# Valuation with Comparables

## Valuation based on Comparables

The P/E valuation method is used to estimate a company’s stock value by applying a benchmark multiple to the company’s actual or forecasted earnings. An equivalent approach is to compare a stock’s actual price multiple with a benchmark value of the multiple.

The steps for valuation based on comparables are as follows:

1. Select and calculate the price multiple.
2. Select the benchmark and compute its price multiple.
3. Estimate the value of the company’s stock using the benchmark multiple.
4. Investigate if the differences between the stock and benchmark multiples are explained by underlying determinants of the multiple. If not, the asset may be mispriced; check the fundamentals!

### Types of Benchmark Values

The benchmark multiple may be:

• The average or median P/E ratio for the company’s peer group of companies in an industry or an average of the past P/E ratios for the stock relative to the peer group.
• The average past value of the P/E for the stock.
• The P/E ratio for a representative equity index.

## The Value of a Stock

If the stock price is higher than the price based on the benchmark multiple, the stock is relatively overvalued. If the stock price is lower than the price based on the benchmark multiple, the stock is relatively undervalued.

### Example: Evaluating P/E Ratios with the Method of Comparables

Consider the following P/E information on two stocks

$$\small{\begin{array}{l|c|c|c|c}& \textbf{Trailing P/E} & \textbf{Leading P/E} & \textbf{5-year growth} & \textbf{Beta}\\ \hline\text{A} & 9 & 7 & 9\% & 1.1 \\ \hline\text{B} & 13 & 10 & 7\% & 1.2 \\ \hline\text{Peer median} & 12 & 11 & 9\% & 1.1\\ \end{array}}$$

Evaluate the value and P/E of each stock based on the method of comparables.

#### Solution

Stock A has a lower P/E than the peer median, even though it has a comparable growth rate and beta. It is undervalued relative to the benchmark.

Stock B has a higher P/E, despite lower expected growth and a higher beta. It is overvalued relative to the benchmark.

## Question

Which of the following can least likely be used as a benchmark multiple in a valuation based on multiples?

1. The average past value of the P/Es for the stock.
2. The P/E ratio for a representative equity index.
3. A group of assets.

### Solution

A group of assets by itself could not be used as a benchmark multiple. However, the mean or median of a group of assets could be used as a benchmark multiple.

A is incorrect. The average past value of the P/Es of the stock could be used as a benchmark multiple.

B is incorrect. The P/E ratio for a representative equity index could be used as a benchmark multiple.

Reading 25: Market-Based Valuation: Price and Enterprise Value Multiples

LOS 25 (r) Evaluate whether a stock is overvalued, fairly valued, or undervalued based on comparisons of multiples.

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

Subscribe to our newsletter and keep up with the latest and greatest tips for success

Daniel Glyn
2021-03-24
I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
michael walshe
2021-03-18
Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
Nyka Smith
2021-02-18
Every concept is very well explained by Nilay Arun. kudos to you man!