Share Price Multiple Methods in Equity Valuation
- Stock share price multiples often heavily factor into stock recommendations.
- Because of this key role that multiples play in equity analysis and investing, CFAI expects candidates to understand how a company's fundamentals and its accounting choices influence its share price multiples.
- Two share price multiple methods in equity valuation are:
- the method of comparables, and;
- the method of forecasted fundamentals.
Method of Comparables
In economic theory, the "law of one price" indicates that the stock of two identical companies should sell for the same price in an efficient market.
Method of Comparables: allows analysts to evaluate a stock's valuation against its industry peers, size peers, and the broader market.
A challenge when employing the method of comparables is that it can be difficult to find two companies that are perfectly comparable.
A stock's price-to-earnings (P/E) ratio, for example, must be assessed against appropriate benchmark P/E ratios, including:
The stock of the most comparable company;
Stocks in the company's business unit peer group;
Stocks in the company's broader industry peer group;
The broad market P/E ratio; and
The company's own historical P/E ratios.
Method of Forecasted Fundamentals
- Forecasted Fundamentals: this methodology forecasts the fundamentals that a company needs in order to generate required cash flows; the cash flows are then discounted.
- The forecasted fundamentals approach seeks to overcome the holes in relative view of the method of comparables by analyzing the relationship between a stock's price multiples and its core economic factors that drive the price multiples.
Either the comparables or forecasted fundamentals method can be used to determine a "justified" price multiple.
- Method of Comparables example: an analyst may look at a stock's P/E relative to its industry average P/E ratio to determine if the company is relatively cheap or expensive; there may be good reasons for a company to trade above or below the average P/E ratio.
- Method of Forecasted Fundamentals example: upon performing a discounted free cash flow valuation, an analyst can form an opinion about what a company's P/E ratio "should" be and then compare that to the P/E based on market price.
- Equity Analysis Part 3 - Introduction
- Free Cash Flow Valuation
- One, Two, and Three Stage FCF Calculations
- Share Price Multiple Methods in Equity Valuation
- Price to Earnings (P/E) Ratio (Leading P/E and Trailing P/E)
- Price to Book (P/B) Value Ratio and Equity Valuation
- Price to Sales (P/S) Ratio
- Price to Cash Flow Ratios
- Enterprise Value (EV) to EBITDA
- Dividend Yield for Valuing Equity
- Residual Income (RI) Valuation Model