Equity Valuations

Chapter 6 – Equity Multiples

We need to understand the distribution of the​​ multiples and the driving factor of the multiples.​​ Multiples have two inputs –​​ numerator and denominator, for equity multiples numerator is equity price of the stock and denominator can be earnings, book value of equities, revenue or free cash flow to equity

Equity value can be per share value or aggregate equity value which is also known as market capitalization. These two values can diverge for various reasons – in case there are different classes of shares, equity value per share can be different for different classes whereas the market capitalization is the sum product of number of all the classes of shares and their prices. The multiple value will be different for per share value and aggregate value. The other case of differing multiple value is when there are employee options or convertible debts or warrants. The potential dilution of these may results in increase in number of shares which would be incorporated in the multiple computation when we take per share value in the numerator​​ but it doesn’t affect the multiple using the market capitalization in numerator. The total market value of equity in a company with substantial management and other equity options outstanding should be the market capitalization plus the estimated or observed market value of equity options.

 

Numerator

Denominator

Price per share

Earnings per share

Aggregate market value of equity (Number of basic share outstanding * Price per share)

Net Income – Option expenses

Net Market Equity – Cash

Net Income – After Tax interest income from cash

Option augmented equity = Market value of equity + Value of management options

Net Income before option expenses

​​ ​​ 

Cash Flow in denominator – The denominator in the equity multiple can be cash flow as well, there are two options in cash flow first one is we can use cash flow obtained by adding depreciation and other non-cash charges back to net income. The other option is we can use free cash flow to equity (FCFE).

Book value of equity in denominator – Non acquisitive companies that grow through internal investments are not required to record the value of the growth potential as part of their assets or in shareholder’s equity, but the companies that grow through acquisitions put goodwill in their asset side and higher value of book equity in equity side. Thus this multiple, price per book value of equity results lower value for acquisitive companies giving them unfair advantage.

Revenue in denominator – This ratio is inconsistent since revenue belongs to the entire firm and not just to its equity investors. This multiple can be used in those sectors where there is little or no debt like technology sector.​​ 

Analysis of Equity Multiples​​ ​​ All of the equity multiples, other than the PEG ratio, increase as the payout ratio and the growth rate increase, and decrease with the riskiness of the firm.​​ The effect of changes in the expected growth rate on equity​​ multiples can also vary depending on the level of interest​​ rates. The intuition for this is straightforward. The value of​​ growth lies in the future, and as​​ interest rates rise, the value of​​ expected growth decreases. Consequently, surprises about​​ expected growth have a bigger impact when interest rates are​​ low than when they are high​​ The payout ratio can be replaced with the FCFE to net income ratio. There are two advantages to this substitution. The​​ first is that we get more realistic estimates of the multiples for​​ companies that are not paying out their FCFE as dividends.​​ The second is that that the FCFE/net income or potential​​ payout ratio is not constrained to be greater than zero. In other​​ words, if the FCFE is negative because the firm reinvests​​ more than its net income, the potential payout ratio can be​​ negative at least for the high-growth phase. A negative​​ potential payout ratio indicates that the firm will have to raise​​ new equity during its high-growth phase to fund its​​ reinvestment, and this expected dilution will push the P/E​​ ratio down today.

Fundamental Variables affecting the equity multiples

Multiple Used

Fundamental Determinants

P/E

Payout ratio, expected growth, equity risk

PEG

Payout ratio, expected growth, equity risk

Price/FCFE

Risk, expected growth

Price/BV of equity

Payout ratio, expected growth, equity risk, return on equity

Price/sales

Payout ratio, expected growth, equity risk, net margin

 

We compare the multiples of the firms in the same sector which is also called comparable firms,​​ we consider ways in which we can expand the number of​​ comparable firms by looking at an entire sector or even the​​ market. There are two advantages to this more expansive​​ analysis. The first is that the estimates may become more​​ precise as the number of comparable firms increases. The​​ second is that an expansive analysis allows us to pinpoint​​ when firms in a small subgroup are being under- or​​ overvalued relative to the rest of the sector or the market.​​ Since the differences across firms will increase when we​​ loosen the definition of comparable firms, we have to adjust​​ for these differences. The simplest way of doing this is with a​​ multiple regression, with the equity multiples as the​​ dependent variable and proxies for risk, growth, and payout​​ forming the independent variables.

Analysts and market strategists often compare the P/E ratio of​​ a market to its historical average to make judgments about​​ whether the market is undervalued or overvalued. Thus, a​​ market that is trading at a P/E ratio that is much higher than​​ its historical norm is often considered to be overvalued,​​ whereas one that is trading at a ratio lower is considered​​ undervalued.

While reversion to historic norms remains a very strong force​​ in financial markets, we should be cautious about drawing too​​ strong a conclusion from such comparisons. As the​​ fundamentals (interest rates, risk premiums, expected growth,​​ and payout) change over time, the P/E ratio will also change.

Other things remaining equal, for instance, we would expect​​ the following.

  • An increase in interest rates should result in a higher​​ cost of equity for the market and a lower P/E ratio.

  • A greater willingness to take risk on the part of​​ investors will result in a lower risk premium for​​ equity and a higher P/E ratio across all stocks.

  • An increase in expected growth in earnings across​​ firms will result in a higher P/E ratio for the market.

  • An increase in the return on equity at firms will result​​ in a higher payout ratio for any given growth rate and​​ a higher P/E ratio for all firms.

In other words, it is difficult to draw conclusions about P/E​​ ratios without looking at these fundamentals. A more​​ appropriate comparison is therefore not between P/E ratios​​ across time, but between the actual P/E ratio and the predicted​​ P/E ratio based on fundamentals existing at that time.

Chapter 5 – Relative Valuation (Prev Lesson)
(Next Lesson) Chapter 7 – Enterprise Multiples
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