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Learning Objectives
Understand why investors prefer to use relative
valuation measures to value stocks
Quick estimation
P0 D / EPS0 D0 / EPS0 (1 g ) (1 b) (1 g )
1
EPS0 kg kg kg
P0 (1 b)
EPS1 kg
P/E Ratio and Growth Opportunities
We can think of the value of a firm as the sum of the value of assets
already in place or no-growth value of the firm and the present
value of future investments that the firm will make (PVGO)
E
0
1
P P
VG
O
k
The above equation can be rearranged as:
P
1PV
G
O
0
1
1
EkE/
k
1
When PVGO=0, P0 =E1/k and P/E ratio =1/k (e.g. in the case of
preference shares
P0 (1 b)
E1 k ( ROE b)
Book values are close to market values for companies having high
amounts of liquid assets such as finance, investment, insurance and
banking companies.
Book value has been used in valuation of companies that are not
expected to continue as a going concern.
P/B ratio and Fundamentals
The justified P/B is an increasing function of ROE, all else equal.
E1 (1 b)
P0
kg
B ROE (1 b)
0
kg
B ROE (1 g / ROE )
0
kg
P0 ROE g
B0 kg
It does not include assets other than those recognized in the financial
statement. For example, human capital is more important in service
companies.
The fact that Sales x Net profit margin = Net income means
that (P/E) x (Net Profit Margin) = (P/S).
For two stocks with the same positive P/E, the stock with the
higher P/S has a higher (actual or forecasted) net profit
margin, calculated as the ratio of P/S to P/E.
Example
Company A Company B
Sales (Rs. Million) 800 1000
Profit Margin 15% 12%
Profit (Rs.Million) 120 120
Number of Shares (Million) 10 10
EPS (Rs.) 12 12
Market Price per share 120 120
(Rs.)
P/E Ratio 10 10
P/S Ratio 1.5 1.2
PS Ratio/PE Ratio 0.15 0.12
Price-to-Cash flow Ratio
Analysts have offered the following rationales for using Price to
cash flow:
Using price to cash flow rather than P/E addresses the issue of
differences in quality of earnings between companies.
EBITDA Multiples
Another cash flow concept used in multiples is EBITDA. In
practice, both EV/EBITDA and P/EBITDA have been used by
analysts as valuation metrics.
The denominator can be an equity measure (EPS, net income, book value of
equity) or a firm measure (operating income, EBITDA, or book value of
capital).