The material here is fairly straight forward and easy points if you focus on the concepts and a few key formulas. The section is large enough and within an important topic area (Equity) that you can count on getting a few questions on the exam.
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Be sure you know the advantages and disadvantages of each market multiple method as well as the general concepts behind the measures. We’ll cover these in today’s post.
You must understand the Gordon Growth Model and be able to move things around to find different variables. Finally, Free-cash-flow-to-equity (FCFE) and Enterprise Value are fairly important formulas, of which we’ll cover on Friday.
Advantages and Disadvantages of Market Multiples
- Relative value is relevant when picking stocks despite general market mood – despite the general trend in the market, there will still be over- and under-valued assets which can be found using relative valuation measures.
- Easy to compute and understand – These measures (P/E, P/B, E/P) are some of the most widely used metrics. The math is easy to compute and the concept is intuitive. There is a risk that these measures are overly simplistic though.
- May be difficult to compare companies across multiples without significant adjustments – Companies in different sectors and industries may vary greatly in their fundamentals, i.e. debt burden, payout ratio, growth and margin characteristics. This makes it inappropriate to compare many companies directly without some kind of adjustment.
- Biggest disadvantage is multiples build in systematic errors- Even if one stock is extremely under-valued compared to another, if the general market or the sector is in an over-valued state then the asset may not truly be a good investment.
Comparables versus Forecasted Fundamentals
The material covers two forms of market-based valuation, comparables and forecasted fundamentals.
- Comparables are relative value measures where a benchmark value is created through analysis or averaging usually the sector or industry average. This is then used to compare equities within that sector to determine relative over- or under-valuation.
- Comparables provide an objective guide for valuation but provide no information on
- Forecasted fundamentals use financial statement data (payout ratio, ROE, earnings, etc.) to find either a present value or future forecast of the asset price, most often cited in the curriculum is discounted cash flows (DCF). This tries to explain the ‘why’ in valuation.
Price to Earnings (P/E)
Price-Earnings is most often quoted on ‘trailing’ earnings or those over the last 12 months but can also be quoted on ‘leading’ earnings, those over the next 12 months, or a combination. Trailing earnings are more widely used and not subjective to forecasting errors but leading earnings should be used if the analyst expects a regime change in earnings.
Advantages/Disadvantages of P/E
- Simple and widely understood
- Intuitive since investment value is derived from corporate earnings
- Negative earnings will cause an error
- Earnings can be volatile or transitory, making the measurement inconsistent
- The biggest disadvantage is management’s incentive to manipulate earnings
Analysts may want to ‘normalize’ earnings by taking the average over an entire business cycle. This helps to reduce the short-term effects of business cycle changes on different industries. The curriculum discusses two ways to do this, the historical method and ROE method. Historical, is just the simple average of earnings over the cycle. The ROE method involves averaging the firm’s ROE over the cycle then multiplying by the current book value per share.
One important piece of vocabulary that often confuses candidates is the ‘justified’ P/E. This is simply the P/E based on forecasted fundamentals as follows:
The earnings yield is just the inverse of the P/E (Earnings divided by Price, E/P). The measurement will yield the same meaning as P/E but is useful when earnings are negative.
Price to Book Value (P/B)
Analysts are generally skeptical of income statement metrics because of the ease and incentive for manipulating earnings. Price to Book uses the Gordon Growth Model and incorporates book value in the following formula:
- intangible assets- patents should be included but goodwill not
- assets usually carried at historical and should be marked to fair value
- adjustments for off balance sheet items
- LIFO vs FIFO adjustments and depreciation
- Book value is more stable than earnings
- Book value more appropriate for highly liquid companies (insurance, banking)
- May be inappropriate to compare book values across industries because of differences in fundamentals
Price to Sales (P/S)
The final relative price multiple is price-to-sales, using net sales divided by number of shares. The main advantage here is that sales, or revenue, is less easily manipulated than earnings and always positive though revenue recognition practices can still distort the outcome.
The main disadvantage is that P/S is often used to justify valuation based on expectations of future earnings profitability even when current earnings are negative.
This happened in the years leading up to the dot-com bust. Analysts used P/S and inflated sales projections to value equities that would never live up to the high expectations and eventually crumbled as investors saw that the companies would not eventually be profitable.
Remember, this is just a quick review of the core concepts and formulas for the material. You need to actively study the study guide and question bank software to make sure you get this stuff down. Again, fairly straight forward material but no less important because it has a good chance of showing up on the exam.
Joseph Hogue, CFA