Chapter 5

Relative Valuation
 Outline

 Steps Involved in Relative Valuation

 Equity Valuation Multiples
 Enterprise Valuation Multiples
 Choice of Multiple
 Best Practices Using Multiples
 Assessment of Relative Valuation
 Introduction
In DCF valuation, an asset is valued on the
basis of its cash flow, growth, and risk
characteristics. In relative valuation, an
asset is valued on the basis of how similar
assets are currently priced in the market. As
Dan Ariely put it: “Everything is relative even
when it shouldn’t be. Humans rarely choose
in ‘absolute terms.’ We don’t have an internal
meter that tells us how much things are
worth. Rather, we focus on the relative
advantage of one thing over another, and
estimate value accordingly.”
 Introduction
Common sense and economic logic tell us that similar assets should
sell at similar prices. Based on this principle, one can value an asset
by looking at the price at which a comparable asset has changed
hands between a reasonably informed buyer and a reasonably
informed seller. For example, if you want to sell your residential flat,
you can estimate its appropriate asking price by looking at market
comparables. Suppose your flat measures 2000 square feet and
recently a flat in the neighbourhood measuring 1500 square feet sold
for Rs.4,500,000 (at the rate of Rs.3,000 per square feet). As a first
pass, you can put a value of 2000 X Rs. 3000 = Rs.6,000,000 for your
flat.

Relative valuation is often considered as a substitute for DCF

valuation. However, as our discussion in this chapter shows, the DCF
approach provides the conceptual foundation for most relative
valuation metrics. Hence the two approaches should be seen as
complementary.
 Steps in Relative Valuation

1. Analyse the subject company.

2. Select comparable companies.
3. Choose the valuation multiple (s).
4. Calculate the valuation multiple for
the comparable companies.
5. Value the subject company.
1. Analyse the Subject Company To begin with, an in-depth
analysis of the competitive and financial position of the
subject company (the company to be valued) must be
conducted. The key aspects to be covered in this analysis
are as follows:

 Product portfolio and market segments covered by the firm

 Availability and cost of inputs
 Technological and production capability
 Market image, distribution reach, and customer loyalty
 Product differentiation and economic cost position
 Managerial competence and drive
 Quality of human resources
 Competitive dynamics
 Liquidity, leverage, and access to funds
 Turnover, margins, and return on investment.
 2. Select Comparable Companies
 Often, it is hard to find truly comparable
companies.
 Look at 10 to 15 companies in the same
industry and select at least 3 to 4 which come
‘as close as possible.’
 3. Choose the Valuation
Multiple (s)
Equity Valuation Multiples

 Price – earnings ratio

 Price – book value ratio
 Price – sales ratio

Enterprise Valuation Multiples

 EV – EBITDA ratio
 EV – FCFF ratio
 EV – book value ratio
 EV – sales ratio
 Calculate the Valuation Multiples for the Comparable
Companies Based on the observed financial attributes and
values of the comparable companies, calculate the valuation
multiples for them. To illustrate, suppose that there are two
comparable companies, P and Q, with the following financial
numbers.
P Q

 Sales 3000 5000

 EBITDA 500 800

 Book value of assets 2000 3000

 Enterprise value 4000 5600

The valuation multiples for the companies are:

P Q Average

EV-EBITDA 8.0 7.0 7.5

EV-book value 2.0 1.87 1.94

EV-sales 1.33 1.12 1.23

 Value the Subject Company

Given the observed valuation multiples of the

comparable companies, the subject company may be
valued. A simple way to do is to apply the average
multiples of the comparable companies to the relevant
financial attributes of the subject company and obtain
several estimates (as many as the number of valuation
multiples used) of enterprise value for the subject
company and then take their arithmetic average.
A more sophisticated way to do is to look at how
the growth prospects, risk characteristics, and size of
the subject company (the most important drivers of
valuation multiples) compare with those of
comparable companies and then take a judgmental
view of the multiples applicable to it.
 Illustration
The following financial information is available for company D, an
unlisted pharmaceutical company, which is being valued.

 EBITDA : Rs. 400 million

 Book value of assets : Rs. 1,000 million
 Sales : Rs. 2,500 million

Based on an evaluation of a number of listed pharmaceutical

companies, A, B, and C have been found to be comparable to
company D. The financial information for these companies is
given below:
A B C

 Sales 1600 2000 3200

 EBITDA 280 360 480

 Book value of assets 800 1000 1400

 Enterprise value (EV) 2000 3500 4200

 Three valuation multiples, as shown below, have been considered
A B C Average

 EV-EBITDA 7.1 9.7 8.8 8.5

 EV-book value 2.5 3.5 3.0 3.0

 EV-sales 1.25 1.75 1.31 1.44

Applying the average multiples to the financial numbers of firm D gives the following
enterprise value estimates:
EBITDA Basis Book Value Basis Sales Basis
 Average EV-EBITDA : 8.5  Average EV- : 3.0  Average EV- : 1.44
book value sales

 EBITDA of D : Rs. 400  Book Value of D : Rs. 1000  Sales of D : Rs.

million million 2500
million
 EV of D : Rs.  EV of D : Rs. 3000  EV of D : Rs.
3400 million 3600
million million

A simple arithmetic average of the three estimates of EV is:

3400 + 3000 +3600
= 3333 million
3
 P/E Ratio

 Marketing price per share

Earnings per share

 Which Measure
 Fundamental Determinants
From a fundamental point of view
(1 - b)
Po/E1 =
r – ROE X b
where (1 - b) is the dividend payout ratio, r is the cost of equity, ROE is
the return on equity, and b is the ploughback ratio.

Example Alpha Company’s ROE is 18 percent and its r is 15 percent.

Alpha’s dividend payout ratio is 0.4 and its ploughback ratio 0.6. So,
from a fundamental point of view, Alpha’s P/E multiple is:

0.4
Po/E1 = = 9.52
0.15 – 018 X 0.6
 Reasons for Using the P/E
Ratio
 Earnings power .. Major driver of
investment value.
 AIMR survey.. earnings ranked first
among four variables – earnings, cash
flow, book value, and dividends – as
an input in equity valuation.
 Empirical research low P/E stocks
outperform the market.
 Drawbacks of P/E

 Negative EPS
 Maintainable EPS
 Manipulation
 P/B Ratio

Shareholders’ funds – Preference Capital

Number of outstanding equity shares
 Fundamental Determinants
From a fundamental point of view,

Po ROE (1 - b)
=
BVo r–g

where ROE is the return on equity, g is the growth rate, (1 - b) is the

dividend payout ratio, and r is the rate of return required by equity
investors.

Example Magna Corporation’s ROE is 20 percent and its r is 16 percent.

Magna’s dividend payout ratio is 0.4 and its g is 12 percent. From a
fundamental point of view, Magna’s.

Po 0.20 (0.4)
= = 2.00
BVo 0.16 – 0.12
 Reasons for Using P/B
 Stock figure.. generally +
 BV .. more stable .. EPS.
 P/B differences'.. long–term average
returns
 Drawbacks of P/B

 Intangible assets
 Inflation and technological changes
 Different business models
 P/S Ratio

 Rationale
 Norm
 Fundamental Determinants
From a fundamental point of view,

Po NPM (1+ g) (1 - b)
=
So r–g

where NPM is the net profit margin ratio, g is the growth rate, (1 - b) is the
dividend payout ratio, and r is the rate of return required by equity
investors.

Example Black Limited has a NPM of 8 percent and a growth rate 12

percent. Black’s dividend payout ratio (1 - b) is 0.3 and its r is 0.16. from
a fundamental point of view, Black’s
Po 0.08(1.12) (0.3)
= = 0.67
So 0.16 – 0.12
 Reasons for P/S

 No manipulation
 Always positive
 More stable than EPS
 PS ratio .. long-term average
returns
 Summation
Let us look at the equations for PE ratio, PBV ratio, and PS ratio.

(1-b) = (1-b)
PE =
r – ROE x b r–g

ROE (1-b)
PBV =
(r – g)

NPM (1+g) (1-b)

PS =
r-g

Looking at these equations, we find that there is one variable that dominates
when it comes to explaining each multiple – it is g for PE, ROE for PBV, and NPM
for PS. This variable – the dominant explanatory variable – is called the
companion variable.
 Companion Variables &
Modified Multiples
Taking into account the importance of the
companion variable, investment practitioners
often use modified multiples which are defined
below.
PE to growth multiple, referred to as PEG : PE
g
PBV to ROE, referred to as value ratio : PBV
ROE
PS to NPM, referred to as PSM : PS
Net profit margin
 EV to EBITDA Ratio

 EV
EBITDA
 Fundamental Determinants

EV ROIC – g
= X (1 - DA) (1 - t)
EBITDA ROIC X (WACC – g)

where ROIC is the return on invested capital, g

is the growth rate, DA is the depreciation and
amortisation charges as a percent of EBITDA, t
is the tax rate, and WACC is the weighted
average cost of capital.
 Determinants of EV/EBITDA
g
EVo = ICo x ROIC x 1 -
ROIC

ROIC - g
= IC o x
WACC - g

EV IC o ROIC – g
= x
EBITDA EBITDA WACC – g

EBITDA = NOPLAT / (1 - DA) (1 - t)

EV ICo ROIC – g
= x
EBITDA NOPLAT / (1 - DA) (1 - t) WACC - g
EV ROIC – g
= x (1 - DA) (1 - t)
EBITDA ROIC x (WACC - g)
 EV/EBIT Multiple

EV
EBIT

EV
EBIT (1 - Tax)
 Fundamental Determinants

EVo (1 - t) (1 – Reinvestment rate)

=
EBIT1 WACC - g

where t is the tax rate, WACC is the weighted

average cost of capital, and g is the growth rate.
EV/FCFF Multiple

EV
FCFF
 Fundamentals Determinants

EVo 1
=
FFCF1 WACC - g

where WACC is the weighted average cost of

capital and g is the growth rate.
 EV/BV

EV

BV
 Fundamental Determinants

EVo ROIC - g
=
BVo WACC - g

where ROIC is the return on invested capital, g

is the growth rate, and WACC is the weighted
average cost of capital.
 Example

Example Felix Company has an ROIC of 15

percent, g of 10 percent, and WACC of 12
percent. From a fundamental point of view
Felix’s:

EVo 0.15 -0.10

= = 1.67
BVo 0.12 – 0.10
 Fundamental Determinants

EVo After-tax operating margin (1 + g)

(1 – Reinvestment rate)
=
So WACC - g

where g is the growth rate and WACC is the

weighted average cost of capital.
 Determinants of EV/Sales
EBITo (1 + g) (1 - t) (1 – Reinvestment rate)
EVo =
WACC – g

EVo EBIT (1 + g) (1 - t) (1 – Reinvestment rate)

S0
=
So WACC – g

After-tax operating margin (1 + g)

(1 – Reinvestment rate)
=
WACC - g
 Operational Multiples
An operational multiple expresses the enterprise
value (EV) in relation to a specific operational
variable, which is usually a key driver of revenue
or cash flow. Some examples of operational
multiples from different industries are shown
below:
Industry Operational Multiple
Energy EV/KWH production capacity
Hotel EV/Number of rooms
Media EV/Number of subscribers
Telecommunications EV/Number of subscribers
From a fundamental point of view, the general
formula for an operational multiple is:

EV ROIC – g NOPLAT
= X
Unit ROIC X (WACC -g) Unit
where ROIC is the return on invested capital,
g is the growth rate, WACC is the weighted
average cost of capital, NOPLAT is the net
operating profit less adjusted taxes, and unit
is the measure of the operational variable.
 Choice of Multiple

 The Cynical View

 The bludgeon View
 The Best Multiple
Three Ways to Find the Best
Multiple
 Fundamental Approach
 Statistical Approach
 Conventional Approach
 Most Commonly Used Multiples
P/E : Proven track record of earnings and no
significant non-cash expenses.
PEG : Stable EPS growth rates and risk
characteristics
P/B : Balance sheets reflect well market values
(Financial institutions)
EV/EBITDA : Substantial non-cash expenses
(Airlines, Telecom operators)
EV/FCFF : Stable growth and predictable capex.
EV/Sales : Young firms .. - earnings
 Best Practices Using Multiples
A judicious use of multiples can provide valuable
insights, whereas an unthinking application of
multiples can result in confusion and distortion.
Bear in mind the following best practices with
respect to multiples:

 Define multiples consistently.

 Choose comparables with similar profitability
and growth prospects.
 Identify the fundamental determinants.
 Use multiples that use forward-looking estimates.
 Prefer enterprise-value multiples.
 Emphasis on Relative
Valuation in Practice
 Investment rules of thumb are .. In terms of
multiples.
 Even when DCF valuation is used; the
recommendations are usually based on
valuation multiple (s).
 Multiples serve as a convenient shorthand for
communication and provide a useful check on
valuation.
 Multiples are easier to sell as well as defend.
 Weaknesses of Relative
Valuation
 Greater scope for manipulation.
 Reflect valuation errors of the
market .
 Reconciling Relative and
DCF Valuation
 DCF valuation and relative valuation generally
produce different estimates of value.
 Main reason.. different views of market efficiency.
(or inefficiency).
 DCF valuation assumes that the markets make
mistakes (which may apply to the entire market or
parts thereof) but correct these mistakes over
time.
 Relative valuation assumes that on average the
markets are correct, although they may make
mistakes on individual stocks.
 MARKET TRANSACTION METHOD
A variant of the market comparable method, the market
transaction method employs transaction multiples in lieu of
trading multiples. As the name suggests, transaction
multiples are the multiples implicit in recent
acquisitions/disposals of similar companies.
The primary advantage of this method is that the
transaction multiples are based on negotiation between more
informed buyers and sellers and hence are less likely to be
affected by market inefficiencies. However, its limitations are
that the characteristics of recently transacted companies and
the conditions under which they may have been transacted
are likely to be very different. Further, the requisite
information relating to transactions, particularly when
unlisted companies are involved, may not be available.
While using transaction multiples, the following factors
should be considered: nature of transaction (friendly or
hostile), the prevailing market sentiment at the time of
transaction, form of compensation (stock or cash), contingent
 SUMMARY OF THE STEPS IN THE RELATIVE
VALUATION METHOD
1. Determine the criteria for selecting comparable publicly traded companies.
2. Identify the companies that meet the criteria.
3. Decide on the relevant time period for comparative analysis.
4. Obtain the financial statements for the subject company and comparable publicly
limited companies for the time period decided in Step 3, and make appropriate
adjustments to the same.
5. Compile the relevant financial ratios for the subject and comparable companies.
6. Decide the value multiples to be used.
7. Obtain the market price for the equity stock for each comparable company as of the
valuation date. If the enterprise valuation multiples are used, obtain the market
value of all securities included in the invested capital.
8. Compile the value multiple tables for all the comparable companies.
9. Analyse the value multiples of the comparable companies in conjunction with the
comparative financial analysis of the subject company and comparable companies
and decide on the appropriate value of the multiples to be used for the subject
company.
10. Calculate the indicative value of the subject company according to each value
multiple, by multiplying the appropriate value of the multiple with the relevant
financial variable for the subject company.
11. Obtain a weighted average of the indicative values determined in Step 10 to get an
estimate of “value as if publicly traded” (a marketable, minority ownership interest
value).
12. Adjust this value, if appropriate, for factors not reflected in the value as if publicly
traded, such as premium for control or discount for lack of marketability.
 Private versus Public Equity
Investing

Private equity investing differs from public

equity investing in several ways:
 Illiquid investment
 Active role
 Finite horizon
 High return expectations
 Procedure for Valuation
1. Establish KPE
2. PE Investment Today (1 + KPE)H
= Required Value of PE Investment H

3. Estimated Equity Value H

= EBITDA H X EBITDA Multiple H
+ Cash H – Debt H
4. Required Value of PE
Investment H
Ownership Share =
Estimated Equity Value
 ILLUSTRATION
Omega Capital Ventures, a PE investor, is considering
investing Rs. 1000 million in the equity of Mylan
Laboratories, a start-up biotech company. Omega’s
required rate of return from this investment is 30
percent and its planned holding period is 5 years.
Mylan has projected an EBITDA of Rs. 1500 million
for year 5. An EBITDA multiple of 7 for year 5 is
considered reasonable. At the end of year 5, Mylan
Laboratories is likely to have a debt of Rs. 1000
million and a cash balance of Rs. 300 million. What
ownership share in Mylan Laboratories should
Omega Capital Ventures ask for?
 Solution

The required ownership share is determined as follows:

1. KPE (required rate of return) = 30 percent

2. Required Value of PE Investment5 = 1000 (1.30)5

= Rs. 3,713 million

3. Estimated Equity Value5 = 1500 x 7 + 300 – 1000

= Rs. 9,800 million

4. Ownership Share = 3713 / 9800 = 37.9

percent
 Post – Money Investment Value

Post-Money Investment Funds Provided by the PE

Value of the Firm’s Equity = PE’s Ownership Interest (%)

Rs. 1000 million

= Rs. 2638 million
0.379
 Pre – Money Investment Value
Pre-Money Investment Post-Money Investment Funding Provided
Value of the Firm’s Equity = Value of the Firm’s Equity - by the PE

= 2638 - 1000
= Rs. 1638 million
 Pre – and Post – Money Value
of the Firm’s Investment
Funds Provided by the
Post-Money Investment PE
Value of the Firm’s Equity =
PE’s Ownership Interest
(%)

Pre – Money Investment = Post-Money Investment

Value of the Firm’s Equity Value of the Firm’s Equity
- Funding Provided by the
PE
 Summary
 In relative valuation, an asset is valued on the basis of how similar
assets are currently priced in the market.
 The relative valuation of a company involves the following steps: (i)
analyse the subject company, (ii) select comparable companies, (iii)
choose the valuation multiple (s), (iv) calculate the valuation
multiple(s) for the comparable companies, and (v) value the subject
company.
 The commonly used equity valuation multiples are: price-to-earnings
multiple, price-to-book value multiple, and price –to-sales multiple.
 The commonly used enterprise valuation (EV) multiples are: EV-FFCF-
ratio, EV-EBITDA multiple, EV-book value multiple, and EV-sales
multiple..
 Since different multiples produce different values, the choice of
multiple can make a big difference to your value estimate.
 In choosing the multiple the analyst can adopt the multiple that
reflects his bias (the cynical view), or use all the multiples (the
bludgeon view), or pick the “best” multiple.
 There are three ways to find the best multiple. The fundamental approach
suggests that we should use the variable that has the highest correlation
with the firms value. The statistical approach calls for regressing each
multiple against the fundamentals that theoretically affect the value and
using the multiple with the highest R-squared. The conventional approach
involves using the multiple that has become the most commonly used one
for a specific situation or sector.
 The following are the best practices with respect to multiples: (a) choose
comparables with similar profitability and growth prospects. (b) use
multiples that use forward-looking estimates, (c) prefer enterprise-value
multiples.
 Relative valuation seems to be more popular compared to DCF valuation
because (a) it relies on multiples that are easy to relate to and easy to
obtain, and (b) it is easier to sell as well as defend.
 Notwithstanding its popularity, relative valuation suffers from certain
weakness. (a) it provides the analyst greater scope for valuation; (b) the
multiples used in relative valuation reflect the valuation errors
(overvaluation or undervaluation of the market).
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