EQUITY VALUATION METHODS

Unit – 2
Dr. Uma Chinchane
Fundamental Analysis :
• Fundamental analysis is a method of assessing the
intrinsic value of a stock. It combines financial
statements, external influences, events, and industry
trends.

• It is important to note that the intrinsic value or a fair

value of a stock does not change overnight. Such analysis
helps you identify key attributes of the company and
analyze its actual worth, taking into account macro and
microeconomic factors.
• Unlike technical analysis that concentrates on forecasting a security’s price movements,
fundamental analysis aims to determine the “correct price” (true value) of a security.

• By knowing the right price, an investor can make an informed investment decision. A security can
be overvalued, undervalued, or fairly valued.
Fundamental analysis uses three sets of data:
1. Historical data to check how things were in the past

2. Publicly known information about the company, including announcements made by the
management and what others say about the company

3. Information that is not known publicly but is useful, i.E., How the leadership handles crises,
situations, etc.
For a stock, fundamental analysis typically includes reviewing
many elements related to stock prices, including:

• Performance of the overall industry the company participates in

• Domestic political environment

• Relevant trade agreements and external politics

• The company’s financial statements

• The company’s press releases

• News releases related to the company and its business

• Competitor analysis
Sources for Fundamental Analysis:
• Fundamental analysis uses publicly available financial data to evaluate the value of an investment.
The data is recorded on financial statements such as quarterly and annual reports.

• IMPORTANT Most public—and many private—companies list annual reports on the investor
relation sections of their websites, highlighting financial decisions made and results achieved
throughout the year.
• For example, you might perform a fundamental analysis of a bond's value by looking at economic
factors such as interest rates and the overall state of the economy. Then, you'd evaluate the bond
market and use financial data from similar bond issuers.

• Finally, you'd analyze the financial data from the issuing company, including external factors such
as potential changes in its credit rating.

• Fundamental analysis uses a company's revenues, earnings, future growth, return on equity, profit
margins, and other data to determine a company's underlying value and potential for future
growth.
 Intrinsic Value:
• One of the primary assumptions behind fundamental analysis is that a stock's current price often
does not fully reflect the value of the company when compared to publicly available financial data.

• A second assumption is that the value reflected from the company's fundamental data is more
likely to be closer to the true value of the stock.

• Intrinsic value means something different in stock valuation than in options trading. Option pricing
uses a standard calculation for intrinsic value, while it can be calculated in many different ways for
a stock.
• For example, say that a company's stock was trading at $20, and after extensive research on the company, an analyst
determines that it ought to be worth $24. Another analyst does equal research but decides it should be worth $26.

• Many investors will consider the average of these estimates and assume that the stock's intrinsic value may be near
$25. Often investors consider these estimates highly relevant because they want to buy stocks trading at prices
significantly below these intrinsic values.

• This leads to a third major assumption of fundamental analysis: In the long run, the stock market will reflect the
fundamentals. The problem is, no one knows how long "the long run" really is. It could be days or years.
• This is what fundamental analysis is all about. By focusing on a particular business, an investor can
estimate the intrinsic value of a firm and find opportunities to buy at a discount or sell at a
premium. The investment will pay off when the market catches up to the fundamentals.

• Fundamental analysis is used most often for stocks, but it is useful for evaluating any security, from
a bond to a derivative. If you consider the fundamentals, from the broader economy to the
company details, you are doing a fundamental analysis.
Components of Fundamental Analysis:
• Fundamental analysis consists of three main parts:

1. Economic analysis

2. Industry analysis

3. Company analysis
Tools of FA:
• The tools required for fundamental analysis are fundamental, most of which are available for free. Specifically, you
would need the following:

1. The company’s annual report – All the information you need for FA is available in the annual report. You can
download the annual report from the company’s website for free

2. Industry-related data – You will need industry data to see how the company under consideration is performing
concerning the industry. Basic data is available for free and is usually published in the industry’s association website
3. Access to the news – Daily News helps you stay updated on the latest developments in the industry and
the company you are interested in. A good business newspaper or services such as Google Alert can help
you stay abreast of the latest news

4. MS Excel – Although not free, MS Excel can be extremely helpful in fundamental calculations.
• Fundamental analysis is an extremely comprehensive approach that requires a deep knowledge of accounting,
finance, and economics. For instance, fundamental analysis requires the ability to read financial statements, an
understanding of macroeconomic factors, and knowledge of valuation techniques. It primarily relies on public data,
such as a company’s historical earnings and profit margins, to project future growth.
Top-down Fundamental Analysis :
• Fundamental analysis can be either top-down or bottom-up. An investor who follows the top-down
approach starts the analysis with the consideration of the health of the overall economy.

• By analyzing various macroeconomic factors such as interest rates, inflation, and GDP levels, an
investor tries to determine the overall direction of the economy and identifies the industries and
sectors of the economy offering the best investment opportunities.
• Afterward, the investor assesses specific prospects and potential opportunities within the
identified industries and sectors. Finally, they analyze and select individual stocks within the most
promising industries.
 Bottom-up Fundamental Analysis :
• Fundamental analysis can be either top-down or bottom-up. An investor who follows the top-
down approach starts the analysis with the consideration of the health of the overall economy.

• By analyzing various macroeconomic factors such as interest rates, inflation, and GDP levels, an
investor tries to determine the overall direction of the economy and identifies the industries and
sectors of the economy offering the best investment opportunities.
• Afterward, the investor assesses specific prospects and potential opportunities within the
identified industries and sectors. Finally, they analyze and select individual stocks within the most
promising industries.
What Is Intrinsic Value?
• Intrinsic value is a measure of what an asset is worth. This measure is arrived at by means of an
objective calculation or complex financial model.

• Intrinsic value is different from the current market price of an asset. However, comparing it to
that current price can give investors an idea of whether the asset is undervalued or overvalued.
• Financial analysis uses cash flow to determine the intrinsic, or underlying, value of a company or
stock.

• In options pricing, intrinsic value is the difference between the strike price of the option and the
current market price of the underlying asset.
Understanding Intrinsic Value
• There is no universal standard for calculating the intrinsic value of a company or stock.

• Financial analysts attempt to determine an asset's intrinsic value by using fundamental and
technical analyses to gauge its actual financial performance.

• While they may build valuation models using qualitative, quantitative and perceptual business
factors, the metric often used in calculations for intrinsic value is discounted cash flows.
Background

• Benjamin Graham and Warrant Buffett are widely considered the forefathers of value investing,
which is based on the intrinsic valuation method.

• Graham’s book, The Intelligent Investor, laid the groundwork for Warren Buffett and the entire
school of thought on the topic.

• The term intrinsic means the essential nature of something. Synonyms include innate, inherent,
native, natural, deep-rooted, etc.

•
Intrinsic Value Formula
Where:

• NPV = Net Present Value

• FVj = Net cash flow for the j th period (for the initial “Present” cash flow, j = 0

• i = annual interest rate

• n = number of periods included

Risk Adjusting the Intrinsic Value
• The task of risk adjusting the cash flows is very subjective and a combination of both art and
science.

• There are two main methods:

• Discount rate – Using a discount rate that includes a risk premium in it to adequately discount the
cash flows

• Certainty factor – Using a factor on a scale of 0-100% certainty of the cash flows in the forecast
materializing (This approach is believed to be used by Warren Buffett. Learn more by reading
Buffett’s annual letters to shareholders)
 Discount Rate
• In the discount rate approach, a financial analyst will typically use a company’s weighted average
cost of capital (WACC).

• The formula for WACC includes the risk-free rate (usually a government bond yield) plus a
premium based on the volatility of the stock multiplied by an equity risk premium. Learn all about
the WACC formula here.

• The rationale behind this approach is that if a stock is more volatile, it’s a riskier investment.
Therefore, a higher discount rate is used, which has the effect of reducing the value of cash flow
that would be received further in the future (because of the greater uncertainty).
Certainty Factor
• A certainty factor, or probability, can be assigned to each individual cash flow or multiplied
against the entire net present value (NPV) of the business as a means of discounting the
investment.

• In this approach, only the risk-free rate is used as the discount rate since the cash flows are
already risk-adjusted.
• For example, the cash flow from a US Treasury note comes with a 100% certainty attached to it,
so the discount rate is equal to yield, say 2.5% in this example.

• Compare that to the cash flow from a very high-growth and high-risk technology company. A 50%
probability factor is assigned to the cash flow from the tech company and the same 2.5% discount
rate is used.

• At the end of the day, both methods are attempting to do the same thing – to discount an
investment basd on the level of risk inherent in it.
DISCOUNTED CASH FLOW METHOD:
• Discounted cash flow (DCF) is an analysis method used to value investment by discounting the
estimated future cash flows.

• DCF analysis can be applied to value a stock, company, project, and many other assets or
activities, and thus is widely used in both the investment industry and corporate finance
management.
Understanding DCF Analysis
• DCF analysis estimates the value of return that investment generates after adjusting for the time
value of money. It can be applied to any projects or investments that are expected to generate
future cash flows.

• The DCF is often compared with the initial investment. If the DCF is greater than the present cost,
the investment is profitable. The higher the DCF, the greater return the investment generates. If
the DCF is lower than the present cost, investors should rather hold the cash.
• The first step in conducting a DCF analysis is to estimate the future cash flows for a specific time
period, as well as the terminal value of the investment. The period of estimation can be your
investment horizon. A future cash flow might be negative if additional investment is required for
that period.
Calculation of Discounted Cash Flow (DCF)

The CFn value should include both the estimated cash flow of that period and the terminal
value. The formula is very similar to the calculation of net present value (NPV), which sums
up the present value of each future cash flow. The only difference is that the initial
investment is not deducted in DCF.
Analyzing the Components of the Formula
1. Cash Flow (CF) :
Cash Flow (CF) represents the net cash payments an investor receives in a given period for owning a
given security (bonds, shares, etc.).

• When building a financial model of a company, the CF is typically what’s known as unlevered free
cash flow. When valuing a bond, the CF would be interest and or principal payments
2. Discount Rate (r)
• For business valuation purposes, the discount rate is typically a firm’s Weighted Average Cost of
Capital (WACC).

• Investors use WACC because it represents the required rate of return that investors expect from
investing in the company.

• For a bond, the discount rate would be equal to the interest rate on the security.
3. Period Number (n)
• Each cash flow is associated with a time period. Common time periods are years, quarters, or
months. The time periods may be equal, or they may be different.

• If they’re different, they’re expressed as a percentage of a year.

• A company requires a $150,000 initial investment for a project that is expected to generate cash
inflows for the next five years. It will generate $10,000 in the first two years, $15,000 in the third
year, $25,000 in the fourth year, and $20,000 with a terminal value of $100,000 in the fifth year.

• Assuming the cost of capital is 5%, and no further investment is required during the term, the
DCF of the project can be calculated as below:
• Without considering the time value of money, this project will create a total cash return of
$180,000 after five years, higher than the initial investment, which seems to be profitable.

• However, after discounting the cash flow of each period, the present value of the return is only
$146,142, lower than the initial investment of $150,000. It suggests the company should not
invest in the project.
What is the DCF Formula Used For?

• The DCF formula is used to determine the value of a business or a

security.

• It represents the value an investor would be willing to pay for an

investment, given a required rate of return on their investment (the
discount rate).
Examples of Uses for the DCF Formula:
• To value an entire business

• To value a project or investment within a company

• To value a bond

• To value shares in a company

• To value an income-producing property

• To value the benefit of a cost-saving initiative at a company

• To value anything that produces (or has an impact on) cash flow
Advantages:
• One of the major advantages of DCF is that it can be applied to a wide
variety of companies, projects, and many other investments, as long as
their future cash flows can be estimated.

• Also, DCF tells the intrinsic value of an investment, which reflects the
necessary assumptions and characteristics of the investment. Thus, there is
no need to look for peers for comparison.

• Investors can also create different scenarios and adjust the estimated cash
flows for each scenario to analyze how their returns will change under
different conditions.
Disadvantages:
• The use of DCF comes with a few limitations. It is very sensitive to the
estimation of the cash flows, terminal value, and discount rate. A large
amount of assumptions needs to be made to forecast future performance.

• DCF analysis of a company is often based on the three-statement model. If

the future cash flows of a project cannot be reasonably estimated, its DCF
is less reliable.

• Innovative projects and growth companies are some examples where the
DCF approach might not apply. Instead, other valuation models can be
used, such as comparable analysis and precedent transactions.
Relative Valuation Technique
Unit – 2
Dr. Uma. Chinchane
Relative Valuation Model
• A relative valuation model is a business valuation method that compares a company's value to
that of its competitors or industry peers to assess the firm's financial worth.

• Relative valuation models are an alternative to absolute value models, which try to determine a
company's intrinsic worth based on its estimated future free cash flows discounted to
their present value, without any reference to another company or industry average.
Relative Valuation Model
Types of Relative Valuation Models
• There are two common types of relative valuation models:

1. Comparable Company Analysis And

2. Precedent Transactions Analysis.

Comparable Company Analysis
• Comparable company analysis (or “comps” for short) is a valuation methodology that looks at
ratios of similar public companies and uses them to derive the value of another business. Comps
is a relative form of valuation, unlike a discounted cash flow (DCF) analysis, which is an intrinsic
form of valuation.
Comparable Company Analysis
1. Find the right comparable companies
• This is the first and probably the hardest (or most subjective) step in performing a ratio analysis of
public companies. The very first thing an analyst should do is look up the company you are trying
to value on CapIQ or Bloomberg so you can get a detailed description and industry classification
of the business.

• The next step is to search either of those databases for companies that operate in the same
industry and that have similar characteristics. The closer the match, the better.
The analyst will run a screen based on criteria that
include:
1. Industry classification

2. Geography

3. Size (revenue, assets, employees)

4. Growth rate

5. Margins and profitability

2. Gather financial information
• Once you’ve found the list of companies that you feel are most relevant to the company you’re trying
to value it’s time to gather their financial information.

• Once again, you will probably be working with Bloomberg Terminal or Capital IQ and you can easily use
either of them to import financial information directly into Excel.

• The information you need will vary widely by industry and the company’s stage in the business
lifecycle. For mature businesses, you will look at metrics like EBITDA and EPS, but for earlier stage
companies you may look at Gross Profit or Revenue.

• If you don’t have access to an expensive tool like Bloomberg or Capital IQ you can manually gather this
information from annual and quarterly reports, but it will be much more time-consuming.
3. Set up the comps table

In Excel, you now need to create a table that lists all the relevant information about the companies
you’re going to analyze.
The main information in comparable
company analysis includes
• Company name

• Share price

• Market capitalization

• Net debt

• Enterprise value

• Revenue

• EBITDA

• EPS

• Analyst estimates
The above information can be organized as shown in our
example comparable companies analysis shown below.
4. Calculate the comparable ratios
• With a combination of historical financials and analyst estimates populated in the comps table,
it’s time to start calculating the various ratios that will be used to value the company in question.
The main ratios included in a comparable company analysis are

• EV/Revenue

• EV/Gross Profit

• EV/EBITDA

• P/E

• P/NAV

• P/B
The comparable ratios
ADVANTAGES AND DISADVANTAGES OF
COMPARABLE COMPANY ANALYSIS

Advantages of Comparable Company Analysis:

• Easy communication

• Benchmarks for the possible valuation multiples

• Easy calculation

• Data is available widely

ADVANTAGES AND DISADVANTAGES OF
COMPARABLE COMPANY ANALYSIS
Disadvantages of Comparable Company Analysis:

• It is easily influenced by non-fundamental factors

• Data not easily available for private companies

• It can be difficult for you to find the correct data for your company to compare due to many
reasons

• This method is not useful for business that has a few or no comparable companies
Precedent Transaction Analysis
• Precedent transaction analysis is a method of company valuation where past M&A transactions
are used to value a comparable business today.

• Commonly referred to as “precedents,” this method of valuation is common when trying to value
an entire business as part of a merger/acquisition and is commonly prepared by analysts working
in investment banking, private equity, and corporate development.
Precedent Transaction Analysis
1 Search for relevant transactions
• The process begins by looking for other transactions that have happened in (ideally) recent
history and are in the same industry.
The screening process requires setting criteria
such as
• Industry classification

• Type of company (public, private, etc.)

• Financial metrics (revenue, EBITDA, net income)

• Geography (headquarters, revenue mix, customer mix, employees)

• Company size (revenue, employees, locations)

• Product mix (the more similar to the company in question, the better)

• Type of buyer (private equity, strategic/competitor, public/private)

• Deal size (value)

• Valuation (multiple paid, i.e., EV/Revenue, EV/EBITDA, etc.)

2. Analyze and refine the available transactions

• Once the initial screen has been performed and the data is transferred into Excel, then it’s time to
start filtering out the transactions that don’t fit the current situation.

• In order to sort and filter the transactions, an analyst has to “scrub” the transactions by carefully
reading the business descriptions of the companies on the list and removing any that aren’t a
close enough fit.

• Many of the transactions would have missing and limited information if the deal terms were not
publicly disclosed. The analyst will search high and low for a press release, equity research
report, or another source that contains deal metrics. If nothing can be found, those companies
will be removed from the list.
3. Determine a range of valuation multiples
• When a shortlist is prepared (following steps 1 and 2), the average, or selected range, of valuation
multiples can be calculated.

• The most common multiples for precedent transaction analysis are EV/EBITDA and EV/Revenue.

• An analyst may exclude any extreme outliers, such as transactions that had EV/EBITDA multiples
much lower or much higher than the average (assuming there is a good justification for doing so).
4. Apply the valuation multiples to the company in question
• After a range of valuation multiples from past transactions has been determined, those ratios can
be applied to the financial metrics of the company in question.
5. Graph the results (with other methods) in a football field

• Once a valuation range has been determined for the business that’s being valued, it’s important
to graph the results so they can be easily understood and compared to other method.

The main valuation methods included in the chart are:

• Comparable company analysis

• Precedent transactions analysis

• DCF analysis

• Ability-to-pay analysis

• 52-week hi/lo (if a public company)

5. Graph the results (with other methods) in a football field
Advantages and Disadvantages of Precedent
Transaction Analysis
Advantages of Precedent Transaction Analysis:
• Provides a Benchmark for Valuation

• Uses Real-World Data

• Considers Market Conditions

• Incorporates Market Trends

• Helps Negotiate M&A Transactions

• Provides a Comprehensive Analysis

Disadvantages of Precedent Transaction Analysis
Disadvantages of Precedent Transaction Analysis:

• Limited Data Availability

• Lack of Transparency

• Industry-Specific

• Time-Sensitive

• Over-Reliance on Historical Data

• Limited Scope
Peer Group Analysis
• Peer group analysis is a financial assessment method used by investors and analysts to compare a
company's financial performance, valuation, and other key metrics against those of a group of similar
companies.

• This comparative analysis helps identify the strengths and weaknesses of a company and evaluate its
relative attractiveness as an investment opportunity.

• Peer group analysis plays a vital role in investment decision-making by providing investors with a
benchmark for evaluating a company's financial position, operational efficiency, and growth potential.

• Peer group analysis is commonly used for various purposes, including stock selection, portfolio
construction, relative valuation, performance benchmarking, and credit analysis in fixed-income
investing.
Identifying Relevant Peer Groups
Criteria for Selecting Peer Companies

• To conduct effective peer group analysis, investors must first identify a group of comparable
companies based on several criteria, such as:

1. Industry and Sector Classification

2. Market Capitalization

3. Geographical Presence

4. Business Model and Strategy

Criteria for Selecting Peer Companies
1. Industry and Sector Classification : Companies operating in the same industry or sector typically
face similar market dynamics, competitive pressures, and regulatory environments, making
them suitable for comparison.

2. Market Capitalization : Companies with similar market capitalizations are more likely to have
comparable financial resources, operational scale, and risk profiles.

3. Geographical Presence : Firms operating in similar geographical regions may be subject to

similar economic conditions, market trends, and regulatory frameworks.

4. Business Model and Strategy : Companies with similar business models and strategies may
share common growth drivers, cost structures, and competitive advantages.
Key Metrics and Ratios in Peer Group Analysis
Financial Performance Metrics : Investors typically compare a company's financial performance against its
peers using various metrics, including:

• Revenue and Earnings Growth: Higher revenue and earnings growth rates may indicate a company's
ability to gain market share, expand its operations, or improve profitability.

• Profit Margins : Comparing gross, operating, and net profit margins can help investors assess a
company's cost structure, operational efficiency, and pricing power relative to its peers.

• Return on Equity (ROE) and Return on Assets (ROA) : Return on Equity (ROE) and Return on Assets
(ROA) are measures of a company's profitability and efficiency in using its equity and assets,
respectively. Higher values may indicate better financial performance compared to peers.
Valuation Ratios
• Valuation ratios are commonly used to compare a company's market value against its earnings, sales, or book value relative to its
peers. Examples of valuation ratios include:

1. Price-to-Earnings (P/E) Ratio : The Price-to-Earnings (P/E) ratio compares a company's stock price to its earnings per share,
indicating how much investors are willing to pay for each dollar of earnings. A lower P/E ratio relative to peers may suggest a more
attractively valued investment opportunity.

2. Price-to-Sales (P/S) Ratio : The Price-to-Sales (P/S) ratio compares a company's stock price to its sales per share, providing insights
into its valuation relative to its revenue. A lower P/S ratio may indicate a more attractive valuation compared to peers.

3. Price-to-Book (P/B) Ratio : The Price-to-Book (P/B) ratio compares a company's stock price to its book value per share, reflecting its
valuation relative to its net asset value. A lower P/B ratio may suggest that a company is undervalued compared to its peers.
Valuation Ratios
3. Price-to-Book (P/B) Ratio : The Price-to-Book (P/B) ratio compares a company's stock price to its
book value per share, reflecting its valuation relative to its net asset value. A lower P/B ratio may
suggest that a company is undervalued compared to its peers.

4. Dividend Yield : Dividend yield is the annual dividend per share divided by the stock price,
representing the income return on an investment. Comparing dividend yields among peers can help
investors identify companies that offer attractive income potential.
Debt and Solvency Ratios
Debt and solvency ratios can help investors assess a company's financial leverage and ability to meet its debt obligations
compared to its peers:

• Debt-to-Equity Ratio : The debt-to-equity ratio measures a company's financial leverage by comparing its total debt to its
shareholders' equity. A lower debt-to-equity ratio may indicate a stronger balance sheet and lower financial risk compared
to peers.

• Interest Coverage Ratio : The interest coverage ratio measures a company's ability to meet its interest payments on
outstanding debt. Higher interest coverage ratios may suggest better debt serviceability and lower default risk compared
to peers.

• Current Ratio and Quick Ratio : The current ratio and quick ratio measure a company's short-term liquidity by comparing
its current assets to its current liabilities. Higher ratios may indicate better liquidity and solvency compared to peers.
Conducting Peer Group Analysis
• Collecting and Comparing Financial Data : To conduct peer group analysis, investors must collect
and compare financial data for the target company and its peers, such as financial statements,
stock prices, and market data. This can be obtained from public sources like company websites,
financial databases, and stock exchanges.

• Assessing Company Performance Within the Peer Group : By analyzing the key metrics and ratios
discussed earlier, investors can evaluate a company's relative performance within its peer group
and identify areas of strength, weakness, opportunity, or threat.
Operational Efficiency Metrics

Operational efficiency metrics can provide insights into a company's ability to generate revenue or manage costs
compared to its peers:

• Asset Turnover : Asset turnover measures the efficiency of a company's use of its assets to generate revenue. A
higher asset turnover ratio may indicate better operational efficiency compared to peers.

• Inventory Turnover : Inventory turnover measures the number of times a company sells and replaces its inventory
during a specific period. Higher inventory turnover ratios may indicate more efficient inventory management and
stronger demand for a company's products.

• Operating Margin : Operating margin is the ratio of operating income to revenue, reflecting a company's
profitability from its core business operations. A higher operating margin may suggest better cost management and
pricing power relative to peers.
Identifying Strengths, Weaknesses,
Opportunities, and Threats (SWOT)
• A Strengths, Weaknesses, Opportunities, and Threats (SWOT) analysis can help investors identify
factors contributing to a company's competitive position within its peer group and develop
insights into its investment attractiveness.

• When comparing companies with different business models or operating in different market
conditions, investors may need to adjust their analysis for these differences to ensure meaningful
comparisons.
Conducting Peer Group Analysis
Applications of Peer Group Analysis in
Investing
• Stock Selection and Portfolio Construction : Peer group analysis can help investors identify attractive
investment opportunities by comparing a company's financial performance, valuation, and risk profile
against its peers.

• Relative Valuation and Target Price Estimation : By comparing a company's valuation ratios with
those of its peers, investors can derive a relative valuation and estimate a target stock price for
potential investment decisions.
Applications of Peer Group Analysis in
Investing
• Identifying Potential Investment Opportunities and Risks : Peer group analysis can help investors
uncover potential investment opportunities or risks by highlighting companies that outperform or
underperform their peers.

• Performance Benchmarking and Attribution Analysis : Investors can use peer group analysis to
benchmark their investment performance against industry or sector averages and identify the
factors driving their portfolio's relative performance.
Peer Group Analysis in Fixed Income Investing
• Identifying Comparable Issuers : In fixed-income investing, peer group analysis can be used to
compare the creditworthiness, yield spreads, and debt structures of different bond issuers.

• Assessing Creditworthiness and Default Risk : Investors can assess their relative creditworthiness
and default risk by comparing credit ratings, financial ratios, and other credit metrics among bond
issuers.
Peer Group Analysis in Fixed Income Investing
• Comparing Yield Spreads and Duration : Investors can use peer group analysis to compare the yield
spreads and duration of bonds issued by comparable companies to identify attractive fixed-income
investment opportunities or potential risks.

• Analyzing Debt Structure and Covenants : Comparing the debt structures and covenants of different
bond issuers can help investors understand the terms and conditions of their debt securities and assess
the relative risks and potential returns.
Limitations of Peer Group Analysis
• Potential for Misleading Comparisons : Peer group analysis can sometimes lead to misleading comparisons if
the selected peers are not truly comparable or if the analysis does not account for differences in business
models, market conditions, or other factors.

• Changes in Business Strategy and Market Conditions : The relevance of a peer group can change over time
due to shifts in business strategy, market conditions, or other external factors, which may affect the validity
of peer group comparisons.

• Subjectivity in Peer Selection and Data Interpretation : The selection of peers and interpretation of financial
data in peer group analysis can be subjective, which may lead to different conclusions or investment
recommendations.
Limitations of Peer Group Analysis
 Understanding valuation multiples

Valuation Multiples : Valuation multiples are financial measurement tools that evaluate one
financial metric as a ratio of another, in order to make different companies more comparable.
Multiples are the proportion of one financial metric (i.e. Share Price) to another financial metric (i.e.
Earnings per Share). It is an easy way to compute a company’s value and compare it with other
businesses. Let’s examine the various types of multiples used in business valuation.
Types of Valuation Multiples
There are two main types of valuation multiples:

• Equity Multiples

• Enterprise Value Multiples

1. Equity Multiples
Investment decisions make use of equity multiples especially when investors look to acquire minor
positions in companies. The list below shows some common equity multiples used in valuation
analyses.

• P/E Ratio

• Price/Book Ratio

• Dividend Yield

• Price/Sales
P/E Ratio

• The price-to-earnings ratio is the ratio for valuing a

company that measures its current share price relative to
its earnings per share (EPS). The price-to-earnings ratio is
also sometimes known as the price multiple or the
earnings multiple.

• P/E ratios are used by investors and analysts to determine

the relative value of a company's shares in an apples-to-
apples comparison to others in the same sector.
Price/Book Ratio
• Many investors use the price-to-book ratio (P/B ratio) to
compare a firm's market capitalization to its book value
and locate undervalued companies. This ratio is
calculated by dividing the company's current stock price
per share by its book value per share (BVPS).
Dividend Yield

• The dividend yield, expressed as a percentage, is a

financial ratio (dividend/price) that shows how
much a company pays out in dividends each year
relative to its stock price.
Price/Sales

• The price-to-sales (P/S) ratio is a valuation ratio that

compares a company’s stock price to its revenues. It is an
indicator of the value that financial markets have placed
on each dollar of a company’s sales or revenues.
2. Enterprise Value Multiples

When an assessment is needed on a merger and acquisition, enterprise value multiples are the
more appropriate multiples to use, as they eliminate the effect of debt financing. The list below
shows some common enterprise value multiples used in valuation analyses.

• EV/Revenue

• EV/EBITDAR

• EV/EBITDA

• EV/Invested Capital
EV/Revenue

• The enterprise value-to-revenue multiple (EV/R) is a

measure of the value of a stock that compares a
company's enterprise value to its revenue. EV/R is one of
several fundamental indicators that investors use to
determine whether a stock is priced fairly. The EV/R
multiple is also often used to determine a company's
valuation in the case of a potential acquisition. It’s also
called the enterprise value-to-sales multiple.
EV/EBITDAR

• Earnings before interest, taxes, depreciation,

amortization, and restructuring or rent costs (EBITDAR) is
a non-GAAP tool used to measure a company's financial
performance. Although EBITDAR does not appear on a
company's income statement, it can be calculated using
information from the income statement.
EV/EBITDA
• EBITDA, or earnings before interest, taxes, depreciation,
and amortization, is an alternate measure of profitability
to net income. By including depreciation and
amortization as well as taxes and debt payment costs,
EBITDA attempts to represent the cash profit generated
by the company's operations.
EV/Invested Capital

• Invested capital is the total amount of money raised by a

company by issuing securities to equity shareholders and
debt to bondholders, where the total debt and capital
lease obligations are added to the amount of equity
issued to investors. Invested capital is not a line item in
the company's financial statement because debt, capital
leases, and stockholder’s equity are each listed separately
in the balance sheet.
Types of Relative Valuation Models
• There are many different types of relative valuation ratios, such as price to free cash flow, enterprise value
(EV), operating margin, price to cash flow for real estate and price-to-sales (P/S) for retail.

• One of the most popular relative valuation multiples is the price-to-earnings (P/E) ratio.

• It is calculated by dividing stock price by earnings per share (EPS), and is expressed as a company's share
price as a multiple of its earnings.

• A company with a high P/E ratio is trading at a higher price per dollar of earnings than its peers and is
considered overvalued.
Types of Relative Valuation Models
• Likewise, a company with a low P/E ratio is trading at a lower price per dollar of EPS and is
considered undervalued.

• This framework can be carried out with any multiple of price to gauge relative market value.

• Therefore, if the average P/E for an industry is 10x and a particular company in that industry is
trading at 5x earnings, it is relatively undervalued to its peers.