UNIT 4: Market‐Based Valuation

 Relative Valuation: First Principles ‐Reasons for Popularity and potential

pitfalls‐
Earnings Multiples
Book Value or Replacement Value Multiples
Revenue Multiples Sector
Specific Multiples
Price to earnings,
Price to an estimate of operating cash flow,
Price to sales,
Price to book value Multiples Based on Comparable
Valuation is the estimation of an asset’s value based on
variables perceived to be related to future investment
returns, or based on comparisons with closely similar assets.
 Relative Valuation Model?

 A relative valuation model is a business valuation method that compares a company's value to that of its

competitors or industry peers to assess the firm's financial worth. Relative valuation models are an

alternative to absolute value models, which try to determine a company's intrinsic worth based on its

estimated future free cash flows discounted to their present value, without any reference to another

company or industry average. Like absolute value models, investors may use relative valuation models

when determining whether a company's stock is a good buy.

In discounted cash flow valuation: The objective is to find the value of assets, given their cash
flow, growth and risk characteristics.

In relative valuation: The objective is to value assets, based upon how similar assets are currently
priced in the market

There are two components to relative valuation.

1. To value assets on a relative basis, prices have to be standardized, usually by converting prices
into multiples of earnings, book values or sales.

2. To find similar firms, which is difficult to do since no two firms are identical and firms in the
same business can still differ on risk, growth potential and cash flows. The question of how to
control for these differences, when comparing a multiple across several firms, becomes a key one.
Use of Relative Valuation
The use of relative valuation is widespread.

Most equity research reports and many acquisition valuations are based upon a multiple

such as a price to sales ratio or the value to EBITDA multiple and a group of comparable

firms.
Reasons for Popularity.
Why is relative valuation so widely used?
There are several reasons.

First, a valuation based upon a multiple and comparable firms can be completed with far

fewer assumptions and far more quickly than a discounted cash flow valuation.

Second, a relative valuation is simpler to understand and easier to present to clients and

customers than a discounted cash flow valuation.

Finally, a relative valuation is much more likely to reflect the current mood of the market,

since it is an attempt to measure relative and not intrinsic value. Thus, in a market where all

internet stocks see their prices bid up, relative valuation is likely to yield higher values for

these stocks than discounted cash flow

 Use of Relative Valuation
The use of relative valuation is widespread. Most equity research reports and
many acquisition valuations are based upon a multiple such as a price to sales
ratio or the value to EBITDA multiple and a group of comparable firms. In fact,
firms in the same business as the firm being valued are called comparable.

In fact, relative valuations will generally yield values that are closer to the
market price than discounted cash flow valuations. This is particularly important
for those whose job it is to make judgments on relative value and who are
themselves judged on a relative basis.
 Potential Pitfalls
The strengths of relative valuation are also its weaknesses.

First, the ease with which a relative valuation can be put together, pulling together a multiple and a group

of comparable firms, can also result in inconsistent estimates of value where key variables such as risk,

growth or cash flow potential are ignored.

Second, the fact that multiples reflect the market mood also implies that using relative valuation to

estimate the value of an asset can result in values that are too high, when the market is over valuing

comparable firms, or too low, when it is under valuing these firms.

Third, while there is scope for bias in any type of valuation, the lack of transparency regarding the

underlying assumptions in relative valuations make them particularly vulnerable to manipulation. A biased

analyst who is allowed to choose the multiple on which the valuation is based and to choose the

comparable firms can essentially ensure that almost any value can be justified.
 What are Valuation Multiples?
Valuation multiples are financial measurement tools that evaluate one financial metric as a ratio of
another, in order to make different companies more comparable. Multiples are the proportion of one
financial metric (i.e. Share Price) to another financial metric (i.e. Earnings per Share). It is an easy way
to compute a company’s value and compare it with other businesses. Let’s examine the various types
of multiples used in business valuation.

In other words The multiples approach is a valuation theory based on the idea that similar assets sell at
similar prices. It assumes that the type of ratio used in comparing firms, such as operating margins or
cash flows, is the same across similar firms.

Investors also refer to the multiples approach as multiples analysis or valuation multiples. When doing
so they may refer to a financial ratio, such as the price-to-earnings (P/E) ratio, as the earnings multiple.
Types of multiples
1. Earnings Multiples
2. Book Value or Replacement Value Multiples
3. Revenue Multiples Sector
4. Specific Multiples
1. Earnings multiples / PER
The earnings multiplier is a financial metric that frames a company's current stock price in
terms of the company's earnings per share (EPS) of stock, that's simply computed as price per
share/earnings per share. Also known as the price-to-earnings (P/E) ratio, the earnings
multiplier can be used as a simplified valuation tool with which to compare the relative
costliness of the stocks of similar companies. It can likewise help investors judge current stock
prices against their historical prices on an earnings-relative basis.
 Calculate Share Exchange Ratio on the basis of
Earnings multiplier OR Price Earnings Ratio (PER)

1. A ltd wants to acquire any of the following firms, calculate share exchange
ration on the basis of PER

particulars A B C D E
Acquiring Target Target Target Target
company company company company company

Market price ₹250 ₹120 ₹ 80 ₹ 70 ₹90

Total earnings 150 Cr 80 Cr 70 Cr 80 Cr 90 Cr

Equity capital 1000 Cr 500 Cr 200 Cr 350 Cr 250 Cr

(₹ 100 Each)
 Solution: PE Ratio = MP or PRICE PER SHARE

A B C D E
AC TC TC TC TC
EPS = Total earnings / 150 Cr 80Cr 70Cr 80 Cr 90 Cr
Total number of shares 10 Cr 5 2 3.5 2.5

EPS= ₹15 ₹16 ₹ 35 ₹22.85 ₹ 36

PE RATIO = MP/EPS = 250/15 = 120 / 16 = 80 / 35 70 / 22.85 90 / 36

= 16.66 = 7.5 = 2.28 ₹3 ₹ 2.5

Exchange ratio 7.5 / 16.66 2.28 / 16.66 3 / 16.66 2.5 / 16.66

=0.45 =0.13 =0.18 =0.15
PER OF TC
PER OF AC
 Calculate Share Exchange Ratio on the basis of
Earnings multiplier OR Price Earnings Ratio (PER)

1. P ltd wants to acquire any of the following firms, calculate share exchange
ratio on the basis of PER

particulars P Q R S T
Acquiring Target Target Target Target
company company company company company

Market price ₹1000 ₹500 ₹ 650 ₹550 600

Total earnings 1500 Cr 650 Cr 720 Cr 800 Cr 810 Cr

Equity capital 1000 Cr 1100 Cr 900 Cr 850 Cr 950 Cr

(₹ 100 Each)
 Solution: PE Ratio = MP or PRICE PER SHARE

P Q R S T
AC TC TC TC TC

EPS = Total earnings / 1500 / 10 650/ 11 720/9 800/8.5 810/9.5

Total number of shares = 150 = 59 = 80 = 94.11 = 85.26

EPS=
1000 / 150 500 /59 650 / 80 550 /94.11 600 / 85.26
PE RATIO = MP/EPS 6.67 8.46 8.13 5.84 7

Exchange ratio
8.46/ 6.67 8.13/6.67 5.84 /6.67 7/6.67
PER OF TC / 1.26 1.21 0.88 1.06
PER OF AC
 2. Book Value or Replacement Value Multiples

What Is the Price-To-Book (P/B) Ratio?

What price should investors pay for a company's equity shares? If the
goal is to unearth high-growth companies selling at low-growth prices,
the price-to-book ratio (P/B) offers investors an effective approach to
finding undervalued companies.

The P/B ratio can also help investors identify and avoid overvalued
companies. However, this ratio has its limitations and there are
circumstances where it may not be the most effective metric for
valuation.
3. Revenue Multiples Sector

A revenue multiple measures the value of the equity or a business relative to the revenues that it
generates. As with other multiples, other things remaining equal, firms that trade at low multiples of
revenues are viewed as cheap relative to firms that trade at high multiples of revenues.

Revenue multiples have proved attractive to analysts for a number of reasons.

First, unlike earnings and book value ratios, which can become negative for many firms and thus not
meaningful, revenue multiples are available even for the most troubled firms and for very young firms.
Thus, the potential for bias created by eliminating firms in the sample is far lower.

Second, unlike earnings and book value, which are heavily influenced by accounting decisions on
depreciation, inventory, 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 firm’s fortune. For instance, the price-earnings ratio of a cyclical firm
changes much more than its price-sales ratios, because earnings are much more sensitive to economic
changes than revenues.
4. Specific Multiples

 Industry specific multiples are the techniques that demonstrate what business is
worth. To evaluate the estimate of the value of the business one can use financial
ratios such as:
• Enterprise value (EV) to gross revenues or net sales
• EV to net income
• EV to EBIT and EBITDA (earnings before interest, taxes, depreciation, and
amortization)
• EV to seller’s discretionary cash flow
• EV to total business assets
• EV to owners’ equity.
Price Multiples
Lets discuss four other major price multiples from the
same practical perspective
1. Price to earnings,
2. Price to an estimate of operating cash flow,
3. Price to sales,
4. Price to book value Multiples Based on Comparable
 1. Price to earnings,
Price‐earnings (P/E) ratio: The P/E ratio is a firm’s stock price divided by earnings per share and is widely used by

analysts and cited in the press. There are a number of rationales for using price‐to‐earnings (P/E) ratio in valuation:

 Earnings power, as measured by earnings per share (EPS), is the primary determinant of investment value.

 The P/E ratio is popular in the investment community.

 Empirical research shows that P/E differences are significantly related to long‐run average stock returns.

On the other hand, P/E ratios have a number of shortcomings:

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

 The volatile, transitory portion of earnings makes the interpretation of P/Es difficult for analysts.

 Management discretion within allowed accounting practices can distort reported earnings, and thereby lessen the

comparability of P/Es across firms.

2. Price to an estimate of operating cash flow,

Price-to-Cash Flow (P/CF) Ratio?

The price-to-cash flow (P/CF) ratio is a stock valuation indicator or multiple that measures the
value of a stock’s price relative to its operating cash flow per share. The ratio uses operating
cash flow (OCF), which adds back non-cash expenses such as depreciation and amortization to
net income.
P/CF is especially useful for valuing stocks that have positive cash flow but are not profitable
because of large non-cash charges.

 The Formula for the Price-to-Cash Flow (P/CF) Ratio Is

Price to Cash Flow Ratio=share Price​/ Operating Cash Flow per share
If share price of the company A is 250 and operating cashflow of the company is Rs 20,00,000
and number of equity shares are 10000. What is the PCF ratio
Solution : 250 / 200
= 1.25 : 1
 3. Price to sales
The price-to-sales ratio (Price/Sales or P/S) is calculated by taking a company's market
capitalization (the number of outstanding shares multiplied by the share price) and divide it
by the company's total sales or revenue over the past 12 months. The lower the P/S ratio, the
more attractive the investment. Price-to-sales provides a useful measure for sizing up stocks

Formula = Total market capitalization / Total sales.

4. Price to book value Multiples Based on Comparable

 Price-to-book (P/B) is an equity valuation ratio that compares market value (stock price per share) to book value
(equity of shareholders). P/B is expressed as a multiple—how many times book value stock investors are willing
to pay to acquire a company's stock. Book value is a calculation of the company's recorded assets, minus the
liabilities shown on its balance sheet—a per-share estimate of the liquidation value of the company. How a
High P/B Ratio Correlates to High ROE

 A high P/B ratio doesn't necessarily correspond to a high return on equity (ROE), but it does under ideal
circumstances. Investors favor companies that offer better returns on equity; as a result, this favor
translates into higher company prices. Understandably, a low P/B ratio often correlates to an undesirable ROE
and return on assets (ROA).

The straightforward calculation of P/B is as follows: CURRENT MARKET PRICE / BOOK VALUE OF THE SHARES

OR
From the following data Calculate:
Price to earnings,
Price to an estimate of operating cash flow,
Price to sales,
Price to book value Multiples Based on Comparable

PE RATIO = MP/EPS
Price to Cash Flow Ratio=Current share Price​/ Operating Cash Flow per share
Price/Sales or P/S= Total market capitalization / Total sales.
Price to book value Multiples Based on Comparable = Current Market Price / Book Value Of The Shares

A B C D E F
Share price or Market 100 110 120 90 100 150
price
Total earning (Rs) 500 cr 600cr 450cr 520 cr 350cr 300cr
Operating cash flow (Rs) 350 cr 450cr 100cr 250cr 250cr 280cr
Total number of shares 1 cr 1 cr 1 cr 1.5 cr 2 cr 2 cr
Market capitalization 100 cr 110cr 120cr 135 cr 200cr 300 cr
(Rs)
Total sales (Rs) 1000 cr 1200cr 1300cr 500cr 1100cr 1200cr
Book value of the shares 20 40 40 50 60 70
(Rs)
Calculate For A
PE RATIO = MP/EPS
Price to Cash Flow Ratio=Current share Price​/ Operating Cash Flow per share
Price/Sales or P/S= Total market capitalization / Total sales.
Price to book value Multiples Based on Comparable = Current Market Price / Book Value Of The Shares

PE RATIO MP/ EPS EPS = TE/TNES 500Cr/ 1 cr = ₹500

₹100/ ₹500
= 0.2

PRICE TO CASH FLOW Current share Price​/ Operating Cash Flow per share (₹350 Cr/ ₹1 cr)
RATIO ₹100 / ₹350
0.28

PRICE TO SALES ₹100Cr / ₹1000cr

0.1

PRICE TO BOOK VALUE ₹100/₹20

5
 B C D E F

PE RATIO MP/ EPS MP/ EPS MP/ EPS MP/ EPS MP/ EPS
= ₹110 / ₹600 = 120 / ₹450 = ₹90 / 346.67 = ₹ 100 / ₹175 = ₹150 / 150
= 0.183 = 0.26 = 0.259 = 0.57 =1

PRICE TO Current share Price​/ Current share Price​/ Current share Price​/ Current share Price​ Current share Price​/
CASH FLOW Operating Cash Flow Operating Cash Flow Operating Cash Flow / Operating Cash Operating Cash Flow
RATIO per share per share per share Flow per share per share

= ₹110 / ₹450 = ₹120 / ₹100 = ₹90 / ₹ 166.7 = ₹100 / ₹ 125 = ₹150 / 140
= 0.24 = 1.2 = 0.53 = 0.8 = 1.07

PRICE TO Total market Total market Total market Total market Total market
SALES capitalization / Total capitalization / Total capitalization / Total capitalization / capitalization / Total
sales. sales. sales. Total sales. sales.
=₹ 110 Cr / 1200cr = ₹120c /₹1300cr = ₹ 135Cr/ 500cr = ₹ 200cr 1100Cr = ₹300cr/ ₹1200cr
= 0.092 = 0.09 = 0.27 = 0.18 = 0.25

PRICE TO Current Market Price / Current Market Price / Current Market Price Current Market Current Market
BOOK Book Value Of The Book Value Of The / Book Value Of The Price / Book Value Price / Book Value Of
VALUE Shares Shares Shares Of The Shares The Shares

= ₹110 / ₹40 =₹120 / ₹40 =₹90 / ₹50 =₹100 / ₹60 =₹ 150 / ₹70
= 2.75 =3 =1.8 =1.66 =2.14
2. From the following data Calculate:
Price to earnings,
Price to an estimate of operating cash flow,
Price to sales,
Price to book value Multiples Based on Comparable

A B C D E F
Share price or Market 90 105 100 95 80 120
price
Total earning (Rs) 750 cr 650cr 550cr 620 cr 450cr 400cr
Operating cash flow (Rs) 300 cr 400cr 120cr 150cr 200cr 120cr
Total number of shares 1.2 cr 1.2 1 cr 1.5 cr 2.5 cr 2 cr
Total sales (Rs) 1000 cr 1200cr 1300cr 500cr 1100cr 1200cr
Book value of the shares 15 28 45 80 55 70
(Rs)
 A B C D E F

PE RATIO MP/EPS MP/ EPS MP/ EPS MP/ EPS MP/ EPS MP/ EPS
= ₹90/ ₹625 = ₹105 / ₹542 = ₹100 / 550 = ₹95 / ₹ 413 = ₹ 80 / 180 = ₹ 120/ 200
= 0.14 = 0.193 =0.18 =0.22 = 0.44 = 0.6

PRICE TO Current share Current share Price​/ Current share Price​/ Current share Current share Current share Price​
CASH FLOW Price​/ Operating Operating Cash Flow Operating Cash Flow Price​/ Operating Price​/ Operating / Operating Cash
RATIO Cash Flow per per share per share Cash Flow per share Cash Flow per Flow per share
share share
= ₹90 / ₹250 = ₹105 / ₹333 = ₹100 / 120 = ₹95 / 100 = ₹80/ 80 = ₹120/60
= 0.36 = .31 = 0.83 = 0.95 =1 =2

PRICE TO Total market Total market Total market Total market Total market
SALES capitalization / Total capitalization / Total capitalization / Total capitalization / capitalization /
sales. sales. sales. Total sales. Total sales.
0.108 =₹ = ₹100c /₹1300cr = ₹ 142.5Cr/ 500cr = ₹ 200cr 1100Cr = ₹240cr/ ₹1200cr
= 0.105 = 0.07 = 0.27 = 0.18 = 0.2

PRICE TO Current Market Price / Current Market Price / Current Market Current Market Current Market
BOOK VALUE Book Value Of The Book Value Of The Price / Book Value Price / Book Price / Book Value
Shares Shares Of The Shares Value Of The Of The Shares
6 Shares
3.7 1.18 1.71
2.22 =1.45