Multiplier Models: Price Multiple Model | CFA Level I Equity Investments

In this lesson, we will explore the price multiple model, which includes two approaches: price multiples based on fundamentals and price multiples based on comparables.

Price Multiples and Common Ratios

Price multiples are calculated by dividing the stock price by a firm fundamental. Common price multiples include:

• Price-to-earnings ratio (P/E) – the company’s stock price divided by its earnings per share.
• Price-to-sales ratio (P/S) – the stock price divided by sales per share.
• Price-to-book value ratio (P/B) – the stock price divided by book value of equity per share.
• Price-to-cash flow ratio (P/CF) – the stock price divided by cash flow per share. Cash flow can be defined as operating cash flow or free cash flow.

Price multiples are widely used due to their easy calculation and use in time series and cross-sectional comparisons. However, a common criticism is that price multiples often reflect the past since trailing data is used in the denominator. To address this, some analysts use forward values based on the company’s projected finances for the following year.

There are 2 approaches to using price multiples for valuation – based on comparables, and based on fundamentals.

Price Multiples Based on Fundamentals

When using price multiples based on fundamentals, an analyst compares a price multiple to what it should be based on a valuation model, such as the Gordon growth valuation model. This results in a “justified” price multiple, which serves as a benchmark for the price at which the stock should trade.

Factors Affecting Justified P/E Ratio

Justified P/E ratio is influenced by the following factors:

• Higher dividend payout ratio – increases the justified P/E ratio.
• Lower required rate of return – increases the justified P/E ratio.
• Higher growth rate – increases the justified P/E ratio.

However, there is a relationship called the dividend displacement of earnings, which means that increasing the dividend payout ratio may also decrease the firm’s value due to a lower growth rate.

Price Multiples Based on Comparables

The price multiples based on comparable approach involves comparing the price multiples of a subject firm to a benchmark to evaluate the relative valuation of its stocks. Common benchmarks include the stock’s historical average (time series comparison) or stocks of peer companies and industry averages (cross-sectional comparisons).

The principle guiding this method is the law of one price, which states that two identical assets should sell at the same price. Stocks of different companies aren’t identical, but they’re comparable assets, so they should have approximately the same multiple.

To make meaningful comparisons, analysts should ensure that comparables are indeed comparable. Firms can differ in size, operate in multiple industries, or be at different stages of growth. Consider similarities across dimensions like company size, product lines, and growth rates when selecting comparables.

Using the fundamentals approach, we previously determined that Macrosoft’s shares are slightly overvalued. Different conclusions can arise when comparing different methods, as the stock is undervalued compared to the industry but overvalued compared to its fundamentals. The analyst should make a judgement on which approach is more appropriate for the company being studied.

Comparing Approaches: Comparables vs. Fundamentals

Using comparables may be simpler for analysts familiar with the specific industry, and price multiples for various listed companies are readily provided by many media outlets. In contrast, the fundamental approach may be simpler as there is no need to identify comparables. However, estimating the required return for the stock and the growth rate can be challenging, and like the Gordon Growth Method, the outcome is very sensitive to these inputs.

One disadvantage of the comparables approach is that different accounting methods can result in price multiples that aren’t comparable across firms, especially internationally.

For both approaches, price multiples for cyclical firms may be significantly affected by economic conditions at a given point in time. For example, the P/E ratios for cyclical firms can be complicated due to their sensitivity to economic conditions. In these cases, the price-to-sales ratio may be more appropriate because sales are less volatile than earnings.