Valuation of a Convertible Bond in an ...
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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:
The benchmark multiple may be:
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 likely be 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 (j) Evaluate a stock by the method of comparables and explain the importance of fundamentals in using the method of comparables.