### 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

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.

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

Isha Shahid
2020-11-21
Literally the best youtube teacher out there. I prefer taking his lectures than my own course lecturer cause he explains with such clarity and simplicity.
Artur Stypułkowski
2020-11-06
Excellent quality, free materials. Great work!
2020-11-03
One of the best FRM material provider. Very helpful chapters explanations on youtube by professor James Forjan.
Rodolfo Blasser
2020-10-15
The content is masters degree-level, very well explained and for sure a valuable resource for every finance professional that aims to have a deep understanding of quantitative methods.
Mirah R
2020-10-15
Priyanka
2020-09-29
Analyst Prep has actually been my soul guide towards this journey of FRM.I really appreciate the videos ad they are ALIGNED , good speed, and the Professor just keeps everything Super CASUAL. If I Clear my exams Ultimately credit goes to you guys. Keep sharing. God bless.
Sar Dino
2020-09-29
Had a test on actuarial science coming up and was dead on all the concepts (had to start from ground zero). came across the channel as it had small bits of FM chapters consolidated by the professor Stephen paris. this made it easy for me to look at the chapters i was having trouble with (basically everything lol). I love the way he explains the questions, and the visualization! its so helpful for me to see the diagrams and how the formulas move around. he really did a great job explaining, and i understand so much better. 7 weeks worth of lessons condensed into 3 days of binge watching their videos.... Amazing and i am truly baffled as to why the videos have not gained traction as they should have!

Share:

#### Related Posts

##### Market Anomalies

Market anomalies are exceptions to the notion of market efficiency and may be present...

##### Issues in Index Construction

Index providers generally take a top-down approach to constructing a portfolio by defining:...