ratio for a firm which has the following characteristics:
Variable High Growth Phase Stable Growth Phase

Expected Growth Rate 25% 8%

Payout Ratio 20% 50%
Beta 1.00 1.00
Number of years 5 years Forever after year 5
• Riskfree rate = T.Bond Rate = 6%; Market Risk Premium = 5.5
• Required rate of return or COE = 6% + 1(5.5%)= 11.5%

Estimate ROE ? ?
ROE for first 5 years ROE in stable growth
= Growth / (1- payout ratio) = Growth / (1- payout ratio)
= 0.25/ (1-.20) = 0.08/ (1- 0.50)
= 0.25/0.8 = 0.3125 = 0.08/0.50 = 0.16
 Problem 2
• Assume that you have been asked to estimate the PE ratio
for a firm which has the following characteristics:
Variable High Growth Phase Stable Growth Phase

Length of growth 5 years After year 5

Expected Growth Rate 10% 3%
Payout Ratio 50% 75% (to find this)
COE 8% 8.5%
ROE 12% (given)
Solution :
Stable payout ratio can be found with ROE values also = 1-(3%/12%) =75%
Two- stage PE =
 Analysis - Problem 2

• Based on its fundamentals, we would expect the firm to trade

at 18.04 times earnings.

• Multiplying this intrinsic PE ratio by the current EPS of $3.82

yields $68.90.

• The same value that we estimated using the two-stage

dividend discount model also.
 EV / EBITDA (Firm Value Multiple)
• Enterprise value (EV) to EBITDA multiple is a firm value multiple.
• In the past two decades, this multiple has acquired a number of adherents among
analysts for several reasons.
• First, there are far fewer firms with negative EBITDA than there are firms with
negative earnings per share, and thus fewer firms are lost from the analysis.
• Second, differences in depreciation methods across different companies—
some might use straight-line while others use accelerated depreciation—can
cause differences in operating income or net income but will not affect EBITDA.
• Third, this multiple can be compared far more easily than other earnings
multiples across firms with different financial leverage (the numerator is firm
value, and the denominator is a pre-debt earnings).
• Hence, this multiple is particularly useful for firms in sectors that require large
investments in infrastructure with long gestation periods.
• Telecom companies or companies involved in airport or toll road construction
would be good examples.
 EV / EBITDA (Firm Value Multiple)
• EV / EBITDA multiple is a firm value multiple
• EV / EBITDA = (M.V of Equity + M.V of Debt – Cash) / EBITDA
• To analyze the determinants of EV/EBITDA multiples - Revert to free cash flow to
the firm valuation model.
• Value of the operating assets (or enterprise value) of a firm:

EV = FCFF1 / (WACC – g)

• Free cash flow to the firm (FCFF) in terms of the EBITDA:

FCFF = EBIT(1-t) – (Capex – DA + Working Capital )

= (EBITDA – DA) (1-t) – (Capex – DA + Working Capital)
= EBITDA (1-t) – DA (1-t) – Reinvestment
Substituting back into the equation, we get:
EV = [EBITDA1 (1-t) – DA 1 (1-t) – Reinvestment1 ] / (WACC – g)
 EV / EBITDA (Firm Value Multiple)

EV = [EBITDA1 (1-t) – DA 1 (1-t) – Reinvestment1 ] / (WACC – g)

• Dividing both sides by the EBITDA and removing the subscripts yields the
following:
 Five determinants of EV / EBITDA multiple
(Firm Value Multiple)

1. Tax rate - Firms with lower tax rates should command higher EV/EBITDA
multiples than otherwise similar firms with higher tax rates.
2. Depreciation and amortization - Firms that derive a greater portion of
their EBITDA from depreciation and amortization should trade at lower
multiples of EBITDA than otherwise similar firms.
3. Reinvestment requirements - Greater the portion of the EBITDA that
needs to be reinvested to generate expected growth, the lower the value to
EBITDA will be for firms.
4. Cost of capital - Firms with lower costs of capital should trade at much
higher multiples of EBITDA.
5. Expected growth - Firms with higher expected growth should trade at
much higher multiples of EBITDA.
 Problem 3

Castillo Cable is a cable and wireless firm with the following

characteristics:
• The firm has a cost of capital of 10% and faces a tax rate of
36% on its operating income.
• The firm has capital expenditures that amount to 45% of
EBITDA and depreciation that amounts to 20% of EBITDA.
There are no working capital requirements.
• The firm is in stable growth and its operating income is
expected to grow 5% a year in perpetuity.

Estimate the Enterprise Value to EBITDA or EV/ EBITDA

 Problem 3

Estimate EV/ EBITDA

First estimate the Reinvestment needs as a percent of

EBITDA:
Price-Book Value Ratio
(Book Value Multiples)

Chapter 19
Price-Book Value Ratio (Book Value Multiples)

• The Price/Book Value (PBV) ratio is the ratio of the market value
of equity to the book value of equity, i.e., the measure of
shareholders’ equity in the balance sheet. Reflects the market’s
expectations of the
firm’s earning power
Equity Multiple
and Cash Flows

• Price/Book Value (PBV) = Market Value of Equity

Book Value of Equity
Bk Value of assets –
Bk. Value of Liabilities

• Price/Book Value (PBV) = Market Price of EQ per share

Book Value of EQ per share

• PBV Multiple is fundamentally consistent : Both Numerator and

denominator are Equity values

Firm or Enterprise Value Multiple: EV/ IC = [ROC – g ] / (WACC – g)

PBV : Why Analysts use Book Value Multiples

• First is that the book value provides a relatively stable, intuitive

measure of value that can be compared to the market price.

• Second given reasonably consistent accounting standards

across firms, price–book value ratios can be compared across
similar firms for signs of under- or overvaluation.

• Finally, even firms with negative earnings, which cannot be

valued using price-earnings ratios, can be evaluated using price–
book value ratios; there are far fewer firms with negative book
value for equity than there are firms with negative earnings.
PBV : Disadvantage of Book Value Multiples

• Book value may not carry much meaning for service and
technology firms that do not have significant tangible assets.

• Book value of equity can become negative if a firm has a

sustained string of negative earnings reports, leading to a negative
price–book value ratio.

• If the Tangible Assets forms a significant part of the Total

Assets of the firm (higher than 50%); then go in for PBV ratio.
• OR when the proportion of PPE in Total assets is higher than
50%; go in for PBV ratio.
Conventional usage…
Sector Multiple Used Rationale
Financial Services, Price/ Book Equity Marked to market?
Banks, Insurance
firms

What to control for…

RV Multiple Companion Variables that determine it…

PBV Ratio ROE, Expected Growth, Risk, Payout Ratio

 Price Book Value (PBV) Ratio: Stable Growth Firm

• If the ROE is based upon expected earnings in the next time

period, this can be simplified to,
Price Book Value Ratio: Stable Growth Firm -
Another Presentation
• This formulation can be simplified even further by relating growth to the
return on equity:

g = b * ROE where b is retention ratio

g = (1 - Payout ratio) * ROE
Payout ratio = 1- (gn / ROEn )
• Substituting back into the P/BV equation,
Numerator
= ROE * Payout Ratio
= ROE * 1- (gn / ROEn )
= [ROE * (ROE- gn) ] / ROE
= ROE- gn

• The price-book value ratio of a stable firm is determined by the differential

between the return on equity and the required rate of return on its projects.
Price Book Value Ratio: Stable Growth Firm -
Inference

• PBV ratio of a stable firm is determined by the differential between the

return on equity and its cost of equity.
• If the return on equity exceeds the cost of equity (ROE > Ke), the price will
exceed the book value of equity (P > BV);
• If the return on equity is lower than the cost of equity (ROE < Ke) , the price
will be lower than the book value of equity (P < BV)
 Price Book Value Ratio: High-Growth Firm
• Value of Equity of a High-Growth firm in 2-stage DDM can
be written as follows (another form of representation):
 Price Book Value Ratio: High-Growth Firm
• Value of Equity of a High-Growth firm in 2-stage DDM can be
written as follows:
High Stable
growth rate Payout ratio of stable
Payout ratio of High growth rate
growth phase
growth phase

COE of Stable
COE of high
growth phase growth phase

High- Growth Phase Stable Growth Phase

• Rewriting EPS0 in terms of the ROE , EPS0 = BV0 × ROE

• To arrive at PBV multiple , bring BV0 to the left-hand side of the equation
Price Book Value Ratio: High-Growth Firm

For a firm that does not pay what it can afford to in dividends, substitute
FCFE/Earnings for the payout ratio.
Looking for undervalued securities - PBV
Ratios and ROE

• Given the relationship between price-book value ratios and

returns on equity, it is not surprising to see firms which have
high ROE selling for well above book value (P/B>1) and
firms which have low ROE selling at or below book value
(P/B < 1).

• The firms which should draw attention from investors are

those which provide mismatches of price-book value ratios
and returns on equity –
– low P/BV ratios and high ROE or
– high P/BV ratios and low ROE.
 Value to Book Multiple : (Firm Value Multiple) EV/IC

• Value to Book multiple is a firm value multiple : EV/IC

• Numerator is the Enterprise Value: EV = (M.V of Equity + M.V of Debt – Cash)
• If the market value of debt is unavailable, the book value of debt can be used
in the numerator.
• Denominator is the Invested Capital: IC = (B.V of Equity + B.V of Debt – Cash)
or B.V of Capital

• B.V. Equity is Total Assets – CL- LTL = OE or Owners’ Equity

• Since Total assets include Cash so we net out cash from IC.

• To analyze EV / IC multiples - Revert to free cash flow to the firm valuation model.
• Value of the operating assets (or enterprise value) of a firm:

EV = FCFF1 / (WACC – g)
 Value to Book Multiple : (Firm Value Multiple) EV/IC
• Value of the operating assets (or enterprise value) of a firm:

EV = FCFF1 / (WACC – g) or EV/ FCFF = 1/ (WACC – g)

EV / EBIT(1-t) = (1- RR) / (WACC – g)

EV = {EBIT (1-t) [1- Reinvestment rate] } / (WACC – g)

Dividing both sides by Book Value of Capital , we get:

EV/ IC = [ROC (1- Reinvestment rate)] / (WACC – g)

where: ROC = EBIT(1-t) / B.V Capital

Expected growth (g) = RR * ROC

Reinvestment Rate (RR) = g/ROC

 Value to Book Multiple : (Firm Value Multiple) EV/IC
Expected growth (g) = RR * ROC

Reinvestment Rate (RR) = (Capex – Depreciation + Change in WC) / [EBIT(1-t)]

Reinvestment Rate (RR) = (Net Capex) / [EBIT(1-t)]

ROC = EBIT(1-t) / B.V Capital

g = (Capex – Depreciation + Change in WC) / [EBIT(1-t)] * [EBIT(1-t) / B.V Capital]

Reinvestment Rate (RR) = g/ROC

FCFF = EBIT (1-t) - [Capex – Depreciation + Change in WC]

FCFF = EBIT (1-t) - [Reinvestment] express this reinvestment as rate

FCFF = EBIT (1-t) - [(Capex – Depreciation + Change in WC) / [EBIT(1-t)]

FCFF = EBIT (1-t) [1- (Capex – Depreciation + Change in WC) / [EBIT(1-t)]

FCFF = EBIT (1-t) [ 1- Reinvestment Rate)

FCFF = EBIT (1-t) [ 1- RR)

EV / IC (Firm Value Multiple) Stable Growth Phase

• EV/ IC = [ROC (1- Reinvestment rate)] / (WACC – g) Numerator :

Reinvestment Rate (RR) = g/ROC
ROC * [ 1- (g/ROC)]
• Now EV/ IC = [ROC – g ] / (WACC – g) ROC * [ (ROC-g)/ROC]
ROC-g

Reinvestment Rate (RR) = g/ROC

Firm is in Stable Growth
EV / IC (Firm Value Multiple) High Growth Phase

Replace equity measures with firm value measures :

• ROE replaced with the ROC,
• cost of equity (COE) with the cost of capital (WACC or COC), and
• Payout ratio with (1 – Reinvestment rate)
Revenue Multiples

Chapter 20
 Price to Sales (PS) & Value to Sales (VS)
Ratio: (Revenue Multiples)

• First, Earnings and Book value ratios can become negative for
many firms, Revenue multiples are available even for the
most troubled firms and for very young firms.

• Second, Earnings and Book value are heavily influenced by

accounting decisions on depreciation, inventory, research and
development (R&D), acquisition accounting, and extraordinary
charges, Revenue is relatively difficult to manipulate.

• Third, Revenue multiples are not as volatile as earnings

multiples, and hence are less likely to be affected by year-to-
year swings in a firm’s fortunes.
Price to Sales (PS) & EV to Sales (EV/S) Ratio:
(Revenue Multiples)

• Equity Multiple Price/Sales (PS) =

• Firm Multiple EV/Sales (EV/S)=

• Consistency Tests
– The PS ratio is internally inconsistent, since the market value of equity is
divided by the total revenues of the firm.
– The problem with this ratio is that revenues belong to the entire firm rather
than just the equity investors in the firm.
– Why do analysts get away with using this multiple? Because it tends to be used
most often with technology companies, which tend to have no debt.
Conventional usage…
Sector Multiple Used Rationale
Young growth Revenue Multiples What choice do
firms with losses you have?
Retailing Revenue multiples Margins equalize
sooner or later

What to control for…

RV Multiple Companion Variables that determine it…

PS Ratio NPM, Expected Growth, Risk, Payout Ratio

Price to Sales (PS) Ratio – EQ Multiple: (Stable Growth Firm)

• The price/sales (PS) ratio of a stable growth firm can be

estimated beginning with a stable equity valuation model:

P0 = [EPS0 * Payout Ratio *(1+gn) ] / [ r- gn ]

Payout Ratio = DPS / EPS or DPS = EPS *Payout ratio

• Dividing both sides by the Sales per share:

• P0 = [EPS0 * Payout Ratio *(1+gn) ] / [ r- gn ] All figures
are of
Sales Sales per share stable
• PS = [ NPM * Payout Ratio *(1+gn) ] / [ r- gn ] period

NPM = EPS / Sales per share

Price to Sales (PS) Ratio – EQ Multiple: (Stable Growth Firm)

NPM = EPS0 / Sales per share

All figures
are of
stable
period
Price to Sales (PS) Ratio – EQ Multiple: (High Growth Firm)

• 2 stage DDM (DCF Valuation) can be written as follows:

• Dividing both sides by the sales per share:

NPM = EPS0 / Sales per share

where Net Marginn = Net Margin in stable growth phase

For a firm that does not pay what it can afford to in dividends, substitute FCFE/Earnings for
the payout ratio.
 Revenue Multiple : (Firm Value Multiple) EV/Sales
• EV = [EBIT (1-t) (1- Reinvestment rate)] / (WACC – gn)

• Dividing both sides by Revenue or Sales, we get:

• EV/ Sales = [EBIT (1-t) / Sales] (1- Reinvestment rate) / (WACC – gn)

• Stable Phase EV/ Sales = [ATOM] (1- Reinvestment rate) / (WACC – gn)

where: ATOM = After-tax Operating Margin

• High-Growth Phase

EV/Sales
 Price/Sales Ratio : Problem 1
High Growth Phase Stable Growth
Length of Period 5 years Forever after year 5
Net Margin 10%6%
Sales/BV of Equity 2.5 2.5
Beta 1.251.00
Payout Ratio 20%60%
Expected Growth (.1)(2.5)(.8)=20% (.06)(2.5)(.4)=.06
COE 0.12875 0.115
 Sector Specific Multiples

• Managers in every sector tend to focus on specific variables

when analyzing strategy and performance. The multiple
used will generally reflect this focus.
• Consider three examples.
– In retailing: The focus is usually on same store sales (turnover)
and profit margins. Not surprisingly, the revenue multiple is most
common in this sector.
– In financial services: The emphasis is usually on return on equity.
Book Equity is often viewed as a scarce resource, since capital
ratios are based upon it. Price to book ratios dominate.
– In technology: Growth is usually the dominant theme. PEG ratios
were invented in this sector.
Relative versus Intrinsic (DCF) Value

• If you do intrinsic value right, you will bring in a

company’s risk, cash flow and growth characteristics
into the inputs, preserve internal consistency and
derive intrinsic value.
• If you do relative value right, you will find the right
set of comparable, control well for differences in risk,
cash flow and growth characteristics.
• Assume you value the same company doing both
DCF and relative valuation correctly. Should you
get the same value? Yes or No.
 Relative versus Intrinsic Value
• If not, how would you explain the difference?
– A stock may be priced correctly, relative to how the market is
pricing other stocks today.
– But if the market is making fundamental mistakes in pricing
stocks collectively or in groups, you can get a very different
intrinsic value for the same stock.
– Depends on your philosophy and mission. If you believe that markets
make mistakes and correct them over time, have a long-time horizon
and don’t get judged (or compensated) relative to others, you should
use intrinsic value.
– Most of us don’t have these luxuries (we operate with short time
horizons and are judged against other investors/analysts/portfolio
managers,,)
 Relative versus Intrinsic Value
• If the numbers are different, which
value would you use?
– Intrinsic value
– Relative value
– A composite of the two values
– The higher of the two values
– The lower of the two values
Depends on your philosophy and
mission.
Use intrinsic value, if you
• believe that markets make mistakes
and correct them over time,
• have a long-time horizon and don’t
get judged (or compensated) relative
to others,

– Depends on what your valuation Most of us don’t have these luxuries (we
“mission” is. operate with short time horizons and are
judged against other investors/ analysts/
portfolio managers, etc.)