Relative Valuation

Question 1

what is relative valuation?

Answer 1

comparing asset prices to market prices

Question 2

which valuation method is used more often: DCF or relative valuation?

Answer 2

relative valuation

Question 3

What are the three basic investment rules?

Answer 3

• invest in stock with Price to Book ratio smaller than 1
• invest in stock with Price to Earnings ratio smaller than their expected growth
• invest in stock that have Earnings to Price (earnings yield) that are greater than long term risk free rates

Question 4

Strengths of relative valuation? (3)

Answer 4

• easier to do: less resources needed than for DCF (i.e. time, effort, deep understanding of industry)
• easier to sell: DCF harder to communicate to clients, relative valuations allow for easy comparison to other alternative assets.
  easier t defend: DCF may vary significantly from the market value.

Question 5

Weaknesses of relative valuation? (4)

Answer 5

• Market imperatives: entire industry may be over valued, causing relative valuations to be over valued.
• Many implicite assumptions: market must have the right price regarding the value of comparable assets, that comparable assets can be found.
• Inconsistent value estimates
• Difficulty finding comparable assets.

Question 6

What does the PE ratio consist of?

Answer 6

Price per share / Net earnings per share

Question 7

What does the PE ratio tell us?

Answer 7

How much we pay for a dollar of earnings

Question 8

What is a condition of the PE ratio?

Answer 8

earnings must be positive

Question 9

What are the 3 different types of PE ratios?

Answer 9

• Current PE: uses current EPS
• Trailing/Historical PE: uses latest 12 months of EPS
• Forward PE: uses forecasted EPS.

Question 10

What does the PB ratio consist of?

Answer 10

Price per share / Book value per share

Question 11

How is book value per share estabilished?

Answer 11

Accounting rules and regulations, depending on:

• historical acquisition prices for assets
• depriciation and amortisation of the firm
• sometimes the replacement value if assets (Tobin’s Q)

Question 12

What are weaknesses for PE and PB? (2)

Answer 12

• earnings and book value are dependant on accounting concepts, rules and principles
• hard to compare accross different countries

Question 13

What does Price to Sales ratio consist of?

Answer 13

Price per share / revenue per share

Question 14

What are the strengths of the PS ratio?

Answer 14

• can almost always be computed (even with negative values)
• can be used to compare between assets in different countries with different accounting rules, i.e. uses revenue to scale price of equity.

Question 15

What are two important factors to maintain while calculating these ratios? (definitional tests)

Answer 15

• consistency

- uniformity

Question 16

What are the 3 descriptive tests to relative valuation?

Answer 16

Distributional characteristics
Statistical Issues
Time variation in Multiples

Question 17

List 3 ways to avoid issues with descriptive tests?

Answer 17

• use the median value instead of an arithmatic average
• drop outliers
• drop useless values in the sample, ie negative EPS or BV

Question 18

How do you calculate the value of equity?

Answer 18

Po= DPS (1+g)/ Ke-g

Question 19

How do you calculate the PE ratio?

Answer 19

Payout ratio x (1+g) / Ke - g

Question 20

How do you calculate the PB ratio?

Answer 20

ROE x Payout ratio x (1+g) / Ke - g

Question 21

How do you calculate the PS ratio?

Answer 21

Profit Margin x Payout ratio x (1+g) / Ke - g

where PM= Net income / Sales

Question 22

How do you calculate the value of a firm using FCFF?

Answer 22

FCFF / Kcap - g(stable)

Question 23

What are the fundamentals determining PE, PB and PS ratio?

Answer 23

PE: expected g, payout, risk
PB: expected g, payout, risk, ROE
PS: expected g, payout, risk, PM

Question 24

what is a PEG ratio?

Answer 24

dividing the PE ratio by % expected growth rate.