Market-Based Valuation: Price and Enterprise Value Multiples

Q: What is a price multiple and how is it fundamentally structured?

A price multiple is a ratio that divides the Market Price per share by a Fundamental Metric (such as earnings, sales, or book value).

Q: What are the two primary methods for using price multiples in valuation?

The two methods are the Method of Comparables (benchmarking against peers) and the Method of Forecasted Fundamentals (calculating a justified multiple based on a valuation model).

Q: What is the difference between a Trailing P/E and a Forward P/E ratio?

Trailing P/E uses the actual earnings from the past 12 months, while Forward (Leading) P/E uses the estimated earnings for the next 12 months.

Q: Which fundamental factors lead to a higher justified P/E ratio?

A higher justified P/E is driven by a higher dividend payout ratio (p), a higher growth rate (g), and a lower required rate of return (r).

Q: When is the Price-to-Book (P/B) ratio most appropriately used?

P/B is best used for financial institutions with liquid assets, or for companies with negative earnings where P/E ratios cannot be calculated.

Q: What is the main rationale for using the Price-to-Sales (P/S) ratio?

The P/S ratio is used because sales are harder to manipulate than earnings and remain positive even when a company is not yet profitable.

CFA Level II · CFA · 6 min read

Welcome to Market-Based Valuation!

Welcome, future Charterholders! Have you ever gone shopping for a new phone or a car and compared the price to what you’re actually getting? You might think, "Is this car worth \$30,000 given its gas mileage and features?" That is exactly what we do in Market-Based Valuation. Instead of building massive, complex spreadsheets to find the "intrinsic value" (like we do in DDM or DCF models), we look at what the market is currently paying for similar companies. It is the "shortcut" of the valuation world, but it requires a careful eye to do correctly.

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In this chapter, we will master two main tools: Price Multiples (comparing stock price to things like earnings or book value) and Enterprise Value Multiples (looking at the whole company’s value). Let’s dive in!

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1. The Logic of Price Multiples

A price multiple is simply a ratio. It’s the Market Price in the numerator divided by a Fundamental Metric (like Earnings, Sales, or Book Value) in the denominator.

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Two Ways to Use Multiples:
\n1. Method of Comparables: Comparing a company's multiple to its peers or the industry average. If your company has a P/E of 15 and the industry average is 20, your company might be undervalued.
\n2. Method of Forecasted Fundamentals: Using a valuation model (like the Gordon Growth Model) to calculate what the multiple should be. We call this the Justified Multiple.

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Quick Review: The Law of One Price

The "Method of Comparables" is based on the economic idea that similar assets should sell for similar prices. If two companies are identical in risk and growth, they should have the same multiple.

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2. Price-to-Earnings (P/E) Multiples

The P/E Ratio is the most popular multiple on Wall Street. It tells you how much investors are willing to pay for every \$1 of the company's earnings.

Trailing vs. Forward P/E

Trailing P/E: Uses earnings from the past 12 months (EPS over the previous year).
Forward (Leading) P/E: Uses estimated earnings for the next 12 months.

Formula:
$ Trailing P/E = \frac{Current Market Price}{EPS_{past 12 months}} $
$ Forward P/E = \frac{Current Market Price}{Estimated EPS_{next 12 months}} $

The Justified P/E (Based on Fundamentals)

Don't worry if this seems tricky! It’s just the Gordon Growth Model (GGM) rearranged. If we know that $ P_0 = \frac{D_1}{r - g} $, and we know that Dividends ($ D_1 $) are just Earnings ($ E_1 $) times the Payout Ratio ($ p $), we can find the Justified Forward P/E:

$ \frac{P_0}{E_1} = \frac{p}{r - g} $

Memory Trick: To get a higher P/E, you want a higher payout ($ p $), higher growth ($ g $), and lower risk ($ r $).

Key Takeaways for P/E:

Rationales: Earnings are the main driver of stock value; P/E is widely used.
Drawbacks: Earnings can be negative (which makes the P/E useless), and managers can "manipulate" earnings through accounting choices.

3. Price-to-Book (P/B) Multiples

The P/B Ratio compares the market price of a share to the Book Value per Share (Common Equity divided by shares outstanding).

Why use it?
Book value is usually positive even when a company is losing money (unlike earnings). It is very useful for valuing financial institutions (like banks) where assets are mostly liquid.

The Justified P/B Formula:
$ \frac{P_0}{B_0} = \frac{ROE - g}{r - g} $

Did you know? A company’s P/B is strongly driven by its Return on Equity (ROE). If ROE is higher than the required return ($ r $), the P/B should be greater than 1.0.

Common Mistake to Avoid:

Don't forget that Book Value is "historical cost." If a company has lots of intangible assets (like a famous brand or patents) that aren't on the balance sheet, the P/B ratio might look artificially high!

4. Price-to-Sales (P/S) and Price-to-Cash Flow (P/CF)

Price-to-Sales (P/S)

Rationale: Sales (Revenue) are much harder to manipulate than earnings. Also, sales are never negative, so we can use this for start-ups that aren't profitable yet.

The Justified P/S Formula:
$ \frac{P_0}{S_0} = \frac{(E_0/S_0) \times p \times (1+g)}{r - g} $
(Note: $ E/S $ is simply the Net Profit Margin!)

Price-to-Cash Flow (P/CF)

Rationale: Cash flow is harder to "fake" than earnings. It's more stable than P/E. Usually, analysts use Free Cash Flow to Equity (FCFE) or Operating Cash Flow (OCF).

5. Enterprise Value (EV) Multiples

Sometimes, looking at just the "Price" (Market Cap) isn't enough because it ignores the company's Debt. If you buy a house for \$100k but take over a \$400k mortgage, the "Enterprise Value" is \$500k.

The EV Formula:
$ EV = Market Value of Common Stock + Market Value of Preferred Stock + Market Value of Debt - Cash and Investments $

Why subtract cash? Because if you bought the whole company, you could use its own cash to pay yourself back immediately!

EV/EBITDA

This is the "Gold Standard" for many analysts. EBITDA is a proxy for total operating cash flow.
Why use it?
1. It’s useful for comparing companies with different capital structures (different levels of debt).
2. It’s useful for capital-intensive industries where Depreciation is a huge non-cash expense.

Key Takeaway:

When using EV in the numerator, always use a "pre-interest" metric in the denominator (like EBITDA or EBIT). This ensures you are comparing "Total Value" to "Total Earnings available to all providers of capital."

6. The PEG Ratio: Adjusting for Growth

A P/E of 20 might look expensive for a company growing at 2%, but cheap for a company growing at 30%. The PEG Ratio levels the playing field.

$ PEG = \frac{P/E}{Growth Rate (g)} $

Rule of thumb: A PEG ratio of 1.0 is considered "fairly valued." Lower than 1.0 is "cheap," and higher than 1.0 is "expensive."

Warning: PEG assumes a linear relationship between P/E and growth, which isn't always true in the real world!

7. Practical Issues: International and Logic

The Method of Comparables Process:

Select a group of comparable firms (same industry, size, and risk).
Calculate their multiples.
Calculate the average or median multiple.
Apply that average to your target company’s fundamentals to find the "fair price."
Adjust for differences (e.g., if your company is growing faster than the average, it should have a higher multiple).

International Considerations:

When comparing companies across borders, be careful! Differences in Accounting Standards (IFRS vs. GAAP) can make earnings or book values look very different, even if the businesses are identical. Inflation rates and tax laws also play a huge role.

Summary Checklist

Quick Review Box:
- P/E: Most common, focus on earnings.
- P/B: Best for banks and liquid assets.
- P/S: Best for distressed or fast-growing firms with no profit.
- EV/EBITDA: Best for comparing firms with different debt levels.
- Justified Multiples: Use the Gordon Growth Model to see what the ratio should be.
- Relative Valuation: Comparing a stock to its peers.

Don't worry if the formulas look intimidating at first. Just remember: almost every "Justified" multiple is just a variation of the Dividend Discount Model! Keep practicing those calculations, and you'll have this mastered in no time!

Quick check

Can you answer these now?

Open each question to check the key ideas from this chapter.

What is a price multiple and how is it fundamentally structured?

A price multiple is a ratio that divides the Market Price per share by a Fundamental Metric (such as earnings, sales, or book value).

What are the two primary methods for using price multiples in valuation?

The two methods are the Method of Comparables (benchmarking against peers) and the Method of Forecasted Fundamentals (calculating a justified multiple based on a valuation model).

What is the difference between a Trailing P/E and a Forward P/E ratio?

Trailing P/E uses the actual earnings from the past 12 months, while Forward (Leading) P/E uses the estimated earnings for the next 12 months.

What is the formula for the Justified Forward P/E based on the Gordon Growth Model?

The Justified Forward P/E formula is: $ \frac{P_0}{E_1} = \frac{p}{r - g} $, where $ p $ is the payout ratio.

Which fundamental factors lead to a higher justified P/E ratio?

A higher justified P/E is driven by a higher dividend payout ratio (p), a higher growth rate (g), and a lower required rate of return (r).

When is the Price-to-Book (P/B) ratio most appropriately used?

P/B is best used for financial institutions with liquid assets, or for companies with negative earnings where P/E ratios cannot be calculated.

How does Return on Equity (ROE) relate to the Justified P/B ratio?

The Justified P/B is calculated as $ \frac{P_0}{B_0} = \frac{ROE - g}{r - g} $; if ROE exceeds the required return (r), the P/B should be greater than 1.0.

What is the main rationale for using the Price-to-Sales (P/S) ratio?

The P/S ratio is used because sales are harder to manipulate than earnings and remain positive even when a company is not yet profitable.

What is the rationale for using Price-to-Cash Flow (P/CF) over P/E?

Cash flow is generally harder for management to manipulate than accrual-based earnings and is typically more stable than net income.

How is Enterprise Value (EV) calculated?

$ EV = \text{MV of Common Stock} + \text{MV of Preferred Stock} + \text{MV of Debt} - \text{Cash and Investments} $.

Why is EV/EBITDA often preferred over the P/E ratio for comparing different firms?

EV/EBITDA is capital structure neutral, meaning it allows for a fair comparison between companies with different levels of debt.

What is the PEG ratio and how is it interpreted?

The PEG ratio is $ \frac{P/E}{Growth Rate (g)} $. A ratio of 1.0 is typically considered fair value; below 1.0 is potentially undervalued.

What are the basic steps in the Method of Comparables process?

Select comparable firms, calculate their multiples, find the average/median, apply that multiple to the target's fundamentals, and adjust for specific differences.

How do international accounting differences affect market-based valuation?

Differences between standards like IFRS and GAAP can cause earnings and book values to vary significantly, making cross-border multiple comparisons difficult.

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