MARKET-BASED VALUATION: PRICE AND ENTERPRISE VALUE MULTIPLES
Introduction to Multiples
Price multiples are among the most widely used tools for valuation of equities. Comparing stocks'
price multiples can help an investor judge whether a particular stock is overvalued, undervalued, or
properly valued in terms of measures such as earnings, sales, cash flow, or book value per share.
Enterprise value multiples relate the total value of a company, as reflected in the market value of its
capital from all sources, to a measure of operating earnings generated, such as earnings before
interest, taxes, depreciation, and amortization. Momentum indicators compare a stock's price or a
company's earnings to their values in earlier periods.
Method of comparables and the method of forecasted fundamentals as approaches to using
price multiples in valuation.
The method of comparables values a stock based on the average price multiple of the stock of similar
companies.
The economic rationale for the method of comparables is the Law of One Price, which asserts that
two similar assets should sell at comparable price multiples (e.g., price - to-earnings). This is a relative
valuation method, so we can only assert that a stock is over- or undervalued relative to benchmark
value.
The method of forecasted fundamentals values a stock based on the ratio of its value from a
discounted cash flow (DCF) model to some fundamental variable (e.g., earnings per share) .
The economic rationale for the method of forecasted fundamentals is that the value used in the
numerator of the justified price multiple is derived from a DCF model: value is equal to the present
value of expected future cash flows discounted at the appropriate risk-adjusted rate of return.
Example: Method of comparables
MK Technologies shares are selling for $ 50. Earnings for the last 12 months were $2 per share. The
average trailing P/E ratio for firms in MK's industry is 32 times. Determine whether MK is over- or
undervalued using the method of comparables.
Example: Method of forecasted fundamentals
Shares of Comtronics, Inc. are selling for $ 30. The mean analyst earnings per share forecast for next
year is $ 4.00, and the long- run growth rate is 5%. Comtronics has a dividend payout ratio of 60%.
The required return is 14%. Calculate the fundamental value of Comtronics using the Gordon growth
model and determine whether Comtronics shares are over- or undervalued using the method of
forecasted fundamentals.
Justified Price Multiple
Price multiples are ratios of a common stock's market price to some fundamental variable. The most
common example is the Price - to - Earnings (P/E) ratio. A justified price multiple is what the multiple
should be if the stock is fairly valued. If the actual multiple is greater than the justified price multiple,
the stock is overvalued; if the actual multiple is less than the justified multiple, the stock is
undervalued (all else equal).
P/E Ratio
Rationales for using price-to-earnings (P/E) ratio in valuation:

Earnings power, as measured by earnings per share (EPS), is the primary determinant of
investment value.

The P/E ratio is popular in the investment community.

Empirical research shows that P/E differences are significantly related to long-run average
stock returns.
Shortcomings of using price-to-earnings (P/E) ratio in valuation:

Earnings can be negative, which produces a meaningless P/E ratio

The volatile, transitory portion of earnings makes the interpretation of P/Es difficult for
analysts.

Management discretion within allowed accounting practices can distort reported earnings, and
thereby lessen the comparability of P/Es across firms.
Trailing and Leading P/E.
We can define two versions of the P/E ratio, trailing and leading P/E.
The difference between the two is how earnings (the denominator) are calculated.
Trailing P/E uses earnings over the most recent 12 months in the denominator.
Leading P/E ratio (a.k.a. forward or prospective P/E) uses next year's expected earnings, which is
defined as either expected earnings per share (EPS) for the next four quarters, or expected EPS for
the next fiscal year.
Trailing P/E =
Market Price per Share
Earnings over previous 12 months
Leading P/E =
Market Price per Share
Earnings over previous 12 months
Trailing P/E is not useful for forecasting and valuation if the firm's business has changed (e.g., as a
result of an acquisition). Leading P/E may not be relevant if earnings are sufficiently volatile so that
next year's earnings are not forecastable with any degree of accuracy.
Example: Calculating P /E ratio
Byron Investments, Inc., reported € 32 million in earnings during fiscal year 2007. An analyst
forecasts an EPS over the next 12 months of € 1 .00. Byron has 40 million shares outstanding at a
market price of€ 18.00 per share. Calculate Byron's trailing and leading P/E ratios.
Price-to-Book (P/B) Ratio
Advantages of using the price-to-book (P/B) ratio include:

Book value is a cumulative amount that is usually positive, even when the firm reports
a loss and EPS is negative. Thus, a P/B can typically be used when P/E cannot.

Book value is more stable than EPS, so it may be more useful than P/E when EPS is
particularly high, low, or volatile.

Book value is an appropriate measure of net asset value for firms that primarily hold
liquid assets. Examples include finance, investment, insurance, and banking firms.

P/B can be useful in valuing companies that are expected to go out of business.

Empirical research shows that P/Bs help explain differences in long-run average stock
returns.

Disadvantages of using P/B include:
P/Bs do not reflect the value of intangible economic assets, such as human capital.

P/Bs can be misleading when there are significant differences in the asset size of the firms
under consideration because in some cases the firm's business model dictates the size of its
asset base. A firm that outsources its production will have fewer assets, lower book value,
and a higher P/B ratio than an otherwise similar firm in the same industry that doesn't
outsource.

Different accounting conventions can obscure the true investment in the firm made by
shareholders, which reduces the comparability of P /Bs across firms and countries. For
example, research and development costs (R&D) are expensed in the United States,
which can understate investment.

Inflation and technological change can cause the book and market values of assets to
differ significantly, so book value is not an accurate measure of the value of
shareholders' investment. This makes it more difficult to compare P/Bs across firms
We often make adjustments to book value to create more useful comparisons of P/B ratios across
different stocks. A common adjustment is to use tangible book value, which is equal to book value
of equity less intangible assets. Examples of intangible assets include goodwill from acquisitions
(which makes sense because it is not really an asset) and patents (which is more questionable since
the asset and patent are separable). Furthermore, balance sheets should be adjusted for significant offbalance- sheet assets and liabilities and for differences between the fair and recorded value of assets
and liabilities. Finally, book values often need to be adjusted to ensure comparability. For example,
companies using first in, first out (FIFO) for inventory valuation cannot be accurately compared with
peers using last in, first out (LIFO). Thus, book values should be restated on a consistent basis.
Example: Calculating P/B ratio
Based on the information in the following figure, calculate the current P/B for Crisco Systems, Inc.
and Soothsayer Corp.
Data for Crisco Systems, Inc. and Soothsayer Corp.
Company
Book
Value
of Sales 2017
Equity 2017
(Millions of $)
(Millions of $)
Crisco Systems,
Inc.
Soothsayer Corp.
Shares
Price
outstanding
FYE 2017
(Millions)
( $)
$28,039
$18,878
7,001
$17.83
$6,320
$ 9,475
5,233
$12.15
The Price-to-Sales (P/S) Ratio
The advantages of using the price-to-sales (P/S) ratio include:

P/S is meaningful even for distressed firms, since sales revenue is always positive. This is
not the case for P/E and P/B ratios, which can be negative.

Sales revenue is not as easy to manipulate or distort as EPS and book value, which are
significantly affected by accounting conventions.

P/S ratios are not as volatile as P/E multiples. This may make P/S ratios more reliable in
valuation analysis when earnings for a particular year are very high or very low relative to
the long-run average.

P/S ratios are particularly appropriate for valuing stocks in mature or cyclical industries and
startup companies with no record of earnings. It is also often used to value investment
management companies and partnerships.

Like P/E and P/B ratios, empirical research finds that differences in P/S are
significantly related to differences in long-run average stock returns.
The disadvantages of using P/S ratios include:

High growth in sales does not necessarily indicate high operating profits as measured by
earnings and cash flow.

P/S ratios do not capture differences in cost structures across companies.

While less subject to distortion, revenue recognition practices can still distort sales
forecasts. For example, analysts should look for company practices that speed up revenue
recognition. An example is sales on a bill -and-hold basis, which involves selling products
and delivering them at a later date. This practice accelerates sales into an earlier reporting
period and distorts the P/S ratio.
P/S multiples are computed by dividing a stock's price per share by sales or revenue per share,
or by dividing the market value of the firm's equity by its total sales:
Example: Calculating P/S ratio
Based on the information in the following figure, calculate the current P/S for Crisco Systems, Inc.
and Soothsayer Corp.
Data for Crisco Systems, Inc. and Soothsayer Corp.
Company
Book
Value
Equity 2017
of Sales 2017
(Millions of $)
(Millions of $)
Crisco Systems,
Inc.
$28,039
$18,878
Shares
Price
outstanding
FYE 2017
(Millions)
( $)
7,001
$17.83
Soothsayer Corp.
$6,320
$ 9,475
5,233
$12.15
Price-To-Cash Flow (P/CF) Ratio Include:
Advantages of using the price-to-cash flow (P/CF) ratio include:

Cash flow is harder for managers to manipulate than earnings.

Price to cash flow is more stable than price to earnings.

Reliance on cash flow rather than earnings handles the problem of differences in the quality
of reported earnings, which is a problem for P/E.

Empirical evidence indicates that differences in price to cash flow are significantly related to
differences in long-run average stock returns.
There are two drawbacks to the price-to -cash flow ratio, both of which are related to the definition
of cash flow. We discuss the specific cash flow definitions next.

Items affecting actual cash flow from operations are ignored when the EPS plus noncash
charges estimate is used. For example, noncash revenue and net changes in working capital
are ignored.

From a theoretical perspective, free cash flow to equity (FCFE) is preferable to operating
cash flow. However, FCFE is more volatile than operating cash flow, so it is not necessarily
more informative.
Dividend Yield
The dividend yield (D/P) is the ratio of the common dividend to the market price. It is most often
used for valuing indexes.
Advantages of the dividend yield approach include:

Dividend yield contributes to total investment return.

Dividends are not as risky as the capital appreciation component of total return.
Disadvantages of the dividend yield approach include:
The focus on dividend yield is incomplete because it ignores capital appreciation. The dividend
displacement of earnings concept argues that dividends paid now displace future earnings, which
implies a trade-off between current and future cash flows.