Chapter

11
Valuation Using Multiples

Chapter Introduction and objectives

In addition to DCF analysis analysts and investors commonly use valuation multiples to
come up with the “relative value” of a company. That is, valuation multiples are used to
estimate relative under or over valuation. This chapter provides an overview of some of
the popular multiples.

This chapter has the following objectives:

 Discuss valuation multiples like P/E, P/B, PEG etc

 Highlight the limitations of multiples
 Discuss the use of yield based measures in constructing investment strategies

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Introduction

In the last chapter we demonstrated how an analyst can estimate the intrinsic value of a
firm using Discounted Cash Flow methods like the Free Cash Flow to Firm approach, the
Adjusted Present Value method, and the Capital Cash flow methods. Quite often analysts
are also interested in knowing whether a stock is over or under valued vis-à-vis the
industry or some peer group. The objective of relative valuation is to find out whether a
stock is relatively over or under valued but not in an absolute sense. That is, it is quite
possible for a stock to be relatively undervalued compared to some benchmarks but over
valued when compared to its own intrinsic value as estimated using the DCF
methodology.

Price multiples are a useful way to compare the valuation of a stock over time, against
“comparable companies” or the market as a whole. These multiples are a ratio of the
stock’s current market capitalization to one of its underlying accounting fundamentals
such as book value (total owners’ equity), sales or net income. Because investors are
usually more familiar with share price rather than market capitalization (share price x
shares outstanding) the accounting fundamentals are often converted to a per-share basis
when using price multiples. Ratios are very popular with investors because they can be
calculated easily, and they are readily available from most financial Web sites and
newspapers.

While valuation ratios have become ubiquitous, it's important to recognize their strengths
and weaknesses Valuation ratios are handy tools to have at your disposal for a quick-and-
dirty analysis, but they all require a lot of context to be useful.

The most common price multiples are:

 Price to earnings (P/E) = (Share price)/(Earnings per share). Since earnings are
meant to approximate the money available to shareholders, the P/E ratio expresses
how much the investor pays for each dollar of earnings. This is the most
frequently used price multiple.

 Price to book value [P/B] = (share price)/(book value per share). This compares
the value of the firm today with the capital provided to the company over time.

 Price to sales (P/S) = (share price)/(sales per share). This ratio can be useful for
valuing cyclical companies where earnings tend to be more volatile than sales, or
situations in which a firm temporarily has little or no earnings.

Exhibit 11-1 presents some commonly used multiples.

A high multiple indicates that the market is wiling to pay a high price relative to the
underlying fundamental value such as earnings. A company may trade at a high multiple
because it has high growth prospects and future earnings are expected to be higher than
past earnings. A low multiple indicates that that the stock is not valued highly - perhaps it

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has low growth prospects, high risk or is simply undervalued by the market. Value
investors tend to search for companies trading at lower multiples than peer companies.

Identifying comparable companies

The first step in the application of multiples is to select a set of comparable firms. In any
industry group a firm would have many peer companies. How should one select a
comparable firm? In other words, what makes two firms comparable? To answer this
question one has to look at the source of risk and return for the two companies in
question. Companies may be matched on the basis of several characteristics like size,
leverage etc. It is important to understand the criterion of comparability differs from one
multiple to another. For example, when one is using the price to earnings multiple,
leverage is crucial because two firms may be similar in all respect except the debt ratio. A
firm with high debt ratio would have fewer shares, higher EPS and lower P/E multiple,
other things remaining constant.

The normal practice in the US is to identify all companies with the same 3 digit SIC code
with available data to estimate multiples1. If fewer than five companies are identified one
may relax the industry requirement to companies with the same 2 digit SIC code and so
on.

Exhibit 11-1: Examples of Multiples

Market Capitalization divided by Stock Price divided by

Net Income Earnings per Share

Net Cash flow Cash Flow per share
EBIT Book Value Per share
Sales per share
Enterprise Value divided by

EBITDA
EBIT
Total Assets
Net Fixed Assets

The P/E Multiple

P/E is the most popular valuation ratio used by investors. It is the ratio of a stock's market
price divided by the earnings per share for the most recent four quarters. One
characteristic of P/E is that accounting earnings are a much better proxy for cash flow
(used for valuation) than sales. Moreover, earnings per share results and estimates about
the future are easily available from many sources.

1
SIC is Standard Industrial Classification. It indicates the company’s type of business. See
http://www.sec.gov/info/edgar/siccodes.htm and http://www.siccode.com for details.

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P/E = Market Price of share / Earnings per share

The P/E ratio shows the number of years' earnings per share (EPS) contained in the
current share price. In other words, it shows the number of years at current earnings
needed to cover the current share price. The P/E ratio measures how much investors are
willing to pay for every dollar of a company's earnings. Generally speaking, the higher
the P/E ratio, the more investors are willing to pay for a dollar's worth of a company's
earnings. The price/earnings ratio (P/E ratio) is commonly used to assess the level of
confidence investors have in a company. It represents the market's view of a company's
growth potential. A high price/earnings ratio indicates that investors have a high level of
confidence in a company's future prospects.By comparing P/E ratios between companies
and across business sectors, investors hope to identify undervalued stocks. But while a
company with a high P/E ratio relative to its sector may have exciting growth prospects,
it might equally be considered to be overvalued depending on prevailing market
circumstances. So while P/E can be a useful measure of a company's value, it should also
be treated with caution.

P/E ratios vary dramatically between sectors. For example, in the new high-tech
economy, we have become accustomed to huge valuations for companies that are making
enormous losses.

While traditionally companies were valued using P/E multiples, it is now becoming
commonplace for the market to value companies on the basis of projected turnover (i.e.
Price/Sales ratio) even though they may be making major losses. Meanwhile, high-tech
companies that are actually making money carry extraordinarily high P/E multiples.

Stocks with high P/Es (typically those with a P/E exceeding 30) usually have greater
future growth prospects, while stocks with low P/Es (typically those with a P/E below 15)
tend to have lesser future growth prospects. However, a P/E ratio by itself does not say
much about a stock's valuation.

The most useful way to use a P/E ratio is to compare it with a certain benchmark. Good
benchmarks are the P/E of another company in the same industry, the P/E of the entire
market, or the same company's P/E at a different point in time. Each of these approaches
has some value.

For example, a company that is trading at a lower P/E than its industry peers could be a
good buy, but even firms in the same industry can have very different capital structures,
risk levels, and growth rates, all of which affect the P/E ratio. All else equal, a firm that
has better growth prospects, lower risk, and lower capital reinvestment needs should be
rewarded with a higher P/E ratio.

One can also compare a stock's P/E with the average P/E of the entire market. However,
the same limitations of industry comparisons apply to this process as well. The stock one
is investigating might be growing faster (or slower) than the average stock, or it might be
riskier (or less risky). In general, comparing a company's P/E with those of industry peers

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or with the market has some value, but one should not rely on these approaches to make
final buy or sell decisions.

Comparing a stock's current P/E with its historical P/E ratios can also be of value. This is
especially true for stable firms that have not undergone major business shifts. If you find
a company that is growing at roughly the same rate with roughly the same business
prospects as in the past, but is trading at a lower P/E than its long-term average, you
should start getting interested. It's entirely possible that the company's risk level or
business outlook has changed, in which case a lower P/E is warranted, but it's also
possible that the market is simply pricing the shares at an irrationally low level.

Investors can also construct trading strategies on the basis of P/E multiple. Academic
studies conducted in the US have found that investors have tended to earn larger long-
horizon returns when purchasing the market basket of stocks at relatively low P/E
multiples. Campbell and Shiller (1988) report that initial P/E ratios explained as much as
30% of variance of future returns.

Limitations of the P/E Multiple

The P/E ratio also has some important drawbacks. A P/E ratio of 15 does not mean
anything by itself; it is neither good nor bad in isolation. The P/E ratio only becomes
meaningful with context.

However one has to keep in mind that using P/E ratios only on a relative basis means that
one’s analysis can be skewed by the benchmark one is using. After all, there will be
periods when entire industries will become overvalued. In 2000, for example, an Internet
stock with a P/E of 75 might have looked cheap when the rest of its peers had an average
P/E of 200. In hindsight, neither the price of the stock nor the benchmark made sense.
Being less expensive than a benchmark does not mean something is cheap, because the
benchmark itself may be vastly overpriced.

It is important to understand that when working with P/E ratio one has to make sure that
the earnings part of the equation makes sense and is representative of a company's
recurring profits. A few things can distort the P/E ratio. First, firms that have recently
sold off a business can have an artificially inflated "EPS" and a lower P/E as a result.

Second, reported earnings can sometimes be inflated (or depressed) by one-time

accounting charges and gains (i.e. extraordinary items like litigation settlements and non
recurring items like discontinued operations and asset sales). As a result, the P/E ratio can
be misleadingly high or low. Further, different companies may follow different
accounting rules relating to inventory (LIFO vs. FIFO), leases (i.e. operating vs. capital),
owner’s compensation and capitalization of intangibles.

Third, cyclical firms that go through boom and bust cycles (e.g. auto manufacturers)
require a bit more investigation. Although you would typically think of a firm with a very
low trailing P/E as cheap, this is precisely the wrong time to buy a cyclical firm because

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it means earnings have been very high in the recent past, which in turn means they are
likely to fall off soon. Likewise, a cyclical stock is going to look the most expensive
when its EPS has bottomed and is about to start growing again. Due to this reason
analysts sometimes calculate normalized EPS to represent “normal earnings” for the
entire business cycle.

Lastly, there are two kinds of P/Es--a trailing P/E, which uses the past four quarters'
worth of earnings to calculate the ratio, and forward (or leading) P/E, which uses
analysts' estimates of the next four quarters' earnings to calculate the ratio.

Current price per share

Trailing P/E =
Last reported earnings

Current Price per share

Leading P/E =
Estimated next period earnings

Because most companies are increasing earnings from year to year, the forward P/E is
almost always lower than the trailing P/E, sometimes markedly for firms that are
increasing earnings very rapidly. Unfortunately, estimates of future earnings by Wall
Street analysts are consistently too optimistic. As a result buying a stock because its
forward P/E is low means counting on that future EPS to materialize in its entirety--and
that usually doesn't happen.

Intrinsic P/E Multiple

Given the prevailing market price of stock and the earnings per share an analyst can
compute the P/E multiple and compare it with those of the peer group or the market.
Often one would be interested in making an estimate of the intrinsic value of the multiple.

From the Gordon Dividend Discount Model we know that:

D1
P =
(k-g)

Where P = Stock Price

D1 = Dividends per share next year
= D0 (1+g) i.e. current dividend inflated at a growth rate g
= (Current Earnings * Payout Ratio) (1+g)
k = expected equity return
g = growth rate in earnings and dividends

E0 * b * (1+g)

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P =
(k-g)
Or
b (1+g)
P/E0 =
(k-g)

That is, the price earnings multiple of a firm is a function of pay out ratio, growth rate in
earnings & dividends, and risk (captured in expected returns). The higher the payout
ratio, the higher is the price-earnings multiple, all else equal. When companies increase
their pay out ratio they invest less in operations (in the absence of outside capital), which
leads to a decrease in growth rate. An increase in growth rate (in the denominator) leads
to a lower spread between expected return and growth rate, and hence, a higher P/E
multiple. Likewise, a decrease in expected return (due to a decrease in risk) leads to a
higher P/E multiple. One can estimate the intrinsic value of P/E multiple by plugging in
the values of k, g and b.

Calculating Normalized Earnings and Diluted EPS

As pointed out earlier the EPS in the denominator in sensitive to the business cycle. An
unusually high EPS will result in a lower P/E and vice versa. Analysts adjust P/Es for
cyclicality by estimating normalized EPS, which is an estimate of EPS in the middle of
the business cycle. To methods are commonly used to estimate normalized EPS:

 An average of EPS during the most recent business cycle is calculated.

 The average Return on Equity (ROE) during the most recent business cycle is
multiplied by the current book value per share

Further, the EPS needs to be adjusted for potential dilution of earnings arising out of
exercise of dilutive securities like Convertible bonds, convertible preferred stocks,
warrants, stock options etc2. A simple capital structure is one that contains only common
stock, non convertible debt, preferred stock and no potentially dilutive securities. A
complex capital structure contains options, warrants, and convertibles.

All firms must report basic and diluted EPS. Basic EPS is defined as:

Net income – Preferred dividends

Basic EPS =
Weighted average number of common shares outstanding

Where Weighted average number of shares = number of shares outstanding during the
year weighted by the portion of the year they were outstanding.

2
The chapter on Investing in Convertible Bonds, Preferred Stocks and Warrants discusses the accounting
for convertible in greater detail. Readers may also refer to articles cited in that chapter.

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Potentially dilutive securities are included in the diluted EPS calculation in one of two
ways. The “if converted” method is used in the case of convertible securities, the treasury
method for options and warrants. The “if converted” method assumes that any security
convertible into common stock is converted. Dilutive securities like Convertibles, options
and warrants cause the weighted average common shares to change. Further the
numerator also needs to be adjusted as follows to eliminate any effect the convertible
security had on the measurement of net income:

 If convertible preferred stock is dilutive the convertible preferred dividends must

be added back to the previously calculated income from continuing operations
less preferred dividends

 If convertible bonds are dilutive then the bond’s after tax interest expense would
not be considered as an interest expense for diluted EPS. Hence interest expense
(1-t) must be added back to the numerator.

 If a dilutive security is issued during the year, the increase in the weighted
average number of shares for diluted EPS is based on only the portion of the year
the dilutive security was outstanding. Dilutive stock options and warrants increase
the number of shares but no adjustment needs to be done to the net income in the
numerator. Stock options and warrants are dilutive only when their exercise price
is less than the average market price of the stock over the year.

The Treasury Stock method applied to options, warrants, and such other arrangements
assumes that the options and warrants are exercised at the beginning of the period (or at
time of issuance, if later) and that the hypothetical funds received by the company from
the exercise of the options are used to purchase shares of the common stock in the market
at the average market price. This reduces the total increase in shares created from the
hypothetical exercise of the options into common stock and the net increase in the
number of shares outstanding will be the number of shares created by exercising the
options less the number of shares repurchased with the proceeds of exercise.

The formula used to calculate the number of net increase in common shares from the
potential exercise of stock options or warrants when X (exercise price) < S (market price
of stock) is:

(S-X)/S * Number of shares that the options or warrants can be converted into

To lustrate, if S=$20, X= $15, and the number of shares upon conversion = 100,000,

Net increase in shares = 5/20 * 100,000 = 25,000 incremental shares.

Once these adjustments are made, the diluted EPS is calculated as:

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 Adjusted income available for common shares
Diluted EPS =
Weighted average common and potential common shares outstanding

Adjusted income = Net income – preferred dividends + dividends on convertible

preferred stock + after tax interest on convertible debt

Net income – preferred dividends + dividends on convertible preferred

stock + After tax interest on convertible debt

Diluted EPS =

Weighted average shares + Shares from conversion of convertible

preferred shares + Shares from conversion of convertible debt + shares
issuable from stock options

In case of stock splits and stock dividends, though the proportional ownership is
unchanged, find the weighted average for the time period shares were outstanding. The
split or dividend is NOT applied to any shares that are issued or repurchased after the
dividend or split.

Predicted P/E Multiple

As pointed out earlier, the Gordon model suggests that the price-earnings multiple is a
function of pay out ratio, risk and growth rate. Using such a model would be better than
naively comparing P/E multiples across firms and industry groups.

Just the firm’s systematic risk (beta) is a function of fundamental variables, and a
fundamental beta can be estimated from linear regression, a predicted P/E can be
estimated from linear regression of historical P/Es on its fundamental variables, including
expected growth and risk. Assume that a firm has a payout ratio of 0.50, a beta of 0.9 and
an expected earnings growth rate of 6%. Further, assume that a regression on other firms
in the industry peers produces the following regression equation:

Predicted P/E = 6.25 + (3.75 * dividend payout) + (12.00 * growth) – (0.5 * beta)

Note that the relationship between dividend payout, growth and P/E is positive whereas
the relationship between beta (a measure of risk) and P/E is negative.

Plug the observed values of the firm into the above equation:

Predicted P/E = 6.25 + (3.75 * 0.50) + (12.00 * 0.06) – (0.5 * 0.9)

= 6.25 + 1.875 + 0.72 – 0.45
= 8.395

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Compare the predicted P/E with the actual to estimate under or over pricing. Of course, it
is quite possible that the predicted and the actual P/E multiples may deviate but yet not
suggest any over or under valuation because the model may not capture all the relevant
variables.

The PEG Ratio

As an offshoot of the P/E ratio, the PEG (price earnings growth) measures the
relationship between a stock's P/E ratio and its growth rate.

PEG is extremely popular with some investors because it seeks to relate the P/E to a piece
of fundamental information--a company's growth rate. On the surface, this makes sense
because a firm that is growing faster will be worth more in the future (all else being
equal).

PEG = (Forward P/E Ratio) / (5-Year EPS Growth Rate)

The decision rule in using the PEG ratio is:

A stock is fairly valued if the PEG ratio is equal to 1.

A stock is undervalued if the PEG is less than 1. Therefore, buy the stock.
A stock is overvalued if the PEG ratio is greater than 1. Therefore, sell the stock.

The problem with PEG is that risk and growth often go hand in glove--fast-growing firms
tend to be riskier than average. This conflation of risk and growth is why PEG is
frequently misused. When one uses a PEG ratio alone to compare companies, one is
basically assuming that all growth is equal, generated with the same amount of capital
and the same amount of risk.

In other words, the PEG ratio is merely an empirical regularity in the US capital markets:
high-growth stocks have P/E ratios approximately equal to the medium-term (three-five
years) EPS growth rate times 100, not grounded in financial theory. Analysts, use this
relation regardless of industry, leverage or systematic risk.

Firms that are able to generate growth with less capital should be more valuable, as
should firms that take on less risk. Consider two stocks. The first stock is expected to
grow at 15% and is trading at 15 times earnings and the second is expected to grow at
15% and is trading at 25 times earnings. Based on this information it would be unwise to
invest in the former because it has a lower PEG ratio. One has to consider the capital that
each firm needs to invest to generate the expected growth, as well as the likelihood that
those expectations will actually materialize. Nevertheless, PEG does provide a quick and
easy way to estimate the price one is paying for future growth.

An example is in order. Exhibit 11-2 presents the analyst estimate of P/E as well as PEG
ratios for Apple Inc, industry, Sector and S&P 500 in 20073.
3
http://finance.yahoo.com/q/ae?s=aapl accessed on 16/03/2007

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Exhibit 11-2: Estimates of PE and PEG for Apple Inc

Growth Estimate Apple Industry Sector S&P 500

Current Qtr. 31.9% 1.6% 11.9% N/A
Next Qtr. 25.9% 8.9% 14.9% N/A
This Year 42.7% 10.4% 15.6% N/A
Next Year 17.9% 22.0% 18.8% N/A
Past 5 Years (per annum) 55.9% N/A N/A N/A
Next 5 Years (per
20.0% 14.51% 14.03% N/A
annum)
Price/Earnings (avg. for
26.8 19.50 19.12 N/A
comparison categories)
PEG Ratio (avg. for N/A
1.34 1.34 1.36
comparison categories)

The Price/Book Value Ratio

The P/B ratio compares a stock's market price with its book value. At the simplest level, a
company is worth the value of its assets minus its liabilities - its "book value". Book
value is the amount of money that would be available to shareholders if the company's
assets (excluding intangibles such as copyright and patents) were sold at their balance
sheet value and all liabilities were paid. For example, if assets equal $500m, while
liabilities are $300m, then the company's book value is $200m.

Book value is the equity balance on a firm's balance sheet divided by the number of
shares outstanding. Book value is often expressed in terms of book value per share (book
value divided by the number of outstanding shares). The market price per share is then
compared to the book value per share. Conservative investors often prefer the P/B ratio,
because it offers a more tangible measure of a company's value than earnings do.
Legendary investor Benjamin Graham was a big advocate of book value and P/B in
valuing stocks.

The P/B multiple is calculated as:

Market Price per share

Price-to-book value ratio =
Book Value per Share

Limitations of the P/B Multiple

There are caveats to using P/B, just as there are for all the other simple ratios. A major
drawback with book value is that it is difficult to value assets accurately. There are a
variety of legitimate accounting techniques for measuring tangible assets, all of which

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arrive at different valuations. It may be unrealistic to assume that the value of a tangible
company asset on the balance sheet equals the value it would fetch if it were to be sold
off.

The carrying value of an asset on a company's balance sheet may not reflect the true
value of the asset. For example, a future charge to write down the value of an overvalued
asset could dramatically reduce a firm's book value and change the P/B in one swipe. On
the other side of the coin, the book value of a company doesn't always accurately measure
its true worth, especially for firms with lots of intangible assets such as patents, human
capital, and brand names that don't show up on the balance sheet. Some assets, like land,
are also carried on a company's books at cost. If a company has held a property for a long
time, chances are the value of the land is much greater than what its books state.
Likewise, a company building may have depreciated to zero over time, yet may have a
market value of millions of dollars. Similarly, a company operating in a very fast-moving
industry may be showing a high-tech computer in its books at a significant value. That
computer might, however, fetch very little in the market were it to be sold immediately. It
is even more difficult to value intangible assets such as patents and brands. This problem
is compounded by the fact that in recent times a far higher value has been placed on
intangible assets than in the past.

The P/B multiple can be misleading when there are significant differences in the asset
size of the firms under consideration because the firm’s business model often dictates the
asset size. A firm that outsource its production may have fewer assets, lower book value
and hence, a higher P/B multiple.

Determinants of Market-to-Book Ratio

A company’s value is determined by three value drivers viz. Profitability, Advantage

Horizon and Reinvestment. The spread between the Return on Equity and cost of equity
is the firm’s true profitability; the period for which a firm can maintain a positive (ROE –
cost of equity) spread is called advantage horizon and the rate at which a firm reinvests
(its earnings) is the reinvestment.

The greater the abnormal return, the longer the advantage horizon, the sooner the
abnormal returns, the higher the M/B ratio4.

The market value of equity can be obtained by discounting equity cash flows at an
appropriate discount rate.

M = [ECF / (1+k)1 + ECF / (1+k)2 + ………….]

If we assume that cash flows and discount rate are constant the series reduces to
perpetuity.

4
Fruhan , William , Financial Strategy : Studies in the Creation , Transfer and Destruction of Shareholder
Value , Irwin , Homewood , IL , 1979
Benjamin C Esty , “ Note on Value Drivers “ , HBS Case Study No , 9-297-082, April 7 , 1997

259
M = ECF / k

Further, if we assume that ECF = Net income i.e. retention is zero,

M = Net income / k

But Net income = ROE * Book value of equity

M = [ROE * B] / k

Or M / B = ROE / k

Thus, market – to – book ratio is a function of ROE and cost of equity.

If all earnings are returned to shareholders and earnings are constant

M = (ROE*B) / (1+k) + (ROE*B) / (1+k)2 + ………….

Divide both sides by B

M /B = (ROE) / (1+k) + (ROE) / (1+k)2 + ………….

Add and subtract k from each of the terms

M / B = [(ROE + k) – k] / (1+k) + [(ROE + k) – k] / (1+k)2 + ………….

The first term (ROE – k) is the abnormal earnings and the second term, k, is the normal
earning.

It can be proved that the present value of this series is:

PV = 1 + (ROE-k) [(1/k) – { 1 / k(1+k)n}-------------------- (1)

This model assumes that retention is zero. Allowing for different rates would yield a
more realistic model.

M = D1 / (k-g) = (Net income * payout) / (k-g)

But

Payout = (1- retention) = 1 – r

g = sustainable growth rate = ROE * r

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Net income = ROE * B

M = [ROE*B*(1-r)] / [k - (r*ROE)]

M/B = [ROE*(1-r)] / [k - (r*ROE)] ------------------ (2)

If a firm pays out all its earnings as dividends, r is zero. Those firms that generate
positive abnormal returns can increase value by retaining a larger fraction of earnings and
invest in business.

Equations 1 and 2 can be combined as:

M/B = [1 + (ROE*r)] / (1+k) + [ROE (1-r)/ (k – r*ROE)] [1 - (1+r*ROE)/(1+k)n]

Thus, Market-to-Book ratio is a function of ROE, retention rate and the advantage
horizon, n.

The Price/Sales Multiple

One of the most basic valuation ratios is the P/S ratio. The P/S ratio is equal to a stock's
market price divided by its sales per share.

P/S = Market Price per Share / Sales per Share

The good thing about the P/S ratio is that sales are not subject to much accounting
assumption and manipulation like earnings. Although firms could use accounting tricks to
lift sales, it's much harder to do and far easier to catch. Further, sales are not as volatile as
earnings, because one-time charges or gains can depress or boost earnings temporarily.
Plus, the bottom line of economically cyclical companies can vary significantly from year
to year, but sales are a more stable benchmark. Moreover, the P/S ratio can be used for
companies that do not have positive earnings.

The relative smoothness of sales makes the P/S ratio useful for quickly valuing
companies with highly variable earnings by comparing their current P/S ratios with
historic P/S ratios.

Valuing established companies is difficult enough, but valuing start-up companies is

trickier. Typically, most start-ups make losses for several years, yet many technology
start-ups, for example, can have huge valuations. In the absence of profits, many analysts
instead focus on sales growth as a measure of the future growth potential of such
companies, and this is reflected in the sales-to-stock price ratio.

Limitations of P/S Ratio

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Despite several advantages, the P/S ratio has some limitations. One major flaw is that
sales may be worth a little or a lot, depending on a company's profitability. If a company
is posting billions in sales, but it is losing money on every transaction, we would have a
hard time pinning an appropriate P/S ratio on the shares because we have no idea what
level of profits (if any) the company will generate. Further, sales may not have much
correlation with cash flow, the fundamental driver of value.

When using the P/S ratio, it is important to keep in mind that a dollar of earnings has the
same value regardless of the level of sales needed to create that dollar. A dollar of sales at
a highly profitable firm is therefore worth more than a dollar of sales for a company with
a narrower profit margin. That is, P/S ratios do not capture differences in cost structures.
Thus, the P/S ratio is generally useful only when comparing firms within an industry or
industries with similar profitability levels, or when looking at a single firm over time.

A firm’s revenue recognition policy has a bearing on the P/S multiple. Managers may
accelerate revenues by billing now and delivering later. This will boost the multiple.

The Price/Cash Flow Ratio

The price-to-cash flow multiple is the ratio of market price of stock and operating cash
flow per share.

The multiple can be computed using different definitions of cash flow. Cash flow can be
calculated using either gross cash flow (i.e. Net income + non cash charges) or free cash
flow to equity (i.e. EBIT (1-T) + non cash charges – Capital Expenditure – incremental
working capital – after tax interest payments – principal repayments + new borrowings)
or EBITDA (i.e. Earnings Before Interest, Tax, Depreciation and Amortization).

The advantage of the price-to-cash flow ratio is that:

 It is harder to manipulate than earnings

 It is more stable than earnings
 It obviates the need to handle differences in quality of earnings between firms

The drawback of this ratio is that the denominator can be expressed in more than one
way. Using one definition over the other has both advantages and disadvantages.

The EV/EBITDA ratio

It is the ratio of enterprise value and Earnings before Interest Tax Depreciation and
Amortization. Since EBITDA flows to both shareholders and bondholders the numerator
has enterprise value.

Enterprise Value = Market Value of Equity + Book Value of debt

This ratio is more useful in situations where:

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The firms under comparison have different financial leverage (EBITDA is pre debt flow)
The firm under analysis has high levels of depreciation and amortization (e.g. airline
companies)

All the key valuation measures for the General Electric Company are given in Exhibit 11-
35.

Exhibit 11-3: Valuation Measures for General Electric

Market Cap (intraday): 353.33B

Enterprise Value (19-Mar-07): 772.01B
Trailing P/E (ttm, intraday): 17.15
Forward P/E (financial year ending 31-Dec-08): 13.80
PEG Ratio (5 yr expected): 1.55
Price/Sales 2.21
Price/Book 3.16
Enterprise Value/Revenue: 4.81
Enterprise Value/EBITDA 22.899

Yield Based Measures

In addition to ratio-based measures, one can also use yield-based measures to value
stocks. For example, if we invert the P/E and divide a firm's earnings per share by its
market price, we get an earnings yield. If a stock sells for $40 per share and has $2 per
share in earnings, then it has a P/E of 20 (40/2) but an earnings yield of 5% (2/40).
Unlike P/Es, the nice thing about yields is that we can compare them with alternative
investments, such as bonds, to see what kind of a return we can expect from each
investment. One main difference, however, is that earnings generally grow over time
whereas bond payments are fixed.

In early 2005, 10-year Treasury bonds were yielding a risk-free return of about 4.5% in
the U.S. Therefore, one would want to demand a higher rate of return from stocks
because they are riskier than Treasuries. A stock with a P/E of 20 would have an earnings
yield of 5%, which is a bit better than Treasuries, but perhaps not enough considering the
additional risk one is taking. It all depends on whether the company will be able to grow
its profits in the future to make accepting a 5% yield today worthwhile.

A stock with a P/E of 12 would have an earnings yield of 8.3% (1/12), which is much
better than Treasuries, even if earnings never grow. Thus, in this situation one might be
induced to take on the additional risk of owning the stock.

5
http://finance.yahoo.com/q/ks?s=GE accessed on March 19, 2007

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Dividend yield is actually one of the oldest valuation methods. It was very popular back
in the days when dividends were the primary reason people owned stocks, and it is still
widely used today, mainly among income-oriented investors. Dividend yield is equal to a
company's annual dividend per share divided by a stock's market price. For example, a
company that pays an annual dividend of $1.00 per share and trades for $20 has a
dividend yield of 5% (1/20). If that same stock's price rose to $40 a share, its dividend
yield would fall to 2.5%--the more expensive the stock, the lower the yield.

Dividend Yield = Annual Dividends per Share / Market Price per share

This strategy entails investing in the top 100 highest dividend yielding stock in the S&P
500 (or Dow Jones Index). The top Dividend Yields Portfolios invested in the S&P 500
(top 100) returned 3% per year more than the S&P 500 index whereas the lowest yielding
stocks lagged the market by almost 2% per year. Choosing the 10 highest yielding stocks
among the largest 100 S&P 500 stocks does even better than the Dow 10. A thousand
dollars invested in these high yielding stocks at the end of 1957 accumulates to more than
$811000 in 20056.

The Dow Jones Industrial Average has outperformed the S&P 500 for the period 1958-
2003. The Dow-10 strategy consists of buying the ten highest yielding Dow stocks and
rebalancing annually. The return of the Dow 10 strategy is much better than the Dow
industrials.

The "Dogs of the Dow" (strategies of investing in the unpopular stocks in the DJIA i.e.
buying either the six or ten issues in the DJIA selling at the lowest earnings multiples and
rebalancing at holding periods ranging from one to five years or they also involve picking
stocks with high dividend yields is a stock picking strategy that has been the subject of a
great deal of attention in the last few years. Proponents of the strategy cite the fact that it
has outperformed the Dow Jones Industrial Average and other indexes by significant
margins. Many cite figures for the last 25 years with others going back even farther.
Given below are some facts about the high dividend Dow stocks:

During the tech bubble of the late 90s, the high dividend stocks of the Dogs of the Dow
were up 28.6% in 1996, up 22.2% in 1997, up 10.7% in 1998, and up 4.0% in 1999.

During the difficult bear market years of 2000 - 2002, the Dogs of the Dow were up 6.4%
in 2000, down 4.9% in 2001, and down 8.9% in 2002, and that was enough to
significantly outperform the Dow, S&P 500, and Nasdaq.

In 2003, the high dividend stocks of the Dogs of the Dow gained 28.7% and made new,
all-time highs despite the massive bear market of 2000-2002!

In 2004, the high dividend yield Dogs of the Dow remained in record territory with a
4.4% gain and then gave back 5.1% in 2005.

6
www.jeremysiegel.com

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In 2006, the Dogs of the Dow surged to new record highs with a gain of 30.3%. The
Small Dogs of the Dow did even better with a gain of 42%!

Following the Dogs of the Dow strategy is ridiculously simple. After the stock market
closes on the last day of the year, of the 30 stocks that make up the DJIA, select the ten
stocks which have the highest dividend yield. Then simply get in touch with your broker
and invest an equal dollar amount in each of these ten high yield stocks. Then hold these
ten "Dogs of the Dow" for one year. Repeat these steps each and every year. That's it!

A variant of the Dow 10 strategy is the Foolish Four strategy – consisting of investing
40% of a portfolio in the second lowest priced of the ten and 20% each in the third,
fourth, and fifth lowest priced. The rational for "The Foolish Four" strategy is back-tested
results showing the strategy to have yielded 25.5% annually over a twenty year period7.

Another variant of the Dogs of the Dow strategy is the Small Dogs strategy (Sometimes
referred to as the Puppies of the Dow or the Flying Five). This strategy involves selecting
the five Dogs with the lowest stock price and investing an equal dollar amount in each of
these 5 high yielding, low priced stocks. Then hold these five "Small Dogs of the Dow"
for one year. Investing in the Puppies of the Dow would have resulted in a 20.9% average
annual return since 1973! Exhibit 11-4 lists the ten highest yielding Dow stocks as of the
most recent Friday close. Note that the table contains small dogs as well:

Exhibit 11-4: The Dow stocks ranked by yield on 3/23/07

Company $ Price Yield Small Dog

on 3/23/07 on 3/23/07

Pfizer 25.66 4.52% Yes

Verizon 38.12 4.25% Yes
Citigroup 51.72 4.18% No
Altria 85.47 4.02% No
AT&T 38.88 3.65% Yes
Merck 44.45 3.42% No
General Electric 35.82 3.13% Yes
General Motors 31.99 3.13% Yes
DuPont 51.03 2.90% No
J P Morgan Chase 48.52 2.80% No

It is important to understand that the Foolish Four and Dow 10 strategies ignore volatility
and benefits of diversification. In other words, these strategies are more volatile and
riskier than investing in an index like DJIA. The issue of whether the Dow 10 indeed
does better than the Dow 30 after accounting for risk, taxes, transaction costs etc was

7
Gardner, David and Tom Gardner, The Motley Fool Investment Guide: How the fools beat Wall Street’s
Wise men and how you can too, Simon & Schuster, 1996

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addressed by one academic study8. This study finds that the Dow-10 did in fact produce
significant excess returns over the 50 year period. The average annual return (arithmetic
mean) for the Dow-10 was 16.77% versus 13.71% for the Dow-30. Higher risk as
measured by standard deviation (19.10% versus 16.64%) accompanied the higher returns.
The authors point out that transactions costs and risk explain most of the Dow-10 excess
return, and they believe that most if not all of the remaining excess return would have
gone to the IRS. The authors also looked at sub periods and found that during some
extended periods the strategy outperformed, but during other long stretches (decades) the
authors suggest that economically, an investor would have been better off (after adjusting
for risk, transactions costs, and taxes) in the Dow-30.

As with all valuation ratios, dividend yield must be used with caution. Stocks with very
high dividend yields might seem like bargains, but these companies are often going
through financial problems that have caused their stock price to plunge. It is not unusual
for companies in such situations to cut their dividend in order to save cash, so their actual
dividend yield going forward might be lower than the currently reported figure. Lastly,
one major drawback of dividend yield is that it is useless for companies that do not pay a
dividend--a group that includes many technology stocks.

Formal statistical tests of the ability of dividend yields to forecast future returns have
been conducted by Fama and French (1988) and Campbell and Shiller (1988). These
studies find that as much as 40% of the variance of future returns for the stock market as
a whole can be predicted on the basis of the initial dividend yield on the index.

This phenomenon does not work consistently with individual stocks. That is, investors
who purchase a portfolio of individual stocks with high dividend yields in the market will
not earn a particularly high return.

What do analysts do?

Given the fact that analysts have the choice of choosing from a wide menu of ratios and
measures what do they actually do? Academic surveys suggest that a large fraction of
analysts concentrate on earnings and book value multiples. The same studies suggest that
EVA and DCF are less popular. The result of one study is presented in Exhibit 11-5.

Concluding Comments

Although analysts around the world continue to use multiples for the purpose of valuation
it must be noted that multiples have restricted use in the sense that one cannot naively
compare them across firms, industry groups and time. Indeed finding a relevant peer
group itself can be a daunting task. A better way to apply them is to estimate a regression
equation as demonstrated in this chapter. Further, the multiples approach is sometimes
used to estimate a subject company’s equity value rather than its enterprise value. In such
cases the multiples computed from comparable companies are derived from stock prices
or market capitalization rather than enterprise values (which include the value of debt).
8
McQueen, Grant, Kay Shields and Steven Thorley, “Does the 'Dow-10 Investment Strategy' Beat the Dow
Statistically and Economically?", Financial Analysts Journal, July/August 1997

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Multiples are also commonly used to estimate terminal values as pointed out in the last
chapter.

Exhibit 11-5: Equity Valuation Analysis: What do analysts Use?

Earnings Multiple 99%

P-E 97%
Relative P-E 35%
Revenue Multiple 15%
Price-to-Book 25%
Cash flow multiple 13%
DCF 13%
EVA 2%
Other 4%

Analysts also use industry specific multiples like price per square feet or new store
openings or proven reserves of oil/gas, number of pipeline customers etc

In general, the following may be kept in mind while using multiples:

 Asset multiple (market-to-book ratio) generates more precise and less biased
estimates than do the sales and earnings multiple.
 The EBITDA multiple generally yields better estimates than does the EBIT
multiple
 The accuracy and bias of value estimates vary greatly by company size, company
profitability, and the value of intangibles.

Price may be estimated as a multiple of any of the following:

 Sales
 EBITDA
 EBIT
 Net Income
 Book Value (retained earnings)

This is essentially a simplified income statement. As you move down from Sales to book
value, accounting choices and distortions become more relevant due to income and cost
recognition, depreciation rules, interest expense etc. While sales are the least affected,
book value is the most affected (due to accounting distortions). But as you move down,
you incorporate the effects of greater capital and operating efficiency. So the trade off is
between incorporating accounting distortions and recognizing operating efficiency. That
is, as you move down you are closer to cash flow, the driver of value. In choosing a
multiple, find the one that has the lowest variance across all stocks.

The P/E multiple captures risk (via the cost of equity), industry effect and growth because
P/E = 1/k-g according to the Gordon Model.

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Size, an important determinant of the P/E multiple, seems to be left out of the equation.
The cost of equity can be estimated either using the CAPM or the Fama-French three
factor model, which captures the size and Book/Market effect in addition to the
systematic risk. In other words, using the Fama-French model to estimate the cost of
equity enables us to capture size as well.

End of the chapter exercises

1. Which of the following would you consider the best indicator of an undervalued
firm?

A. A firm with a lower P/E ratio than its peer group, and a lower expected
growth rate.
B. A firm with a lower P/E ratio than its peer group and a higher expected
growth rate, and higher risk.
C. A firm with a lower P/E ratio than its peer group, and lower expected
growth rate, and lower risk.
D. A firm with a lower P/E ratio than its peer group, a higher expected
growth rate, and lower risk

2. Refer to the data given below for a valuation target and three comparable companies:

Company Name Valuation Company Company Company

Target
Long Term Forecast EPS Growth Rate 8.0% 8.2% 7.0% 4.0%
5-year Growth in sales 15.0% 14.9% 12.0% 8.0%
Revenues 496 430 11,420 582
Net Income 52 42 1,037 56
EBIT 126 111 1,921 128
Book Value Equity 263 270 5,704 410
Book Value Debt 440 467 3,261 422
Non-debt Liabilities 46 44 980 64
Market Capitalization 764 17,007 896
Market Value Firm 1,231 20,268 1,318
EBIT Margin 25% 26% 17% 22%
Net Margin 10% 10% 9% 10%
Asset Turnover 66% 55% 115% 65%
Leverage 285% 289% 174% 219%
Return on Equity 19.8% 15.6% 18.2% 13.7%

Estimate the Price/Earnings, Market Value of firm/EBIT, Equity Price/Book and Firm
Price/Book multiples for the comparable companies and the target. Assume equal weight
for these multiples.

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 3. What are the limitations of P/E, M/B and P/S multiples?
4. How is intrinsic P/E multiple derived?
5. Explain the rationale for using PEG ratio as an investment metric.
6. Explain how yield based measures are used in investing.
7. What is the “dogs of the dow” strategy?

References

1. Asquith, Paul, Michael B. Mikhail and Andrea S. Au. "Information Content of

Equity Analyst Reports," Journal of Financial Economics, 2005, v 75 (2, Feb),
245-282.
2. Block, Stanley, “A study of financial analysts: Practice and Theory”, Financial
Analysts Journal, July-August 1999
3. Campbell, John and Robert Shiller, “Stock Prices, Earnings and Expected
Dividends”, Journal of Finance, 43:3, 1988
4. ----------------------------------------------, “Valuation Ratios and the long-run stock
market outlook”, Journal of Portfolio Management, Winter 1988
5. Demirakos, Efthimios, Norman C. Strong and Martin Walker, “What Valuation
Models Do Analysts Use?”, Accounting Horizons, December 2004
6. Fama, Eugene and Kenneth French, “Permanent and Temporary components of
stock prices”, Journal of Political Economy, 96:2, 1988
7. Fluck, Zsuzsanna, B Malkiel and Richard Quandt, “The predictability of stock
returns: A cross sectional simulation”, Review of economics and Statistics, 79:2,
1997
8. Lie, Erik, and Heidi, Lie, “Multiples Used to estimate corporate value”, Financial
Analysts Journal, March/April 2002
9. Neill, John, and Pfeiffer, Glenn, “The Effect of Potentially Dilutive Securities on
P/Es”, Financial Analysts Journal, July-August, 1999

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