L7 - Fundamental Principles and Earnings Multiple_2001s2

L7 - Fundamental Principles and Earnings Multiple_2001s2 -...

Info iconThis preview shows pages 1–5. Sign up to view the full content.

View Full Document Right Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: Prepared by Henry Yip 1 FINS3641 SECURITY ANALYSIS AND VALUATION PART 3: RELATIVE VALUATION MODELS Week 8: Fundamental Principles and Earnings Multiples Topics: What is relative valuation? How do we conduct relative valuation? Learning Outcomes: Learn the linkage between price earnings ratio and dividend discount valuation models Learn how best to measure and apply price earnings ratio to firm valuation, and relate the variation in PE ratios across firms, markets and over time to the fundamentals. Reading: Damodaran Chapters 17, 18 FINS3641 SAV Week 8: Fundamental Principles and Earnings Multiples 2 Relative Valuation in the Market Place Most valuations on Wall Street are relative valuations which i) account for Almost 85% of equity research reports More than 50% of all acquisition valuations ii) are often the basis for final valuation judgements. FINS3641 SAV Week 8: Fundamental Principles and Earnings Multiples 3 Pros and Cons regarding Relative Valuation i) Assumption and Computation Time: Relative valuation is quicker to complete and “ seems to” require fewer assumptions than DCF valuation. The lack of “explicit” assumptions makes relative valuation vulnerable to manipulation ! ii) Simple to Understand and Easier to Present: Users are more receptive to relative valuation than DCF valuation. We all have the experience of comparing similar products and their prices. It is also easy to get carried away with simplicity. By not addressing the potential differences in key variables such as risk, growth expectation and cash flow potential between the firm to be valued and its comparables, relative valuation will result in inconsistent estimates ! iii) In line with the current mood of the market: Multiples have cycles and swing with the mood of the market, hence providing closer values to market prices than DCF values: larger in boom times than in bust times and larger when the industry to which the firm belongs is in favour than when it is out of favour. This means a firm will be overvalued (undervalued) by relative valuation when the market is overvaluing (undervaluing) comparable firms! FINS3641 SAV Week 8: Fundamental Principles and Earnings Multiples 4 What is Relative Valuation? What does it entail? In relative valuation, the value of an asset is based on how the market prices a common variable of comparable firms . Thus we need to i) Identify comparable firms – on the basis of a) Conventional practice – firms in the same industry and similar size (implicit assumption that these firms have …) b) Valuation fundamentals ‐ firms with similar risk (beta), earnings growth & cash flow potential (ROE) c) Statistical techniques – include all listed stocks and use multiple regression to control for differences in valuation fundamentals ii) Specify and measure the common variable that is priced by the market, e.g.: a) Accounting earning & book value measures (though affected heavily by accounting rules and principles)...
View Full Document

{[ snackBarMessage ]}

Page1 / 20

L7 - Fundamental Principles and Earnings Multiple_2001s2 -...

This preview shows document pages 1 - 5. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online