Equity Valuation (Relative Valuation)

What is Relative Valuation

DCF valuation aims at arriving at intrinsic value based upon cash flow, growth rate and risk characteristics of the stock Relative valuation aims to value a stock based on how similar stocks are priced by the market Involves two components
Standardizing stock prices for comparison by converting them into multiples of a common variable Finding similar stocks

Why Relative Valuation

Less time consuming and less resource intensive than DCF valuation Easier for a sales pitch to the client Easier to defend Reflects current market mood better than DCF valuation

Demerits
Ease of method may result in inconsistent estimates Reflection of current market mood may result in too high values when sector is overvalued and too low values when sector is undervalued Assumptions not transparent; analyst biases can creep in

Equity multiples
Price-Earnings Ratio
Ratio of market price/ market capitalization to earnings

PEG ratio
Price-earnings ratio divided by expected growth rate in earnings per share

Price-to-Book Ratio
Ratio of market value of equity to book value of equity

Price-to-Sales Ratio
Ratio of market value of equity to revenues

Measuring the numerator

The numerator is the market value of equity Can be computed on a per-share basis or as an aggregate market value Will be different when
Stock has multiple classes all trading at different prices; will be captured by using market capitalization Divergence between number of shares outstanding today and potential number of outstanding shares; will be captured using diluted earnings/ book value per share

Cum-cash or ex-cash market value Market capitalization adjusted for stock options

Measuring the denominator

To ensure consistency of the ratio, denominator should be measured according to the numerator chosen
Measure of equity value Price per share Measure of equity earnings Earnings per share

Aggregate market capitalization of equity

Net market capitalization = Market value of equity less cash Option augmented equity= Market capitalization plus value of management stock options

Net income after option expensing

Net income less after-tax interest income from cash Net income before option expensing

Measuring the denominator

When Price-to-Book ratio is used
Measure of Equity value Price per share Aggregate market capitalization of equity Measure of Book equity Book value of equity per share Shareholders equity on balance sheet

Net market capitalization = Market value of equity less cash

Option augmented equity= Market capitalization plus value of management stock options

Book value of equity less cash

Book value of equity plus Book value of management stock options granted

Determinants of Equity Multiples

For a stable-growth firm

Where ke is cost of equity and gn is the expected stable growth rate

Using the 2-stage DDM

Example
A company had a net income of Rs.15 crore on sales of Rs.150 crore and equity of Rs.75 crore. It is expected to maintain its net margin, sales to book value ratio and ROE to perpetuity. Current dividend payout ratio was 10% and is expected to be maintained for the next 5 years. Expected growth in net income after fifth year is 4%. The companys equity beta is 1. Risk-free rate is 5% and market risk premium is 4%. Compute the equity multiples for this company.

Key variables to be considered

Expected growth rate in high-growth period
If this is ignored, low growth companies may appear cheap on the basis of P/E, P/BV and P/Sales

Length of growth period

If this is ignored, companies with short-lived competitive advantages may appear cheap

Risk of equity
If this is ignored, companies with high equity risk may appear cheaper

Key variables to be considered

Return on equity
If this is ignored, companies with low return on equity relative to cost of equity may appear cheaper

Net profit margin

If this is ignored, companies that adopt volume leader strategies (high volumes, low price) may appear cheaper