Price Multiples

Summaries

Justified Price Multiples: what the multiples should be if the stock is fairly valued.

1. Through method of comparables: based one Law of One Price
2. Through method of forecasted fundamentals: use DCF

P/E is significant related to long term returns

P/B good for –ve earning and volatile earning. Also shows relationship to long-term returns

P/B = market value of equity / book value of equity

Book value of equity = total asset – liability – preferred stocks

Tangible BV = BV – intangible BV (e.g. goodwill)

P/S (price to sales) – always positive, not easy to manipulate, not volatile, good relationship with long term earnings

P/CF difficult to manipulate, more stable, can compare different earnings qualities

1. CF = NI + D + A (earnings + NCC)
2. CF = adjusted CFO = CFO + I (1-t)
3. CF = FCFE = CFO + net borrowing – FCInv
4. CF = EBITDA

(note CFO = NI – WCInv + NCC, FCFF = NI + I(1-t) + NCC –FCInv – WCInv)

EV/EDITDA

EV (Enterprise value) =MV of common stock + MV of preferred stock + MV of debt + minority interest – cash and investment

(EV is the true overall value to pay if to acquire the company)

Dividend Yield (Trailing and leading) D/P

*** Trailing D/P = 4 x most recent quarter D/P

 Dividend Displacement of Earnings concept – displacement of future earnings by paying dividends

Underlying Earnings: persistent earnings that exclude the nonrecurring components

Normalized Earnings: get rid of Molodovsky effect (high P/E at cycle bottom and low P/E at cycle top)

-          method of historical average EPS

-          method of historical average ROE (then x BVPS) –can capture the effect of firm size change

Earnings Yield = E/P

Justified P/B0 = (ROE – g) / (r-g)

Justified P/S0 = (1-b) (1+g) E0/S0 / (r-g) = E0/S0 * trailing P/E

E0/S0 is just the net profit margin

Justified dividend yield D0/P0= (r-g)/(1+g)

Benchmarks:

1)      Peer Group, Sector, Industry Benchmark

2)      Equity Index Benchmark

a.      Fed Model: interest rate influences the market P/E. market P/E is overvalued when earnings yield (E/P) is less than 10-year treasury bond yield

b.      Yardeni Model: relates the current earnings yield of the market to the current yield A-rated corporate bonds (-ve related to P/E) and 5-year consensus growth rate (+ve related to P/E)

3)      Historical average P/E

a.      Justified price = historical average P/E * most recently EPS

PEG ratio = P/E divided by g

(to standardize the PE for different g)

*** But does not account multiple growth stage

Cross boarder valuation can be very different due to different financial standards. Among all price multiples, P/CFOadjusted and P/FCFE are affected the least.