###### Expectations Valuation Approach

One-step Binomial Tree Since a hedged portfolio returns the risk-free rate, it can... **Read More**

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:

- Select and calculate the price multiple.
- Select the benchmark and compute its price multiple.
- Estimate the value of the company’s stock using the benchmark multiple.
- 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!

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.

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.

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.

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 likelybe used as a benchmark multiple in a valuation based on multiples?

- The average past value of the P/Es for the stock.
- The P/E ratio for a representative equity index.
- A group of assets.
## Solution

The correct answer is C.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.*