Topic 6 Flashcards
What is the relative valuation method
an estimate of an assets value relative to that of similar assets
what is the rationale of the relative valuation method
identical assets should all sell at the same price
What are some different valuation indicators
- Share price
- Earnings multiples
- Book value multiples
- sales multiples
- CF multiples
What are the different multiples ratios
- Price/
2. enterprise value/
What are the advantages of P/E
- Most popular
- EPS is chief driver of value
What are the advantages of P/B
- B is more stable than E
- Particularly appropriate for firms which are not expected to continue
What are the advantages of P/S
- S is always positive and more stable than E and B
- S is less affected by accounting differences
What are the advantages of P/CF
- CF is less subject to accounting differences and manipulation
- More linked with valuation theory
What are the disadvantages of P/E
- Not applicable for zero,, small and negative earnings
- Accounting difference
- Management manipulation
What are the disadvantages of P/B
- Not applicable for negative equity
- Carry less information for service and technology firms
- Accounting differences (r&d)
- Stock buybacks and issuances
What are the disadvantages of P/S
- Numerator and denominator not match
- Manangement manipulation
- Sales growth doesn’t necessarily indicate positive E and CF
What are the disadvantages of P/CF
- No applicable for negative CF
- Biased calculation
- Increasingly managed by firms
what is the justified trailing P/E formula
P0/E0 = [(1-b)(1+g)]/r-g
What is the justified leading P/E formula
P0/E1 = 1-b/r-g
What happens to justified (trailing or leading) P/E if payout increases
Increase
What happens to justified (trailing or leading) P/E if growth increases
Increase
What happens to justified (trailing or leading) P/E if Beta increases
Decrease
What happens to justified P/B is ROE increases
Increase
Whats P/S relationship to growth, payout, PM and Beta
Increase
Increase
Increase
Negative
Whats P/CF relationship to growth, payout, PM and Beta
Increase
Increase
Increase
Negative
PAST EXAM Q What are the methods used to measure whether a stock of overvalued, undervalued or fairly valued
- Market price vs estimate of intrinsic value
- Actual multiples vs justified multiples
- Expected alpha (topic 2)
- Implied growth rate (topic 3)
- Implied required return (topic 3)
What are the steps to use multiples to make valuation decisions
- Define the multiple consistently and uniformly across firms being compared
- Describe the multiple
- Analyse the multiple
- Compare multiples and control for differences
What are examples of defining the multiple consistently and uniformly across firms
- Trailing earnings vs Leading earnings
2. Basic EPS vs Diluted EPS
When controlling the differences what are two subjective adjustments
- If the difference in multiples can be explained by differences in the multiples’ determinants, the comparison is inconclusive
- If the difference in multiples cannot be explained by fundamentals, the firms will be viewed as RELATIVELY undervalued, fairly valued or overvalued
Controlling for differences
What is a modified multiple and what are the limitations
PEG ratio = P/E ratio/ expected ST growth rate
- Assumes linear relationship
- Does not account for risk
- Dividing by ST growth forecasts may not capture LT growth prospects
Controlling for differences
How to use the regression model
- Select comparable firms in the same industry
- Regress P/E against its fundamentals
- Predict a justified P/E using the regression model
- Compare the justified P/E with actual P/E
What are the limitations of the regression model
- only for sample of stock over a particular time periods
- coefficients and explanatory power change over time
- multicollinearity
- linear relationship
