Market Based Valuation: Price & Enterprise Value Multiples

Question 1

What is the difference between price multiples and enterprise value multiples?

Answer 1

• price multiples: stock market price to some measure of fundamental value
• enterprise value multiples: market value of company to a fundamental value

Question 2

What are the two methods for price multiples and enterprise value multiples valuation, describe them.

Answer 2

• method of comparables: values an asset based on multiples of similar assets or relative to a similar asset
• method based on forecasted fundamentals: values an asset based on company personal fundamental values

Question 3

What is the method of comparables based on?

Answer 3

• based on law of one price: which states identical assets should trade at the same price

Question 4

What are 3 drawbacks of using P/E multiples?

Answer 4

• EPS can be zero, negative, or very small.
• difficult to determine if earnings are sustainable.
• reported EPS may be distorted due to differences in accounting standards.

Question 5

What are 5 considerations when calculating trailing EPS?

Answer 5

• potential dilution of EPS
• non recurring items (one time events should be removed because focus is on future cash flows)
• business cycle influences
• comparability with other companies
• extremely low, zero, or negative earnings (undefined or meaningless P/E ratios )

Question 6

What is formula for justified forward/leading P/E ratio?

Answer 6

justified leading P/E ratio = P0/E1 = ((D1/E1) / (r-g)) = ((1-b) / (r-g))

P0 = share price
E0 = earnings per share now
D0 = dividend now
r = required rate of return
g = dividend growth rate
b = retention ratio

Question 7

What is formula for justified trailing P/E ratio?

Answer 7

justified trailing P/E ratio = P0/E0 = ((D0 (1+g))/ E0) /r-g = ((1+g)*(1-b)) / r-g

P0 = share price
E0 = earnings per share now
D0 = dividend now
r = required rate of return
g = dividend growth rate
b = retention ratio

Question 8

What is the formula for PEG’s ratio? Is a lower PEG or higher PEG more attractive?

Answer 8

PEG = (P/E) / expected earnings growth rate

lower PEG is more attractive than higher PEG, all else equal

Question 9

What is the FED model? When is it overvalued and what does overvalued mean?

Answer 9

• compares S&P 500 earnings yield to the 10-year treasury yield
• market is considered undervalued if the earnings yield is less than the T-bond yield, means companies aren’t producing relatively high earnings compared to the yield on 10-year bond yields

Question 10

What is the yardeni model and formula?

Answer 10

• Yardeni model is a valuation model used to determine whether the overall stock market is overvalued or not

CEY = CBY - b *LTEG + residual

CEY = current earnings yield on market index
CBY = current moody’s investor service A - rated corporate bond yield
LTEG = consensus 5 year earnings growth rate
b = weight investors give earnings

Question 11

What is the P/E ratio based on the yardeni model?

Answer 11

justified P/E ratio = 1/ (CBY - b * LTEG)

CBY = current Moody’s Investors Service A-rated corporate bond yield
LTEG = is the consensus five-year earnings growth rate
b = represents the weight that investors give to earnings, which is normally between 0.10 and 0.25

Question 12

What is formula for justified P/E with inflation?

Answer 12

P0/E1 = 1/ (p + (1- inflation pass) * I)

p = real rate of return for a company’s shares
inflation pass = amount of inflation that can be passed through to consumer
I = cost of inflation

Question 13

What is book value per share formula?

Answer 13

BV per share = common shareholders equity - preferred stock period / common shares outstanding

Question 14

What is formula for justified price to book ratio?

Answer 14

P0/B0 = (ROE - g) / (r - g)

ROE = return on equity
g = growth
r = required rate of return

Question 15

Using the residual income model, what is the justified P/B formula?

Answer 15

P0/B0 = 1 + (present value of expected future residual earnings/B0)

B0 = book value now
P0 = price now

Question 16

What is the formula that shows the relationship between P/S & P/E?

Answer 16

(P/E) * (net profit margin) = P/S

Question 17

What is formula for price to sales ratio derived from Gordon growth model?

Answer 17

P0/S0 = {(E0/S0) * (1-b) * (1+g)} / r -g

E0/S0 = profit margin
b = retention ratio
(1-b) = dividend payout ratio

Question 18

What is the formula for dividend yield derived from Gordon growth model?

Answer 18

D0/P0 = r - g / 1 + g

Question 19

What is formula for enterprise value?

Answer 19

enterprise value = market value of common equity + market value of preferred stock + market value of debt + minority interest - cash & investment

Question 20

What is formula for EBITDA?

Answer 20

EBITDA = NI + Int + taxes + depreciation & amortization

Question 21

What is formula for earnings surprise?

Answer 21

UE = EPS - EEPS

UE = unexpected earnings or earnings surprise
EPS = report earnings per share
EEPS = expected earnings per share

Question 22

What is formula for standardized unexpected earnings (SUE)?

Answer 22

SUE = EPS - EEPS / Sd [EPS- EEPS]

SUE = standardized unexpected earnings
EPS = reported earnings per share
EEPS = expected earnings per share
SD [EPS - EEPS] = standard deviation of EPS - EEPS

Question 23

What is harmonic mean formula for calculating weighted average of P/E?

Answer 23

weighted harmonic mean = 1 / {(stock 1 weight) * (1/PE of stock 1)} + {(stock 2 weight) * (1/PE of stock 2)}

Question 24

What is look ahead bias and screening?

Answer 24

• look ahead bias: information used to make decisions in the model was not available when the decision was made (eg. lag in reporting)
• screening: process of using filtering criteria to reduce the number of potential investments.