1. Valuation Multiples
We now move on to determining the valuation multiples.
2. Price-to-Earnings Ratio
Arguably the most common valuation multiple that you see in the financial press is the price-to-earnings or P/E ratio. The P/E ratio is the ratio of the market price of the firm divided by earnings per share or EPS. This tells us how much investors are willing to pay for each dollar of the firm's earnings.
The EPS measure can be historical, which is typically based on the last twelve months' EPS. Historical EPS can be found by looking at the firm's income statement.
The denominator can also be forecasted EPS, such as next twelve months or next fiscal year. Forecasted EPS are usually based on analyst forecasts.
P/E Ratios are not meaningful if the subject firm has negative earnings. It doesn't make sense to say that investors are paying $x for each dollar the firm loses.
There is no fixed rule as to whether historical or forecasted EPS is better. The only thing that you have to be careful of is that you are consistent. By that I mean if you are going to use Price to LTM EPS for the comparable firms, you have to apply LTM EPS to imply the price for the subject firm. You should not mix and match types of EPS.
3. Price-to-Book Ratio
Another common metric is the price-to-book ratio. The price-to-book ratio is the ratio of the market price of the firm divided by the book value of equity per share. This tells us how much investors are willing to pay for each dollar of the firm's book value of equity.
The Book Value can be historical, such as the book value as of the last fiscal quarter. Book value of equity can be found on the firm's balance sheet.
Some analysts also forecast book values. In those cases, you can use those forecasts to create the P/B ratio.
Like EPS, BVPS can sometimes be negative that result in non-meaningful P/B ratios. We have to make sure we do not include those observations.
4. Implying the Price
It is typical to use a set of comparable companies instead of a single comparable firm. This is because when the average or median multiple is calculated, the individual differences between firms are "averaged out".
This average or median valuation multiple is then applied to the subject firm's metric.
5. Implying the Price
The resulting price that is generated is an "Implied Price" and may not even be close to the fundamental value of the stock. Why is that? Because it is dependent on the valuation of the comparable companies. If the comparable companies are overvalued, for example, then the implied price will also be overvalued.
6. Example Using P/B Ratio
In this example, you are asked to value a $5 billion financial firm with a BVPS of $30. You have decided that the members of the S&P 400 Midcap Index in the financial sector are the appropriate comparables. Midcap stocks generally have a market capitalization between $2 to $10 billion. We can then use the subset() command in R to subset firms in the GICS Financials sector.
We then calculate the P/B Ratio by dividing the firm's price by its book value per share. However, we need to make sure that observations with negative or missing BVPS would return an "NA". This way, we can use the complete dot cases() argument to delete these nonmeaningful observations.
Then, we take the Average P/B Ratio of the comps, which is 2.7x.
Assuming a $30 book value per share, our subject firm has an implied price of $81.
7. Let's practice!
You will now practice what you've learned in this video.