Week 5

Question 1

How to perform a relative valuation (4 steps)

Answer 1

• Identify comparable assets and obtain market values for these assets
• Convert these market values into standardized values (note absolute values can’t be compared): Multiple
• Compare the multiple for the asset being analyzed to the multiple for comparable assets
• (Optional: Control for differences)
• Conclude: Over-/undervalued

Question 2

Essence of relative valuation: Suppose you observe two companies. Company A has a share price of $6 and earnings per share of 2. Share B has a price of $8 and earnings per share of 4. If company C has 4000 shares outstanding and has net income of $6000, what share price do you expect for share C?

Answer 2

3.75

Question 3

What are the four steps for multiples?

Answer 3

1. Define the multiple Same multiple can be defined in different ways by different users. Definition is critical for fair comparison
2. Describe the multiple What is the cross-sectional distribution? Critical to assess if multiple is high or low
3. Analyze the multiple Fundamentals that drive multiple. Critical to take into account
4. Apply the multiple

Question 4

• Assume that you have been asked to estimate the PE ratio for a firm which has the following characteristics.

What is your (rounded) estimate for PE? * G=4%, payout ratio=50%, beta=1, rf=2%, MRP=5.5%

Answer 4

14.85

Question 5

Name the PE fundamentals

Answer 5

• Other things held equal, higher growth firms will typically have higher PE ratios than lower growth firms
• Other things held equal, higher risk firms will have lower PE ratios than lower risk firms
• Other things held equal, firms with lower reinvestment needs will have higher PE ratios than firms with higher reinvestment rates

Question 6

What do the numbers of PEG multiple tell you?

Answer 6

High risk companies will trade at lower PEG ratios than low risk companies with the same expected growth rate

Companies with low reinvestment rates (that attain growth efficiently) will have high PEG ratios

Companies with very low or very high growth rates will tend to have higher PEG ratios than firms with average growth rates. This bias is worse for low growth stocks (PEG goes to infinity as growth approaches 0)

Question 7

Which multiple to use (3 steps)?

Answer 7

1- Use the multiple that best fits your objective. Pick the multiple that yields the highest value.

2- Use the multiple that has the highest R-squared in the sector when regressed against fundamentals. Thus, if you have tried PE, PBV, PS, etc. and run regressions of these multiples against fundamentals, use the multiple that works best at explaining differences across firms in that sector.

3- Use the multiple that seems to make the most sense for that sector, given how value is measured and created.