The relative valuation model values assets based on market prices of similar assets. It is widely used in practice due to its ease of use, though it can also be misused. Comparable assets are found based on risk, growth, and cash flow potential. Market prices are standardized using common variables like firm size or industry to generate comparable prices. Adjustments are made for accounting and fundamental differences. Common equity multiples include P/E ratios based on net income or EPS. Value multiples use enterprise value in the numerator and metrics like EBITDA or book value of capital in the denominator. Examples show calculating equity value using industry average P/E ratios and forecasted financials.

1. Relative Valuation
RT

2. Relative valuation model
• Relative valuation model
– Asset valued based on market pricing of similar
assets
• Most widely adopted valuation model in
practice
– Easy to use, but also easy to misuse!
– Most investment thumb rules based on multiples
– Less time and resource intensive
– Reflects current market sentiments

3. Contd...
• Relative valuation technique
– Find comparable assets that are priced by market
• Comparable in terms of risk, growth and cash flow potential
• Common proxies ~ firm size, life cycle, sector / industry
– Scale market prices to a common variable to generate
standardized prices that are comparable
• Equity values for equity multiples
• Firm values for value multiples
– Adjust for differences across assets
• Accounting differences; differences in fundamentals

4. Standardized Values and Multiples
• Earnings multiples
– Price-earnings (current P/E, trailing P/E, forward
P/E)
• Book value or replacement value multiples
– Price-to-book ratio, Tobin’s Q
• Revenue multiples
– Price-to-Sales ratio
• Sector specific multiples
– Price-to-hits ratio, Price-to-subscriptions ratio

5. Issues in Multiples Based Valuation
• Consistency in using multiples for valuation
– If numerator is equity value, denominator should
also be equity value
• Numerator ~ Share price or market value of equity
• Denominator ~ EPS, net income, book value of equity
– If numerator is firm value, denominator should
also be firm value
• Numerator ~ Enterprise value or firm value
• Denominator ~ EBIT, EBITDA, book value of capital

6. Contd...
• Differences in accounting standards
– May affect earnings and book value numbers
differently even for similar firms
• Differences in depreciation, expense or revenue recognition
• Effect of outliers
– Positively skewed distributions ~ mean > median
• Biases in multiples estimation
– Negative P/E ratios not meaningful, hence ignored
– Upward bias in average P/E ratio due to elimination

7. Scaling Variables for Equity Multiples
• Equity earnings variables
– Net Income, Earnings Per Share
• Equity cash flow measures
– Dividends, Free Cash Flow to Equity
• Equity book value measures
– Book value of equity
• Revenue measures
– Sales

8. Common Equity Multiples
• Price-Earnings Ratio (P/E)
– P/E = Market value of equity / Net income
– P/E = Share price / Earnings per share
– Current P/E, trailing P/E, forward P/E
– Skewed distribution of P/E ratios
• Negative P/E ratios not meaningful, hence ignored
• PEG Ratio
– PEG Ratio = P/E ratio / Expected earnings growth rate
– Helps portfolio manager to identify undervalued
stocks

9. Contd...
• Price-to-Book Ratio
– P/B ratio = Market value of equity / BV of equity
– Affected by accounting conventions
• Price-to-Sales Ratio
– Price-to-Sales ratio = Market value of equity /
revenues
– Widely used, although inconsistent
– Revenues almost always positive, easily available
• Price-to-Cash Flow Ratio
• Price/FCFE = Market value of equity / FCFE

10. Example 1
• XYZ company’s current net income is $25m.
Comparable firms in the same industry are
trading at an average current P/E ratio of 15x.
The company currently has 2,50,000 shares
outstanding. Calculate value of equity.

11. Answer
• Value of equity
P/E = Price / EPS
P/E = Equity value / Net Income
=> 15 = Equity value / 25000000
=> Equity value = 15 x 25000000 = 375000000
=> Equity value per share = 375000000 /250000
= $1500/share

12. Example 2
• XYZ company’s current net income is $25m.
Comparable firms in the same industry are
trading at an average trailing P/E ratio of 12x.
The company currently has 2,50,000 shares
outstanding. Calculate value of equity.

13. Answer
• Value of equity
P/E = Price / EPS
P/E = Equity value / Net Income
=> 12 = Equity value / 25000000
=> Equity value = 12 x 25000000 = 300000000
=> Equity value per share = 300000000/250000
= $1200/share

14. Example 3
• XYZ company’s management has forecasted
the net income of the firm as $10m in the next
financial year. Comparable firms in the same
industry are trading at an average P/E ratio of
25x. The company currently has 2,50,000
shares outstanding. Calculate valuation of
equity.

15. Answer
• Value of equity
P/E = Price / EPS
P/E = Equity value / Net Income
=> 25 = Equity value / 10
=> Equity value = 25 x 10000000 = 250000000
=> Equity value per share = 250000000/250000
= $1000/share

16. Common Value Multiples
• EV/EBITDA
– EV/EBITDA = Enterprise Value / EBITDA
• EV/EBIT
– EV/EBIT = Enterprise Value / EBIT
• EV/Book Value of Capital
– Enterprise Value / Book Value of Capital
• EV/Sales
– Enterprise Value / Sales

17. • EV = (Market Value of Equity + Market Value
of Debt) – Non-Operating Cash + Market value
of minority interests
• Approximation:-
• EV = (Market Value of Equity + Market Value
of Debt) – Non-Operating Cash

18. • Thank you