While the phrase “relative valuation” may not be common, investors use relative valuation models quite frequently. Price-earnings, price-book, price-to-cash flow, price-sales and dividend yield ratios are all examples of relative valuation. What most of them have in common is that they compare one thing with another, as in “price” in relation with “earnings” for example.
That’s in contrast with “absolute” valuations, which stand on their own. We have reviewed these absolute valuations in previous chapters of "Strategic Value Investing: Practical Techniques of Leading Value Investors." Authors Stephen Horan, Robert R. Johnson and Thomas Robinson explained how dividend growth discount models and free cash flow models lead to absolute valuations.
We also use the phrase “price multiples” when discussing relative valuation; for example, the price in price-earnings tells us how many multiples of earnings it will cost to buy a stock. In their conclusion to the chapter, the authors wrote, “Price multiples are both readily available and easy to apply in order to ascertain the relative value of stocks.”
Their goal in this chapter was to alert investors to the importance of knowing what is being combined with price. The authors added:
“We must take relative a step or two further. Relative value is different from the absolute valuation methods we discussed in the last few chapters. Relative valuation requires that you compare a relative value metric for one company to something else: the same metric for peer companies, the industry, or the market. As value investors, we are looking to buy companies that are selling at a lower multiple relative to other companies of similar quality and similar risk.”
What are the drivers of price multiples?
Broadly speaking, four issues drive the price-earnings multiple:
- Risk-free rate.
- Risk-free rate plus equity risk premium.
- Risk-free rate plus size premium.
- Risk-free rate plus specific premiums (for example, heavy leverage or lack of liquidity).
The first two drivers are common to all companies, while the third and fourth drivers are company-specific. The drivers listed above are for price-earnings ratios, while the following trio are drivers of all ratios:
- Risk, which is inversely related to the multiples.
- Growth, which is positively related to the multiples.
- Profitability, which is positively related to the multiples.
Next, we have specifics about the different ratios.
Price-earnings ratio
Not all price-earnings ratios are calculated the same way; for example:
- Historical price-earnings refers to the last full fiscal year’s earnings.
- Historical price-earnings is based on the last 12 months of earnings.
- Leading price-earnings refers to an estimate of earnings in the next fiscal year.
- Leading price-earnings refers to earnings that are forecast for the next four quarters.
- Value line price-earnings uses the last two historical quarters plus two upcoming quarters.
PEG ratio
This ratio begins with price-earnings, but is augmented with growth prospects to reflect the fact that higher growth implies a higher price-earnings multiple. To calculate PEG, divide the price-earnings ratio by the growth rate. The authors wrote, “The idea is that a lower PEG ratio means a lower P/E relative to expected growth and connotes greater value.”
They warn, though, “The PEG ratio assumes a linear (or a one-to-one) relationship between growth and P/E ratios, meaning it is OK to divide the two. In reality, the relationship is more complex—certainly nonlinear.”
Price-book ratio
This ratio is also popular among investors, particularly for situations in which the price-earnings ratio is impractical (negative earnings, for example). The authors said it had “tremendous flexibility” and, given the direct relationship between residual income and the price-book ratio, it would be a useful tool for analyzing financial companies.
Price-sales ratio
This ratio is available when a company has no earnings, cash flow or positive book value; sales is always positive. With that, the authors added it is frequently used and frequently misused. They went on to write, “The price-to-sales ratio is quite commonly applied in valuing service businesses, such as professional firms in the context of a potential merger or acquisition. In these circumstances, an acquirer often cares most about the revenue stream it is acquiring and not as much about the business models and expense levels of the target company (since after the acquisition it probably would apply its own business model).”
Referring to the misuse of this ratio, consider the many examples that emerged during the dot-com boom of the late 1990s, when new internet companies were being valued on practically everything but earnings and cash flows.
Price-to-cash flow ratio
Another very useful ratio, so long as the analyst does not use “crude approximations” (earnings per share plus depreciation). The authors recommended using operating cash flow from the cash flow statement:
And following up with this formula:
Dividend yield
This metric is the inverse of a price-to-dividend ratio. It is almost always used for a relative valuation when available (when the company pays a dividend). It is computed by dividing the annual dividend per share by the price per share:
According to the authors, investors looking for income should be careful about choosing companies with high dividend yields. First, the tax consequences may be unfavorable, at least compared with harvesting long-term capital gains. Second, high dividend companies are not retaining earnings to reinvest in the business; as a result, these stocks will achieve little if any growth in coming years. Third, watch out for companies that keep paying high dividends despite lower earnings and unfavorable prospects.
Enterprise value approach
This approach uses an enterprise value-Ebitda formula, which is:
The authors reported this might be used in a specific circumstance. They wrote, “Such an approach is very useful in acquisition situations when the acquirer may significantly change the capital structure for the acquired firm, such as in a leveraged buyout.”
Conclusion
In their conclusion to the chapter, the authors wrote about price multiples, such as those above, saying, “They are especially useful in screening large databases of stocks to identify potential value opportunities. However, as noted at the beginning of this chapter, you are ascertaining value relative to peer companies or the market and would be wise to combine a relative valuation approach with an absolute approach.”
Put another way, relative valuations such as price-earnings, price-book and the dividend yield ratio are handy tools for investors trying to narrow the universe of all stocks or other securities. But once you have a shortlist and start analyzing individual stocks, match them with an absolute valuation model such as the dividend growth model or the free cash flow model.
Read more here:
- Strategic Value Investing: Residual Income Models
- Strategic Value Investing: Deep-Value StocksÂ
- Strategic Value Investing: Replacement ValueÂ
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