A beggar to another beggar: I had a grand dinner at Taj yesterday. How? The other beggar asked.

First beggar: Some one gave me a Rs 100/- note yesterday. I went to Taj and ordered dinner worth Rs 1,000/-, And enjoyed the dinner. When the bill came, I said, I had no money. The Taj manager called the policeman, and handed me over to him. I gave the Rs 100/- note to the police fellow, and he set me free. A wonderful example of financial management indeed :)

Relative Valuations
Represent

valuations based on some comparable

variables. In the absence of audited data, such relative valuations often provide a thumb rule for valuations. Often due to role of intangibles in the valuation of the firm the traditional models of valuation like DDM, DCF model etc. do not work. Here the Relative valuations provide useful tips Care to be exercised in its application.

Relative valuation is pervasive

Most valuations on Wall Street are relative valuations. Almost 85% of equity research reports are based upon a multiple and comparables. More than 50% of all acquisition valuations are based upon multiples Rules of thumb based on multiples are not only common but are often the basis for final valuation judgments. While there are more discounted cashflow valuations in consulting and corporate finance, they are often relative valuations masquerading as discounted cash flow valuations. The objective in many discounted cashflow valuations is to back into a number that has been obtained by using a multiple. The terminal value in a significant number of discounted cashflow valuations is estimated using a multiple.

So, you believe only in intrinsic value? Here is why you should still care about relative value
Even if you are a true believer in discounted cashflow valuation, presenting your findings on a relative valuation basis will make it more likely that your findings/recommendations will reach a receptive audience. In some cases, relative valuation can help find weak spots in discounted cash flow valuations and fix them. The problem with multiples is not in their use but in their abuse. If we can find ways to frame multiples right, we should be able to use them better.

Standardizing Value
You can standardize either the equity value of an asset or the value of the asset itself, which goes in the numerator. You can standardize by dividing by the Earnings of the asset Price/Earnings Ratio (PE) and variants (PEG and Relative PE) Value/EBIT Value/EBITDA Value/Cash Flow Book value of the asset Price/Book Value(of Equity) (PBV) Value/ Book Value of Assets Value/Replacement Cost (Tobins Q) Revenues generated by the asset Price/Sales per Share (PS) Value/Sales Asset or Industry Specific Variable (Price/kwh, Price per ton of

The Four Steps to Understanding Multiples

Define the multiple Describe the multiple Analyze the multiple Apply the multiple

Definitional Tests
Is the multiple consistently defined? Proposition 1: Both the value (the numerator) and the standardizing variable ( the denominator) should be to the same claimholders in the firm. In other words, the value of equity should be divided by equity earnings or equity book value, and firm value should be divided by firm earnings or book value. Is the multiple uniformly estimated? The variables used in defining the multiple should be estimated uniformly across assets in the comparable firm list. If earnings-based multiples are used, the accounting rules to measure earnings should be applied consistently across assets. The same rule applies with book-value based multiples.

Relative Valuations
Price-Earning Ratio/Multiple ( P/E):Market price per share / EPS

Most widely used ratio reflecting customer confidence on the shares of the company.

Price Earnings Ratio: Definition

PE = Market Price per Share / Earnings per Share There are a number of variants on the basic PE ratio in use. They are based upon how the price and the earnings are defined. Price: is usually the current price is sometimes the average price for the year EPS: earnings per share in most recent financial year earnings per share in trailing 12 months (Trailing PE) forecasted earnings per share next year (Forward PE) forecasted earnings per share in future year NOTE: SENSITIVE NUMERATOR AND INSENSITIVE DENOMINATOR High future growth potential- high P/E Established cos. With stable profits- Low P/E P/E High in bullish market and Low in Bearish market

PE Ratio and Fundamentals

Proposition: Other things held equal, higher growth firms will have higher PE ratios than lower growth firms. Proposition: Other things held equal, higher risk firms will have lower PE ratios than lower risk firms Proposition: Other things held equal, firms with lower reinvestment needs will have higher PE ratios than firms with higher reinvestment rates.

Relative Valuations
P/E to Growth Ratio:Market Price / Growth rate of EPS Used in valuation of Technology companies to avoid astronomical P/E ratios. Suitable for growth oriented cos. Finds the reason for real growth in Price.

PEG as a Valuation Tool

Security-1- Let Price be-Rs. 30 and EPS- Rs.5 P/E ratio= 6. Security-2- Let Price be Rs. 40 and EPS- Rs.8 P/E ratio= 5. DECISION TO BUY=SECY-2 Suppose the Growth rate is Secy-1-30% and Secy-2- 15% PEG- Secy-1 = 6/30= 0.2 and Secy-2 =0.33 Lower the PEG better it is . SO SECY-1 IS BETTER IF PEG < 1- BETTER AND CHEAPER STOCK IF PEG > 1- STOCK COSTLY CARE: IBM-based on 5 yr.avg. growth rate-1.26 (Yahoo Finance) and 1 yr. growth rate-1.14(Nasdaq)

Relative Valuations
Relative P/E Ratio:P/E of firm / P/E of Market index* * P/E of market index can be calculated by dividing Market capitalisation of index companies by the total EPS of the index companies. To consider whether the stock is more valuable for the same earnings compared to the market.

Relative Valuations
Value /EBITDA := Market cap of the company +Market Value of debt / EBITDA Used extensively for valuation of technology stocks . The ratio compares the value of the company to earnings before reducing finance charges. Used to avoid valuation of companies showing losses.

Reasons for Increased Use of Value/EBITDA

1. The multiple can be computed even for firms that are reporting net
losses, since earnings before interest, taxes and depreciation are usually positive. 2. For firms in certain industries, such as cellular, which require a substantial investment in infrastructure and long gestation periods, this multiple seems to be more appropriate than the price/earnings ratio. 3. In leveraged buyouts, where the key factor is cash generated by the firm prior to all discretionary expenditures, the EBITDA is the measure of cash flows from operations that can be used to support debt payment at least in the short term.

Value/Earnings and Value/Cashflow Ratios

While Price earnings ratios look at the market value of equity relative to earnings to equity investors, Value earnings ratios look at the market value of the firm relative to operating earnings. Value to cash flow ratios modify the earnings number to make it a cash flow number. The form of value to cash flow ratios that has the closest parallels in DCF valuation is the value to Free Cash Flow to the Firm, which is defined as: Value/FCFF = (Market Value of Equity + Market Value of Debt-Cash) EBIT (1-t) - (Cap Ex - Deprecn) - Chg in WC Consistency Tests: If the numerator is net of cash (or if net debt is used, then the interest income from the cash should not be in denominator The interest expenses added back to get to EBIT should correspond to the debt in the numerator. If only long term debt is considered, only long term interest should be added back.

Relative Valuations
EV / EBITDA: Enterprise Value* / EBITDA

Used in takeovers/acquisitions

Value/EBITDA Multiple
The Classic Definition The No-Cash Version
Value Market Value of Equity + Market Value of Debt EBITDA Earnings before Interest,Taxes and Depreciation

Enterprise Value Market Value of Equity + Market Value of Debt - Cash EBITDA Earnings before Interest,Taxes and Depreciation

When cash and marketable securities are netted out of value, none of the income from the cash and securities should be reflected in the denominator.

Relative Valuations
Price/ Book Value:Market price of the share / Book value*

* Book value = Net worth / No. of shares outstanding Widely used for valuation of finance companies/ Banks etc. whose assets are Marked to Market.

Price-Book Value Ratio: Definition

The price/book value ratio is the ratio of the market value of equity to the book value of equity, i.e., the measure of shareholders equity in the balance sheet. Price/Book Value = Market Value of Equity Book Value of Equity Consistency Tests: If the market value of equity refers to the market value of equity of common stock outstanding, the book value of common equity should be used in the denominator. If there is more that one class of common stock outstanding, the market values of all classes (even the non-traded classes) needs to be factored in.

Relative Valuations
Price to Sales: Value of the company (marketcap)/ Sales
Widely used in FMCG and consumer durables manufacturing companies where sales /market share are more important than Earnings.

Price Sales Ratio: Definition

The price/sales ratio is the ratio of the market value of equity to the sales. Price/ Sales= Market Value of Equity Total Revenues

TOBINs Q
Q = market value of assets / estimated replacement cost Thus when Q is >1,there is incentive to invest and visa-versa. When Q is < 1, it is wiser to acquire assets through merger than purchase of new assets. Q is higher for firms with a strong competitive advantage/brand image.

In Practice
As a general rule of thumb, the following multiple for a sector Sector Multiple Used Cyclical Manufacturing PE, Relative PE High Tech, High Growth PEG High Growth/No Earnings P/S, V /Sales Heavy Infrastructure EV/EBITDA table provides a way of picking a Rationale Often with normalized earnings Big differences in growth across firms Assume future margins will be good Firms in sector have losses in early years and reported earnings can vary depending on depreciation method Generally no cap ex investments from equity earnings Book value often marked to market If leverage is similar across firms If leverage is different

REITs

P/CF

Financial Services

PBV

Retailing,FMCG,Pharma PS VS

Reviewing: The Four Steps to Understanding Multiples

Define the multiple Check for consistency Make sure that they are estimated uniformly Describe the multiple Multiples have skewed distributions: The averages are seldom good indicators of typical multiples Check for bias, if the multiple cannot be estimated Analyze the multiple Identify the companion variable that drives the multiple Examine the nature of the relationship Apply the multiple

Primer on Relative Valuation Methodology

Simple applications

Applying Market-Based (Relative Valuation) Methods

MVT = (MVC / IC) x IT
Where

MVC = Market value of the comparable company C IC = Measure of value for comparable company C IT = Measure of value for company T (MVC/IC) = Market value multiple for the comparable company

Market based valuation

T- Target company Ic Measure of Value(P/E) of comp.co.(10) It - Measure of value of Target co. say-8 C- Comparable company MVt = MVc(1000 lacs)/Ic * It 1000/10 * 8= Rs. 800 lacs.

Market-Based Methods: Same or Comparable Industry Method

Multiply targets earnings or revenues by market value to earnings or revenue ratios for the average firm in targets industry or a comparable industry. Primary advantage is the ease of use and availability of data. Disadvantages include presumption industry multiples are actually comparable and analysts projections are unbiased.

Valuation for cos. In same Industry

Target co. earnings- say Rs.1000 lacs Comparable co. ( MV/Earnings)20( Industry avg.) Market value of Target co. 1000 x 20 = Rs. 20000 lacs.

Asset-Based Methods: Tangible Book Value

Tangible book value (TBV) = (total assets goodwill) Targets estimated value = Targets TBV x [(industry average or comparable firm market value) / (industry or comparable firm TBV)]. Often used for valuing Financial services firms where tangible book value is primarily cash or liquid assets Distribution firms where current assets constitute a large percentage of total assets

Asset Based Method Tangible book value

Tangible Book Value of Target co. = Total assetsgoodwill say Rs. 1000- 200 =800 lacs. Avg. market value of comp. firm- Rs. 2000 lacs Avg. Tangible Book value of com. Firm-1200 lacs Market Value of Target co.= 800 *2000/1200 Rs. 1333 lacs.

Asset-Based Methods: Liquidation Method

Value assets as if sold in an orderly fashion (e.g., 9-12 months) and deduct value of liabilities and expenses associated with asset disposition. While varies with industry, Receivables often sold for 80-90% of book value Inventories might realize 80-90% of book book value depending on degree of obsolescence and condition Equipment values vary widely depending on age and condition and purpose (e.g., special purpose) Book value of land may understate market value Prepaid assets such as insurance can be liquidated with a portion of the premium recovered.

Replacement Cost Method

All target operating assets are assigned a value based on what it would cost to replace them. Each asset is treated as if no additional value is created by operating the assets as part of a going concern. Each assets value is summed to determine the aggregate value of the business. This approach is limited if the firm is highly profitable (suggesting a high going concern value) or if many of the firms assets are intangible.

Weighted Average Valuation Method

An analyst has estimated the value of a company using multiple valuation methodologies. The discounted cash flow value is $220 million, comparable transactions value is $234 million, the P/E-based value is $224 million and the liquidation value is $150 million. The analyst has greater confidence in certain methodologies than others. Estimate the weighted average value of the firm using all valuation methodologies and the weights or relative importance the analyst gives to each methodology.
Estimated Value ($M) 220-DCF Relative Weight .30 Weighted Avg. ($M) 66.0

234-comp.

.40

93.6

224-P/E

.20

44.8

150Liq.value

.10

15.0

1.00

219.4

Adjusting Firm Value

Generally, the value of the firms equity is the Enterprise Value less market value of firms long-term debt. However, value may be under or overstated if not adjusted for nonoperating assets or liabilities assumed by the acquirer.

Adjusting Firm Value Example

A target firm has the following characteristics: An estimated enterprise value of $104 million Long-term debt whose market value is $15 million $3 million in excess cash balances Estimated PV of currently unused licenses of $4 million Estimated PV of future litigation costs of $2.5 million 2 million common shares outstanding What is the value of the target firm per common share?

Adjusting Firm Value Example Contd.

Enterprise Value Plus: Non-Operating Assets Excess Cash Balances PV of Licenses $104

$3 $4

Less: Non-Operating Liabilities PV of Potential Litigation

Less: Long-Term Debt

$2.5 $15

Equals: Equity Value

Equity Value Per Share

$93.5
$46.75

Things to Remember
Alternatives to discounted cash flow analysis include the following: Market based methods Comparable companies Recent transactions Same or comparable industries Asset based methods Tangible book value Liquidation value Replacement cost method Weighted average method Firm value must be adjusted for both non-operating assets and liabilities.

Relative Valuations
The three choices: Since there can be only one final valuation
Use simple average of valuations obtained using various multiples. OR Use weighted average depending on the weights that fits properly OR Choose one of the multiples that best fits.

Relative Valuations
In conclusion None of the relative valuations are perfect. A view needs to be taken after calculating the relative valuations and comparing the same with Traditional Valuations like DDM, FCFF Model, FCFE Model etc. Non-financial factors needs careful examination Indirect benefits / drawbacks need to be also inputted before deciding valuation.

Relative Valuation

For after all, The True Value is what you perceive to be true !! The methodologies only help in beginning the negotiations

Financial Data of an FMCG Company:Current share price (P) $ 68.24

No. shares of common stock outstanding Growth rate (g)

641,387,165 13.50%

Earnings per share (EPS)

$ 4.68

Operating profit per share

Sales per share Book value per share (BVPS)

$ 8.37
$ 114.29 $ 25.82

Industry Benchmark ratio is given Find the following ratios for the co. and comment on relative valuation
To Find for the Co. Price to earnings (P/E) Price to next year expected earnings Price-earnings-growth (PEG) Price to operating profit (P/OP) Price to sales (P/S) Price to book value (P/BV) Industry Benchmark 18.54

16.87
1.87 10.95 0.91 3.23