The ability to benefit from identifying on a mispriced equity depends on the market price converging to the estimated intrinsic value. If estimated value is greater than market price, then the equity is perceived to be overvalued. If estimated value is less than market price, then the equity is perceived to be undervalued. If estimated value equals market price, then the equity is perceived to be fairly valued.
Multiplier models or market multiple models include share price multiples or enterprise value multiples, which may be stated on a forward or trailing basis (as long as usage is consistent across companies being examined). The following are few key notes:
1. Enterprise Value (“EV”) is viewed as the cost if a takeover would occur. EV is widely used in Europe with EV/EBITDA. An alternative to EBITDA is using operating income. P/E can be problematic because of negative earnings, but using the EV/EBITDA multiple can generally be computed as EBITDA tends to be positive.
2. Price multiple refers to ratio that compares share price with some monetary flow or value to allow evaluation of the relative worth of a company’s stock. Common Price Multiples include: Price/Earnings (P/E), Price/Book (P/B), Price/Sales (P/S), and Price/Free or Operating Cash Flow (P/FCF or P/OCF).
3. The comparable method is the “most widely used” approach for reporting valuation judgments on the basis of price multiples. The economic rationale is the law of one price which states that identical assets should sell for the same price where similar companies should trade at the same multiple levels (i.e. P/E, P/B). For identifying a comparable company, it is important to identify companies that are most similar to a number of dimensions, which includes size, product lines, and growth rate.
4. Common criticism for multiples is that they do not consider the future. This is true if multiples are calculated from trialing or current values of the divisor. However, individuals attempt to forecast fundamental values, such as the Justified Forward P/E, for multiple years. This effectively may make the forward looking value differ from the trailing price multiples, referred as the justified value of a multiple, where the value is justified by a set of cash flow predictions.
5. Justified forward P/E estimates can be sensitive to small changes; analysts benefit from creating a sensitivity analysis.
6. Advantages: (i) Comparison between both cross-sectional and time-series data; (ii) Beneficial for analysts who are assigned to a particular industry and need to identify best performing stocks, (iii) Can be easily calculated and are readily available.
7. Limitations: (i) Stock may be undervalued in relative measures, but overvalued when compared with an intrinsic value by discounting cash flows; (ii) Differences in reporting rules can result in non-comparable earnings, revenues, and other line items; (iii) Multiples may result from cyclical companies that are highly influenced from economic conditions.
1. Justified forward P/E: Po/E1= (D1/E1)/r-g = P/r-g; where p is the dividend payout ratio of dividends to earnings.
2. Enterprise Value (EV) = Market Cap + Market value of preferred stock + Market value of debt – cash and investments.
3. Multiples Empirical Implications: P/E, shows higher return advantages with low P/E stocks; P/B, inversely related to future rate of returns; P/S, low multiple is most useful for predicting future returns
Asset-based valuation estimates intrinsic value of a common share from the estimated value of the assets of a corporation minus estimated value of liabilities and preferred shares. Market value of assets is determined by making adjustments to the book (carrying) value of assets and liabilities. Important facts to note is that we should realize, (i) companies with assets that do not have easily determinable market values are very difficult to analyze using asset valuation methods, (ii) Assets and Liabilities fair values can be very different from the values at which they carry on the BS, (iii) some assets are “intangible” and if a company has a significant amount of “intangibles”, we should prefer a forward-looking cash flow valuation, and (iv) asset values may be more difficult to estimate in a hyper-inflationary environment. Asset based valuation approach is most applicable when the market value of the corporate assets is readily determinable and the intangible assets are a small proportion to the sum of all assets. However, even for other types of companies, asset-based valuation of tangible assets may provide a baseline for minimal valuation.