Using Price Multiples to Value Equity

The use of price multipliers to earnings, book value, and sales have all shown to have significant predictive value in determining relative future returns, implying that price multiples can be an effective tool for valuation of companies. Calculation of the “justified value” (the value justified by fundamentals or a set of cash flow predictions) of certain multiples offer an alternative way of estimating intrinsic value.

Justified Price/Earnings Multiple

Assuming a constant rate of growth, the justified forward price-to-earnings ratio can be found using the following equation:

$$ \frac{P_0}{E_1}= \text{justified forward P/E}$$

$$ \frac{P_0}{E_1}=\frac{p}{r-g}$$

p = payout ratio

r = required rate of return

g = expected growth rate of dividends

The justified forward P/E is inversely related to the required rate of return and positively related to the growth rate. This relationship may sometimes not be true, however, because a higher payout ratio may imply a slower growth rate as a result of the company retaining a lower proportion of earnings for reinvestment. These estimates may be highly sensitive to small changes in assumptions so it may be useful to carry out a sensitivity analysis.

The Method of Comparables

The economic rationale underlying the method of comparables is the law of one price: identical assets should sell for the same price. If an appropriate benchmark multiplier representative of a peer group or industry can be set, an analyst can determine the current relative value of a given company.

However, it is not always easy to determine comparable companies or industries due to other business lines and differing company sizes. For instance, it would be relatively hard to find a comparable company to Apple – one that sells over 200 million smart phones per year and millions of computers and tablets throughout the world.

Question

All else equal, a decrease in which of the following will cause an increase in the justified forward P/E multiple?

A. Payout ratio

B. Required rate of return

C. Growth rate

Solution

The correct answer is B.

Due to the inverse relationship between the required rate of return and the justified P/E, a decrease in the required return will justify a higher forward P/E. This should make sense intuitively since investors are willing to pay a higher price for assets as they relax their return requirements.

Reading 41 LOS 41i:

Explain the rationale for using price multiples to value equity, how the price to earnings multiple relates to fundamentals, and the use of multiples based on comparables



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