1.RELATIVE VALUATIONS(Market based Valuations):
1.1 P/E Ratio:It is known as Price to Earning ratio,It is valued by dividing company's current market price by annual earning per share(EPS).It shows how much times the share is traded on its earnings.
Formula,
P/E ratio = Market price/Earning per share(EPS)
Advantages of P/E ratio's:
a)It is easy to compute/calculate becuase easily data of EPS and Market price is available.
b)It is widely and easily use by any Retail investor's to check the level of affordability of shares.
Disadvantage of P/E ratio:
a)If earnings of the company is negative then the P/E/ ratio produce is useless and can't show current picture of stock affordability.
b)It there is a volatility and trasitory position of earning makes the interpretation of P/E 's difficult of analyst.
c)If there is discretion in the management within the allowed accounting practices which can distort reported earning and thereby lessen the comparability of P/E's across firms.
There are two types of P/E ratio:
(1) Trailing P/E ratio:It is calculated by dividing company's current market price by trailing earning per share for the most recent four quarters.
Formula,
Trailing P/E = Current market price(CMP)/EPS over 4th quarter
(2) Leading P/E ratio:It is calculated by dividing company's market price by expected future earning (expected EPS) of the next years.It may not be relevent if the earning are sufficiently volatile,so the future years earning are not forcastable with any degree of accuracy.
Formula,
Leading P/E = Current market price(CMP)/Forcasted EPS of next year
1.2 P/B Ratio:It is also known as Price to Book ratio,It is a ratio of Firm's Current market price to it's Book value.It compare the firm's market price to its book value.It is calculated by dividing current closing price of the company with it's latest book value per share.
Formula,
P/B ratio = Current market price/(Total assets-Intangible assets and Liabilities)
Lower P/B ratio shows that stock is a under value,which shows there is some problems with the fundamentals of the company.It also shows the how much you are paying for a particular stock and how much you get after company go bankrupts.
Advantages of Using Price to Book(P/B) ratio:
a) Book value is cumulative amount that is usually positive even when firm reports loss and EPS is negative.so it hepls P/B to be positive.
b) Book value is more stable than EPS,so it may be moe useful than P/E when EPS is volatile.
c) Book value is an appropriate measure of net assets value for the firms,which are usually liquid assets like Finance,Insurance,Banking ,Investment ect.
Disadvantages of using P/B ratio:
a) P/B ratio does not refect the intangible assets such as human capital.
b) Sometimes P/B ratio may be mislead in case of firms which are outsouce some of the activities and have lower assets which have lower book value and hence have higher P/B ratio,example software firms.
c)Book value and market value are too different due to the Technological and inflation,which makes difficult to value accurate shareholders investments.
1.3 P/S Ratio:It is a ratio which compare price of the stock with the sales revenue of the firm.It is also known as valuation ratio.It is calculated by dividing total market capitalization of the company with it's total sales revenue.It is also calculated by dividing price per share by sales revenue per share.The P/S ratio of any firm is compare by the average P/S ratio of the industry.If P/S ratio is undervalue or below the industry average then the share/stock price of that firm is undervalued.Also,if it is above the average P/S ratio then it is overvalued.
Formula,
P/S ratio = Market value of equity/Total sales
P/S ratio = Market price per share/Sales per share
Advantages of using P/S ratio :
a) Sales revenue is always positive,so the P/S ratio is always positive and meaningful even firm is facing financial truble.This is not in the case of P/E or P/B which are may be negative.
b) Sales revenues are not easly manipulate as in the cases of EPS and Book value which are maniputated easly.
c) P/S ratio are not volatile as P/E multiples.This make P/S ratios more reliable in valuation analysis when earnings of the particular year very high or low relative to the long run average.
d) P/S ratio is used for valuations for start ups and cyclic industries,where records of earnings are not available and P/E ratio is mislead here.It is also used in investment management and partnership companies.
Disadvantages of using P/S ratio:
a) High growth in sales does not necessarly indicate high operating profits as measure by earning and cash flow ,Although high sales growth inflate the P/S ratio which is mislead.
b) P/S ratio include the cost part and does not include the cost part,so high cost part would lead mislead information for analyst.
Formula,
P/S ratio = Market value of equity/Total sales
P/S ratio = Market price per share/Sales per share
Advantages of using P/S ratio :
a) Sales revenue is always positive,so the P/S ratio is always positive and meaningful even firm is facing financial truble.This is not in the case of P/E or P/B which are may be negative.
b) Sales revenues are not easly manipulate as in the cases of EPS and Book value which are maniputated easly.
c) P/S ratio are not volatile as P/E multiples.This make P/S ratios more reliable in valuation analysis when earnings of the particular year very high or low relative to the long run average.
d) P/S ratio is used for valuations for start ups and cyclic industries,where records of earnings are not available and P/E ratio is mislead here.It is also used in investment management and partnership companies.
Disadvantages of using P/S ratio:
a) High growth in sales does not necessarly indicate high operating profits as measure by earning and cash flow ,Although high sales growth inflate the P/S ratio which is mislead.
b) P/S ratio include the cost part and does not include the cost part,so high cost part would lead mislead information for analyst.
1.4 EV/EBITDA:
It is known as Enterprise multiple,it is used to determine the value of the company .It is used for the firms want to search attractive takeover candidates for takeover there firms it is beacuse enterprise multiple consists of equity and debts both which shows clear picture of the firms.Debts part does not consists in P/E ratio.
Enterprise Multiple = Enterprise value/EBITDA
Whereas,Enterprise value = Market value of common stock+Market value of preferred equity+Market value of debts+Minority interest - Cash and Investments
Advantages of EV/EBITDA:
a) EV/EBITDA ratio is more useful than P/E ratio beacuse it compare firm with different degrees of financial leverage.
b) It is useful for the candidate who want to acquire any firm,Enterprise value is better than market capitalization of the firm beacuse it consists of debts parts also.Therefore low Enterprise multiple indicate good takeover deal.
c) EBITDA is useful in valuing capital intensive businesses with high level of depreciation and amortizations.
d) EBITDA is usually positive when EPS is not .
PEG Ratio:
It is a ratio derived by dividing P/E ratio of the any stock by the growth rate of it's earning for a specified time period.It shows the attractiveness of the stock,lower the PEG ratio indicate the undervalued of the stock and vise a versa.PEG ratio below one would shows the undervalue of the stock or it is cheap.
Formula,
PEG Ratio = PE ratio/Annualise EPS growth
Terminal Value Estimations(using price multiple)
1.Terminal value projected at the end of the investment horizone reflect the earning growth that the firm can sustain over the long run beyond that point in time.
There are two method of calculating Terminal value:
1.1 Based on fundamental approach:
Terminal value in year n = (justified leading P/E ratio)*(forecasted earning in year n+1)
Terminal value in year n = (justified trailing P/E ratio)*(forecasted earning in year n+1)
Fundamental approach requires estimate of growth rate,required rate of return and payout ratio.
1.2 Based on comparables approach:
Terminal value in year n = (benchmark leading P/E ratio)*(forecast earning in year n+1)
Terminal value in year n = (benchmark trailing P/E ratio)*(forecast earning in year n+1)
Comparable approach uses market data exclusively.
Economic Value Added(EVA):
it is a measure of company's internal financial performance,calculated by subtracting weight avarage cost of capital(WACC) from it's operating profits after tax(NOPAT).
Formula,
EVA = Net operating profit after tax(NOPAT) - Weighted avarage coast of capital(WACC)
It is known as Enterprise multiple,it is used to determine the value of the company .It is used for the firms want to search attractive takeover candidates for takeover there firms it is beacuse enterprise multiple consists of equity and debts both which shows clear picture of the firms.Debts part does not consists in P/E ratio.
Enterprise Multiple = Enterprise value/EBITDA
Whereas,Enterprise value = Market value of common stock+Market value of preferred equity+Market value of debts+Minority interest - Cash and Investments
Advantages of EV/EBITDA:
a) EV/EBITDA ratio is more useful than P/E ratio beacuse it compare firm with different degrees of financial leverage.
b) It is useful for the candidate who want to acquire any firm,Enterprise value is better than market capitalization of the firm beacuse it consists of debts parts also.Therefore low Enterprise multiple indicate good takeover deal.
c) EBITDA is useful in valuing capital intensive businesses with high level of depreciation and amortizations.
d) EBITDA is usually positive when EPS is not .
PEG Ratio:
It is a ratio derived by dividing P/E ratio of the any stock by the growth rate of it's earning for a specified time period.It shows the attractiveness of the stock,lower the PEG ratio indicate the undervalued of the stock and vise a versa.PEG ratio below one would shows the undervalue of the stock or it is cheap.
Formula,
PEG Ratio = PE ratio/Annualise EPS growth
Terminal Value Estimations(using price multiple)
1.Terminal value projected at the end of the investment horizone reflect the earning growth that the firm can sustain over the long run beyond that point in time.
There are two method of calculating Terminal value:
1.1 Based on fundamental approach:
Terminal value in year n = (justified leading P/E ratio)*(forecasted earning in year n+1)
Terminal value in year n = (justified trailing P/E ratio)*(forecasted earning in year n+1)
Fundamental approach requires estimate of growth rate,required rate of return and payout ratio.
1.2 Based on comparables approach:
Terminal value in year n = (benchmark leading P/E ratio)*(forecast earning in year n+1)
Terminal value in year n = (benchmark trailing P/E ratio)*(forecast earning in year n+1)
Comparable approach uses market data exclusively.
Economic Value Added(EVA):
it is a measure of company's internal financial performance,calculated by subtracting weight avarage cost of capital(WACC) from it's operating profits after tax(NOPAT).
Formula,
EVA = Net operating profit after tax(NOPAT) - Weighted avarage coast of capital(WACC)
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