Section 9 Firm valuation: Price multiples

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1 Section 9 Firm valuation: Price multiples A little inaccurancy sometimes saves tons of explanation. --H.H. Munro 1

2 Learning objectives After studying this chapter, you will understand How to use price multiples in firm valuation Main problems in using price multiples Ways to address the problems in using price multiples Links between price multiples and firm fundamentals 2

3 Price multiples In Section 2, we calculated P/E- and P/B-ratios from pershare numbers to Show the link between accounting numbers and stock prices Calculate the expected return of a stock Price multiples are many, and they can be used for more comprehensive valuation analysis Price multiples are also linked to valuation models Valuation based on price multiples is called relative valuation 3

4 Relative valuation: what does it mean? Definition The value of the firm (a target firm) is estimated by looking at how the market prices similar or comparable firms Philosophical basis The value of the firm is whatever the market is willing to pay for it given its financial characteristics like earnings, book equity or sales Information needed A group of similar or comparable firms Average (median) value of the price multiples of similar or comparable firms 4 Typically, price multiples like P/E- or P/B-ratio are used

5 Relative valuation: how to do it? 1. Identify comparable firms that have similar operations to the firm whose value you are calculating Operate in the same industry or otherwise have similar business models 2. Calculate price multiples for the comparable firms by using their financial statement numbers and current stock price Earnings, book value, sales 3. Apply these multiples to the corresponding measures for the target to get its intrinsic value Example: P(target) = EPS(target) P/E(comps) 3-5

6 Example on relative valuation: Dell, Hewlett Packard, and Lenovo, 2008

7 Relative valuation: some considerations Use financial statement numbers consistently when calculating price multiples Use exactly the same financial statement numbers for target firm and for all comparable firms For example, the same earnings numbers must be used for all firms when calculating P/E ratio What if accounting methods are different for comps and target? What about negative denominators? Conceptual problem: circular reasoning Firm value is calculated from the market values of the comps 7

8 Many ways to calculate P/E-ratios There are a number of variants on the P/E-ratio based upon how the price and the earnings are defined Price Usually the current price (though some like to use average price over last 6 months or year) EPS EPS in most recent fiscal year (current) EPS in most recent four quarters (trailing) EPS expected in next fiscal year or next four quarters (both called forward) EPS in some future year EPS in many past fiscal years Some combination of all these 8

9 Price-Book ratio Recall from Section 2 that P/B ratio is calculated by dividing stock price (P) by the book value of equity per share (BPS): P/B = P/BPS Abnormal earnings model (we will dicuss it in Section 10): Equity value P Dividing by B 0, we get: 0 B 0 t 1 ( ROE P B 0 0 t r (1 r 1 t 1 E t E ) ) B t 1 ( ROE t r (1 r E E ) ) t B B t 1 0 9

10 Price-Book ratio Implications: P/B ratio is directly related to the future abnormal earnings, i.e. the difference between forecasted ROE and the cost of equity Forecasted ROE equals the cost of equity: P = B P/B = 1 Forecasted ROE is greater than the cost of equity: P > B P/B > 1 Forecasted ROE is less than the cost of equity: P < B P/B <1 10

11 Links between P/E, P/B and ROE PB P BPS P E E BPS P E ROE P E PB ROE P/B ratio increases with ROE P/B as such is not indicative of the firm value without considering ROE P/E ratio is the ratio of P/B ratio to ROE P/E ratio indicates the current valuation of the firm relative to its profitability 11

12 Links between P/E, P/B and ROE Value of the firm having high ROE should be higher than that of the firm having low ROE Simple investment strategy Buy firms having low P/B ratios and high ROE Sell firms having high P/B ratios and low ROE Some empirical evidence from Helsinki Stock Exchange P/B vs. ROE calculated by using analysts EPS forecasts P/B vs. ROE calculated by using EPS from previous year What can you learn from these two graphs? 12

13 Example: P/B-ratio and forecasted ROE for firms listed in Helsinki Stock Exchange 10,00 9,00 8,00 7,00 6,00 P/B 5,00 4,00 3,00 2,00 1,00 0,00 0,00 10,00 20,00 30,00 40,00 50,00 60,00 ROE

14 Example: P/B-ratio and previous year s ROE for firms listed in Helsinki Stock Exchange 10,00 9,00 8,00 7,00 6,00 P/B 5,00 4,00 3,00 2,00 1,00 0,00 0,00 10,00 20,00 30,00 40,00 50,00 60,00 ROE

15 Lots of price multiples Denumerator of the multiple can be based on: Earnings Price/Earnings Ratio (PE) and its variants (PEG) Enterprise value/ebit Enterprise value/ebitda Enterprise value/cash Flow Book value of the asset Price/Book Value (of Equity) (PB) Value/ Book Value of Assets Value/Replacement Cost (Tobin s Q) Revenues generated by the asset Price/Sales per Share (PS) Value/Sales Asset or industry specific variables (Price/kwh, Price per ton of steel...) 15

16 Example: Valuation of Novo Nordisk based on price multiples as of May 5, 2014 by Nordea 16

17 EV/EBIT-ratio EV/EBIT = Enterprise value (EV) / Earnings before interest and taxes (EBIT) Enterprise value (EV) = Market value of equity + Net value of debt Net value of debt is calculated as we have done it: Interest bearing debt - Financial assets = Net value of debt 17

18 Price-Sales Ratio (P/S) P/Sales ratio is calculated as follows: P/S = Stock price / Sales per share = Market value of equity / Sales P/S ratio is commonly used despite its deficiencies By relying on sales, it neglects all the costs need to generate sales Firm having a high level of sales can be deeply unprofitable 18

19 Summary Valuation based on price multiples is called relative valuation Price multiples can be defined in numerous ways Selection of the group of comparable firms is essential in relative valuation Relative valuation can give very strange results 19