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Welcome back.
We've just a few more models to learn so hang in there.
The end of this course is near.
In this lesson we shall learn the price multiple model and there are two approaches to this price multiples
based on fundamentals and price multiples based on comparables.
We shall go through both.
Let's begin when using the price multiple approach an analyst first selects and computes a ratio that
has the stock price as the numerator and a firm fundamental as the denominator common price multiples
used for valuation include price to earnings ratio the company stock price divided by its earnings per
share.
This ratio is widely used by analysts and often cited in the press the price to sales ratio the stock
price divided by the sales per share the price to book value ratio the stock price divided by book value
of equity per share and the price to cash flow ratio the stock price divided by cash flow per share
the cash flow may be defined as operating cash flow or free cash flow.
The reason why some analysts prefer the price multiple approach is that price multiples are readily
available in numerous media outlets besides price multiples are easily calculated and can be used in
time series and cross-sectional comparisons.
Many of these ratios have been shown to be useful for predicting stock returns where stocks with low
multiples tend to produce higher future returns.
However one common criticism is that price multiples reflect only the past because trailing data are
often used in the denominator for this reason.
Some analysts use forward values which are based on projections of the company's finances for the following
year.
Analysts should ensure consistency when making comparisons across firms.
For example a forward P E is used for comparison.
The P E for all the firms should be based on forward data.
There are two approaches to using price multiples for valuation based on comparables and based on fundamentals
when we compare a price multiple of a firm to those of other firms or to the firm's own historical multiples.
We're using price multiples based on comparables.
In contrast when we compare a price multiple to what it should be based on sound valuation model we're
using price multiples based on fundamentals let's start with multiples based on fundamentals to understand
fundamental price multiples.
Consider the golden growth valuation model.
If we divide both sides of the equation by next year's projected earnings.
E 1 we get this equation on the right side.
We have the forward dividend divided by forward earnings in the numerator This is the expected dividend
payout ratio for the next period as we've learnt from Gordon growth model.
R is the required rate of return on the stock and g is the expected constant growth rate of dividends
on the left side.
We have the current price of the stock divided by the forward earnings we call this the forward all
leading P E ratio for the stock.
This is because it's based on expected earnings next period not on actual earnings for the previous
period which would produce a lagging or trailing P E ratio of these p e that we calculate here is also
referred to as a justified P E it's justified because assuming we have the correct inputs for the right
hand side the P E ratio will be based on the present value of the future cash flows.
For example if ABC stock has an expected dividend payout ratio of 45 percent a required rate of return
of 12 percent and an expected dividend growth rate of 7 percent the firm's justified P E ratio will
be 9 times the justified P E ratio serves as a benchmark for the price at which the stock should trade.
If the firm's forward P E based on the stock's market price is higher than the justified P E the stock
would be considered overvalued.
Conversely if the P E ratio is lower the stock would be considered undervalued let us work on an example
Microsoft's stock price is currently sixty dollars and has just paid a dividend of two dollars Microsoft's
dividend is expected to have a constant growth of 3 percent indefinitely the trailing IBS of the stock
is five dollars and is expected to grow by 6 percent next year calculate Microsoft's justified P E ratio
and determine if the stock is currently overvalued or undervalued required return for the stock is six
point five percent if you're up to the challenge do pose the video and attempt to solve this and we're
back.
Let's first note down the data we're given current prices 60 dollars current dividend is two dollars
current earnings per share is 5 dollars required return a six point five percent and the constant growth
rate is 3 percent our first step is to estimate the following years dividend using the constant growth
rate of 3 percent we get 2 dollars and 6 cents next we estimate the forward earnings we're told it is
expected to grow by 6 percent the forward earnings is therefore 5 dollars and 30 cents the justified
P E can be calculated using this formula that we've just learned plug in the appropriate figures and
we get eleven point eleven times the market P E is the current stock price against the forward earnings.
Note that we should be using forward earnings here are not past earnings plug in the figures are we
get eleven point three two times since market's P E of Microsoft stock is slightly higher than it's
justified P E the stock is slightly overvalued one advantage of this approach is that it makes it clear
how the firm's P E ratio should be related to its fundamentals we can see from the formula that other
things equal the justified P E ratio will increase with a higher dividend payout ratio and other things
equal the justified P E ratio will increase with a higher growth rate so if the subject firm has a higher
dividend payout ratio lower required return and higher growth rate than its peers a higher P E ratio
may be justified in practice however other things are not equal.
Remember in the last lesson we learned that the sustainable growth rate of a company is its Aro e multiplied
by one minus the dividend payout ratio.
This means that when a firm increases its dividend payout ratio the growth rate of the dividends will
decrease as the firm has retained less cash to fund growth.
So while higher dividends will increase the firm's value a lower growth rate will decrease the firm's
value this relationship is referred to as the dividend displacement of earnings as such.
The net effect on firm value of increasing the dividend payout ratio is ambiguous intuitively it makes
sense that firms cannot continually increase their market values by increasing the dividend payout ratio.
Otherwise all firms would have 100 percent pay out ratios let us work on one more example you are tasked
to analyze Pincher Corp. a seafood wholesaler selected financial data of the company are summarized
together with the industry average make a recommendation on whether pinchers justified P E ratio should
be higher or lower than the industry average in this example we observe that Pincher has a similar dividend
payout ratio with the industry.
So this has no effect the return on equity is lower than that of the industry since the dividend payout
ratio of the firm is similar to the rest of the industry.
This suggests that the sustainable growth rate of the firm is lower and the total debt to equity ratio
of the firm is higher than industry average the higher level of debt suggests that its stock has higher
risk and therefore a higher required rate of return based on these last two factors.
The justified P E of Pincher stock should be lower than industry average.
Now let's move on to price multiples based on comparables under this approach.
The price multiples of the subject firm is compared against the benchmark to evaluate the relative valuation
of its stocks common benchmarks include the stocks historical average a time series comparison or stocks
of peer companies and industry averages which are cross-sectional comparisons.
The economic principle guiding this method is the law of one price which asserts that two identical
assets should sell at the same price in this case stocks of different companies are not identical but
they are comparable assets certainly should have approximately the same multiple so in order for the
comparisons to be meaningful the analyst should make sure that the comparables are really comparable.
And this can be a challenge.
Firms are often of different sizes some are in multiple industries or maybe at different stages of growth.
The analyst should consider similarities across a number of dimensions when selecting comparables.
The dimensions can be but not limited to company size product lines and growth rates.
Now that we are done with a theory let's learn this method by example the financial results of Microsoft
for the last year are summarized in the table below calculate the trailing P E P S and P P ratios of
the firm and comment on the relative valuation of the firm against the industry averages pause the video
now to work out your answers and where back the multiples should be relatively easy to calculate.
Remember to convert the denominator to per share values.
That is to divide by the number of shares outstanding check if you've got the calculations correct.
Next we compare the ratios against the industry average all three multiples are lower than the industry
average.
This cross-sectional study suggests that Microsoft shares are undervalued relative to the industry average
now.
Recall that in an earlier exercise we determined that Microsoft shares are slightly overvalued using
the fundamentals approach as they are compared to different benchmarks.
The conclusion can be different when using different methods the stock is undervalued when compared
to the industry but overvalued when compared to its fundamentals the analyst should make a judgment
on which approach is more appropriate for the company being studied comparing the two approaches using
comparables may be simpler for analysts who are familiar with the particular industry besides price
multiples of various listed companies are readily provided by many media outlets comparatively.
One can argue that the fundamental approach is simpler because there's no need to identify comparables
for the company.
However estimating the required return for the stock and the growth rate can be challenging.
And like the Gordon Growth method the outcome is very sensitive to these two inputs for the comparables
approach.
One disadvantage is that different accounting methods can result in price multiples that are not comparable
across firms especially internationally for both approaches.
One limitation is that price multiples for cyclical firms may be greatly affected by economic conditions
at a given point in time.
For example the P E ratios for cyclical firms are complicated due to their sensitivity to economic conditions
in this case the price to sales ratio may be more appropriate because the sales are less volatile than
earnings and that concludes this lesson on price multiple models.
We shall discuss enterprise value multiples next.
See you again.