Session 5 Intro to Relative Valuation Flashcards
What is the general method for relative valuation of a company?
Relative valuation is done through multiples. The multiples all share the same structure:
Multiple = (Price you pay for the asset)/(Profit generated by the asset)
What are the three main steps in applying the multiple valuation approach
Step 1: Identify comparable assets and find market values
Step 2: Make market values comparable to each other (absolute values are never comparable) creating multipliers
Step 3: Compare standardized (multiple) value of the target asset to the standardized values of comparable assets
What are the multiples generally used for different sectors in terms of Sector, Multiple Used, and Rationale?
Sectors include: Cyclical Manufacturing, Growth Firms, Young growth firms w/ losses, Infrastructure, REIT (real estate investment trust), Financial Services, Retailing
What are the four steps to deconstruct a multiple?
- Define the Multiple
* The same multiple may be defined differently depending on the user. It is crucial to understand how they have been estimated. - Describe the Multiple
* Often those who use a multiple do not know its nature; if the nature of the multiple is not known, it is impossible to make judgments about the result obtained by the evaluation. - Analysze the Multiple
* It is essential to understand the fundamentals that ‘guide’ each multiple and the nature of the relationship between the multiple itself and each of the variables that affect it. - Apply the Multiple
* To narrow the boundaries of comparable companies, be very attentive to the peculiarities of each individual company considered.
What are the two main points to keep in mind when it comes to defining the multiple for relative valuation?
- Is the multiple consistently defined?
* Both the value (the numerator) and the standardizing variable ( the denominator) should be to the same claimholders in the firm. In other words, the value of equity should be divided by equity earnings or equity book value, and firm value should be divided by firm earnings or book value. - Is the multiple uniformly estimated?
* The variables used in defining the multiple should be estimated uniformly across assets in the “comparable firm” list.
* If earnings-based multiples are used, the accounting rules to measure earnings should be applied consistently across
assets. The same rule applies with book-value based multiples.
What is the diffence between currnet multiple, trailing multiple, and leading multiple when it comes to P/E ratio?
What does describing a multiple for relative valuation entail?
What are the two main points to keep in mind when it comes to analyzing the multiple for relative valuation?
- What are the fundamentals that determine and drive these multiples?
* Embedded in every multiple are all of the variables that drive every discounted cash flow valuation - growth, risk and cash flow patterns.
* In fact, using a simple discounted cash flow model and basic algebra should yield the fundamentals that drive a multiple - How do changes in these fundamentals change the multiple?
* The relationship between a fundamental (like growth) and a multiple (such as PE) is seldom linear. For example, if firm A has twice the growth rate of firm B, it will generally not trade at twice its PE ratio
* It is impossible to properly compare firms on a multiple, if we do not know the nature of the relationship between fundamentals and the multiple.
When analyzing a multiple for relative valuation, how does one arrive at the fundamentals that drive the multiple?
What does the perfect undervalued company look like?
The perfect undervalued company…
If you were looking for the perfect undervalued asset, it would be one
* With a low PE ratio (it is cheap)
* With high expected growth in earnings
* With low risk (and cost of equity)
* And with high ROE
In other words, it would be cheap with no good reason for being cheap
* In the real world, most assets that look cheap on a multiple of earnings basis deserve to be cheap. In other words, one or more of these variables works against the company (It has low growth, high risk or a low ROE).
What are the two main points to keep in mind when it comes to applying the multiple for relative valuation?
- Given the firm that we are valuing, what is a “comparable” firm?
* While traditional analysis is built on the premise that firms in the same sector are comparable firms, valuation theory would suggest that a comparable firm is one which is similar to the one being analyzed in terms of fundamentals.
* There is no reason why a firm cannot be compared with another firm in a very different business, if the two firms have the same risk, growth and cash flow characteristics. - Given the comparable firms, how do we adjust for differences across firms on the fundamentals?
* It is impossible to find an exactly identical firm to the one you are valuing.
What are the three ways of controlling for differences across firms?
- Subjective adjustments
- Modified multiples (i.e., growth adjusted -> from P/E to PEG)
- Sector and/or market regressions
What are the five common multiples used for relative valuation, their definitions, and important caveats?
