We’re using cookies, but you can turn them off in Privacy Settings.  Otherwise, you are agreeing to our use of cookies.  Accepting cookies does not mean that we are collecting personal data. Learn more in our Privacy Policy.

2024 Curriculum CFA Program Level II Equity Investments

Introduction

Among the most familiar and widely used valuation tools are price and enterprise value multiples. Price multiples are ratios of a stock’s market price to some measure of fundamental value per share. Enterprise value multiples, by contrast, relate the total market value of all sources of a company’s capital to a measure of fundamental value for the entire company.

The intuition behind price multiples is that investors evaluate the price of a share of stock—judge whether it is fairly valued, overvalued, or undervalued—by considering what a share buys in terms of per share earnings, net assets, cash flow, or some other measure of value (stated on a per share basis). The intuition behind enterprise value multiples is similar; investors evaluate the market value of an entire enterprise relative to the amount of earnings before interest, taxes, depreciation, and amortization (EBITDA), sales, or operating cash flow it generates. As valuation indicators (measures or indicators of value), multiples have the appealing qualities of simplicity in use and ease in communication. A multiple summarizes in a single number the relationship between the market value of a company’s stock (or of its total capital) and some fundamental quantity, such as earnings, sales, or book value (owners’ equity based on accounting values).

Among the questions we will study for answers that will help in making correct use of multiples as valuation tools are the following:

  • What accounting issues affect particular price and enterprise value multiples, and how can analysts address them?

  • How do price multiples relate to fundamentals, such as earnings growth rates, and how can analysts use this information when making valuation comparisons among stocks?

  • For which types of valuation problems is a particular price or enterprise value multiple appropriate or inappropriate?

  • What challenges arise in applying price and enterprise value multiples internationally?

Multiples may be viewed as valuation indicators relating to individual securities. Another type of valuation indicator used in security selection is momentum indicators. They typically relate either price or a fundamental (such as earnings) to the time series of its own past values or, in some cases, to its expected value. The logic behind the use of momentum indicators is that such indicators may provide information on future patterns of returns over some time horizon. Because the purpose of momentum indicators is to identify potentially rewarding investment opportunities, they can be viewed as a class of valuation indicators with a focus that is different from and complementary to the focus of price and enterprise value multiples.

We first put the use of price and enterprise value multiples in an economic context and present certain themes common to the use of any price or enterprise value multiple. We then present price multiples. The treatment of each multiple follows a common format: usage considerations, the relationship of the multiple to investors’ expectations about fundamentals, and using the multiple in valuation based on comparables. The subsequent sections present enterprise value multiples, international considerations in using multiples, and treatment of momentum indicators. We then discuss several practical issues that arise in using valuation indicators.

Learning Outcomes

The member should be able to:

  1. distinguish between the method of comparables and the method based on forecasted fundamentals as approaches to using price multiples in valuation and explain economic rationales for each approach;

  2. calculate and interpret a justified price multiple;

  3. describe rationales for and possible drawbacks to using alternative price multiples and dividend yield in valuation;

  4. calculate and interpret alternative price multiples and dividend yield;

  5. calculate and interpret underlying earnings, explain methods of normalizing earnings per share (EPS), and calculate normalized EPS;

  6. explain and justify the use of earnings yield (E/P);

  7. describe fundamental factors that influence alternative price multiples and dividend yield;

  8. calculate and interpret the justified price-to-earnings ratio (P/E), price-to-book ratio (P/B), and price-to-sales ratio (P/S) for a stock, based on forecasted fundamentals;

  9. calculate and interpret a predicted P/E, given a cross-sectional regression on fundamentals, and explain limitations to the cross-sectional regression methodology;

  10. evaluate a stock by the method of comparables and explain the importance of fundamentals in using the method of comparables;

  11. calculate and interpret the P/E-to-growth (PEG) ratio and explain its use in relative valuation;

  12. calculate and explain the use of price multiples in determining terminal value in a multistage discounted cash flow (DCF) model;

  13. explain alternative definitions of cash flow used in price and enterprise value (EV) multiples and describe limitations of each definition;

  14. calculate and interpret EV multiples and evaluate the use of EV/EBITDA;

  15. explain sources of differences in cross-border valuation comparisons;

  16. describe momentum indicators and their use in valuation;

  17. explain the use of the arithmetic mean, the harmonic mean, the weighted harmonic mean, and the median to describe the central tendency of a group of multiples; and

  18. evaluate whether a stock is overvalued, fairly valued, or undervalued based on comparisons of multiples.

Summary

We have defined and explained the most important valuation indicators in professional use and illustrated their application to a variety of valuation problems.

  • Price multiples are ratios of a stock’s price to some measure of value per share.

  • Price multiples are most frequently applied to valuation in the method of comparables. This method involves using a price multiple to evaluate whether an asset is relatively undervalued, fairly valued, or overvalued in relation to a benchmark value of the multiple.

  • The benchmark value of the multiple may be the multiple of a similar company or the median or average value of the multiple for a peer group of companies, an industry, an economic sector, an equity index, or the company’s own median or average past values of the multiple.

  • The economic rationale for the method of comparables is the law of one price.

  • Price multiples may also be applied to valuation in the method based on forecasted fundamentals. Discounted cash flow (DCF) models provide the basis and rationale for this method. Fundamentals also interest analysts who use the method of comparables because differences between a price multiple and its benchmark value may be explained by differences in fundamentals.

  • The key idea behind the use of price-to-earnings ratios (P/Es) is that earning power is a chief driver of investment value and earnings per share (EPS) is probably the primary focus of security analysts’ attention. The EPS figure, however, is frequently subject to distortion, often volatile, and sometimes negative.

  • The two alternative definitions of P/E are trailing P/E, based on the most recent four quarters of EPS, and forward P/E, based on next year’s expected earnings.

  • Analysts address the problem of cyclicality by normalizing EPS—that is, calculating the level of EPS that the business could achieve currently under mid-cyclical conditions (normalized EPS).

  • Two methods to normalize EPS are the method of historical average EPS (calculated over the most recent full cycle) and the method of average return on equity (EPS = average ROE multiplied by current book value per share).

  • Earnings yield (E/P) is the reciprocal of the P/E. When stocks have zero or negative EPS, a ranking by earnings yield is meaningful whereas a ranking by P/E is not.

  • Historical trailing P/Es should be calculated with EPS lagged a sufficient amount of time to avoid look-ahead bias. The same principle applies to other multiples calculated on a trailing basis.

  • The fundamental drivers of P/E are the expected earnings growth rate and the required rate of return. The justified P/E based on fundamentals bears a positive relationship to the first factor and an inverse relationship to the second factor.

  • The PEG (P/E-to-growth) ratio is a tool to incorporate the impact of earnings growth on P/E. The PEG ratio is calculated as the ratio of the P/E to the consensus growth forecast. Stocks with low PEG ratios are, all else equal, more attractive than stocks with high PEG ratios.

  • We can estimate terminal value in multistage DCF models by using price multiples based on comparables. The expression for terminal value, Vn , is (using P/E as the example)

    Vn = Benchmark value of trailing P/E × En

    or

    Vn = Benchmark value of forward P/E × En +1.

  • Book value per share is intended to represent, on a per-share basis, the investment that common shareholders have in the company. Inflation, technological change, and accounting distortions, however, may impair the use of book value for this purpose.

  • Book value is calculated as common shareholders’ equity divided by the number of shares outstanding. Analysts adjust book value to accurately reflect the value of the shareholders’ investment and to make P/B (the price-to-book ratio) more useful for comparing different stocks.

  • The fundamental drivers of P/B are ROE and the required rate of return. The justified P/B based on fundamentals bears a positive relationship to the first factor and an inverse relationship to the second factor.

  • An important rationale for using the price-to-sales ratio (P/S) is that sales, as the top line in an income statement, are generally less subject to distortion or manipulation than other fundamentals, such as EPS or book value. Sales are also more stable than earnings and are never negative.

  • P/S fails to take into account differences in cost structure between businesses, may not properly reflect the situation of companies losing money, and may be subject to manipulation through revenue recognition practices.

  • The fundamental drivers of P/S are profit margin, growth rate, and the required rate of return. The justified P/S based on fundamentals bears a positive relationship to the first two factors and an inverse relationship to the third factor.

  • Enterprise value (EV) is total company value (the market value of debt, common equity, and preferred equity) minus the value of cash and investments.

  • The ratio of EV to total sales is conceptually preferable to P/S because EV/S facilitates comparisons among companies with varying capital structures.

  • A key idea behind the use of price to cash flow is that cash flow is less subject to manipulation than are earnings. Price-to-cash-flow multiples are often more stable than P/Es. Some common approximations to cash flow from operations have limitations, however, because they ignore items that may be subject to manipulation.

  • The major cash flow (and related) concepts used in multiples are earnings plus noncash charges (CF), cash flow from operations (CFO), free cash flow to equity (FCFE), and earnings before interest, taxes, depreciation, and amortization (EBITDA).

  • In calculating price to cash flow, the earnings-plus-noncash-charges concept is traditionally used, although FCFE has the strongest link to financial theory.

  • CF and EBITDA are not strictly cash flow numbers because they do not account for noncash revenue and net changes in working capital.

  • The fundamental drivers of price to cash flow, however defined, are the expected growth rate of future cash flow and the required rate of return. The justified price to cash flow based on fundamentals bears a positive relationship to the first factor and an inverse relationship to the second.

  • EV/EBITDA is preferred to P/EBITDA because EBITDA, as a pre-interest number, is a flow to all providers of capital.

  • EV/EBITDA may be more appropriate than P/E for comparing companies with different amounts of financial leverage (debt).

  • EV/EBITDA is frequently used in the valuation of capital-intensive businesses.

  • The fundamental drivers of EV/EBITDA are the expected growth rate in free cash flow to the firm, profitability, and the weighted average cost of capital. The justified EV/EBITDA based on fundamentals bears a positive relationship to the first two factors and an inverse relationship to the third.

  • Dividend yield has been used as a valuation indicator because it is a component of total return and is less risky than capital appreciation.

  • Trailing dividend yield is calculated as four times the most recent quarterly per-share dividend divided by the current market price.

  • The fundamental drivers of dividend yield are the expected growth rate in dividends and the required rate of return.

  • Comparing companies across borders frequently involves dealing with differences in accounting standards, cultural differences, economic differences, and resulting differences in risk and growth opportunities.

  • Momentum indicators relate either price or a fundamental to the time series of the price’s or fundamental’s own past values (in some cases, to their expected values).

  • Momentum valuation indicators include earnings surprise, standardized unexpected earnings (SUE), and relative strength.

  • Unexpected earnings (or earnings surprise) equals the difference between reported earnings and expected earnings.

  • SUE is unexpected earnings divided by the standard deviation in past unexpected earnings.

  • Relative-strength indicators allow comparison of a stock’s performance during a period either with its own past performance (first type) or with the performance of some group of stocks (second type). The rationale for using relative strength is the thesis that patterns of persistence or reversal in returns exist.

  • Screening is the application of a set of criteria to reduce an investment universe to a smaller set of investments and is a part of many stock selection disciplines. In general, limitations of such screens include the lack of control in vendor-provided data of the calculation of important inputs and the absence of qualitative factors.