Share Price Multiple Methods in Equity Valuation

Introduction

  • 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:
  1. the method of comparables, and;
  2. 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.

Justified 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.

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