Introductory Corporate Finance: Valuation - Relative Valuation, Price-Earnings Ratio Price-Book Value Price-Sales PEG Ratio EV/EBITDA

What This Is

Relative valuation is a method of estimating a company's intrinsic value by comparing its stock price to its fundamental metrics, such as earnings, book value, sales, and enterprise value. This approach is essential in corporate finance as it helps investors and analysts determine whether a company's stock is overvalued, undervalued, or fairly valued. For instance, consider Tesla (TSLA) with a stock price of $1,000 and earnings per share (EPS) of $20. Using the price-to-earnings (P/E) ratio, we can calculate the relative valuation as follows: P/E = $1,000 / $20 = 50. This means Tesla's stock price is 50 times its earnings per share.

Key Formulas & Models

• P/E Ratio = Market Price per Share / Earnings per Share – measures the stock price relative to its earnings.
  • Market Price per Share: the current stock price
  • Earnings per Share: the company's net income divided by the number of outstanding shares
• P/B Ratio = Market Price per Share / Book Value per Share – compares the stock price to its book value.
  • Book Value per Share: the company's total equity divided by the number of outstanding shares
• P/S Ratio = Market Price per Share / Sales per Share – measures the stock price relative to its sales.
  • Sales per Share: the company's total sales divided by the number of outstanding shares
• PEG Ratio = P/E Ratio / Growth Rate – adjusts the P/E ratio for the company's growth rate.
  • Growth Rate: the company's expected earnings growth rate
• EV/EBITDA = Enterprise Value / Earnings Before Interest, Taxes, Depreciation, and Amortization – measures the company's enterprise value relative to its EBITDA.
  • Enterprise Value: the company's market capitalization plus debt minus cash
  • EBITDA: the company's earnings before interest, taxes, depreciation, and amortization
• EV/EBIT = Enterprise Value / Earnings Before Interest and Taxes – measures the company's enterprise value relative to its EBIT.
  • EBIT: the company's earnings before interest and taxes
• EV/Sales = Enterprise Value / Sales – measures the company's enterprise value relative to its sales.
• EV/FCF = Enterprise Value / Free Cash Flow – measures the company's enterprise value relative to its free cash flow.
  • Free Cash Flow: the company's operating cash flow minus capital expenditures

Step-by-Step Calculation

1. Calculate the P/E ratio by dividing the market price per share by the earnings per share.
2. Calculate the P/B ratio by dividing the market price per share by the book value per share.
3. Calculate the P/S ratio by dividing the market price per share by the sales per share.
4. Calculate the PEG ratio by dividing the P/E ratio by the growth rate.
5. Calculate the EV/EBITDA ratio by dividing the enterprise value by the EBITDA.
6. Calculate the EV/EBIT ratio by dividing the enterprise value by the EBIT.
7. Calculate the EV/Sales ratio by dividing the enterprise value by the sales.
8. Calculate the EV/FCF ratio by dividing the enterprise value by the free cash flow.

Common Mistakes

1. Mistake: Using the book value instead of the market value for the P/B ratio.
   • Correction: Use the market value to reflect the company's current stock price.
   • Counterexample: If a company has a book value of $100 and a market value of $200, using the book value would result in a P/B ratio of 1, while using the market value would result in a P/B ratio of 2.
2. Mistake: Ignoring flotation costs when calculating the WACC.
   • Correction: Include flotation costs in the WACC calculation to reflect the true cost of capital.
   • Counterexample: If a company has a WACC of 10% without flotation costs, but the actual WACC with flotation costs is 12%, ignoring flotation costs would result in an incorrect valuation.
3. Mistake: Confusing sunk cost with opportunity cost.
   • Correction: Use opportunity cost to reflect the true cost of a decision.
   • Counterexample: If a company has invested $100 in a project, but the opportunity cost is $150, using sunk cost would result in an incorrect valuation.

Exam / CFA Tips

1. Tip: Be careful when using the PEG ratio, as it can be sensitive to the growth rate estimate.
2. Tip: When using the EV/EBITDA ratio, make sure to adjust for any non-operating items, such as interest and taxes.
3. Tip: When using the EV/FCF ratio, make sure to adjust for any non-cash items, such as depreciation and amortization.

Quick Practice Problem

A company has EBIT of $10M, interest of $2M, and tax of 25%. Calculate the DFL (debt-free leverage).

Answer: DFL = (EBIT - Interest) / (EBIT - Interest + Tax) = ($10M - $2M) / ($10M - $2M + $2.5M) = 0.67

Explanation: The DFL measures the company's debt-free leverage, which is the ratio of EBIT to EBIT plus tax.

Last-Minute Cram Sheet

1. P/E Ratio = Market Price per Share / Earnings per Share
2. P/B Ratio = Market Price per Share / Book Value per Share
3. P/S Ratio = Market Price per Share / Sales per Share
4. PEG Ratio = P/E Ratio / Growth Rate
5. EV/EBITDA = Enterprise Value / EBITDA
6. EV/EBIT = Enterprise Value / EBIT
7. EV/Sales = Enterprise Value / Sales
8. EV/FCF = Enterprise Value / Free Cash Flow
9. DFL = (EBIT - Interest) / (EBIT - Interest + Tax)
10. In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield