CFA® Level I · Equities · free lesson

Relative Value Equity Valuation Approaches

Multiples are the most widely quoted valuation tool in equity research because they are quick to calculate and easy to communicate. This module explains the two ways to use multiples, comparables and forecasted fundamentals, how to compute and choose among price and enterprise value multiples, how to build a sensible peer group, and why the timing of the earnings or cash flow in the denominator matters.

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What you will learn

1. Explain how multiples are used to value equity under the method of comparables and the method of forecasted fundamentals, and calculate justified multiples from fundamentals.

Comparables: apply the peer median multiple, adjusted for differences, to the company's own fundamental.
Comparables give relative value only; a mispriced peer group misleads.
Justified leading P/E = payout ratio / (r - g); trailing = leading x (1 + g).
Justified P/B = (ROE - g) / (r - g); ROE above r justifies P/B above 1.
Higher growth, higher payout (for given growth) and lower risk all raise the justified P/E.

2. Calculate and interpret price multiples and enterprise value multiples, and identify the situations in which each is most appropriate.

P/E: most common; useless when earnings are negative or distorted.
P/B: suits financial firms; P/S and EV/sales work for loss-makers but ignore margins.
EV/EBITDA: compares companies with different leverage, taxes and depreciation; ignores capex.
Match numerator and denominator: price with equity measures, EV with pre-interest measures.
From an EV estimate: equity = EV - debt - preferred - NCI + cash.

3. Construct a peer group for multiples-based valuation using industry classification and the specific drivers of a company's expected return.

Peers should match the subject company on growth, risk and profitability drivers.
GICS and ICB classify companies by principal business activity; use them as a first screen.
Refine by products, customers, geography, size, capital intensity and business model.
Use sum-of-the-parts for conglomerates with distinct segments.
Adjust the peer multiple for remaining differences in growth and risk.

4. Describe the use of trailing, current and forward (projected) values in multiples, including normalized earnings for cyclical companies.

Trailing multiples use reported data (objective but backward-looking); forward multiples use forecasts (relevant but uncertain).
Use the same time basis for every company being compared.
Cyclical stocks look cheapest on trailing P/E near the earnings peak; use normalized earnings.
Normalized EPS: average EPS over the cycle, or average ROE x current BVPS.
Remove non-recurring items and use diluted EPS for underlying earnings.

Module at a glance

Comparables apply a peer median multiple; fundamentals derive what the multiple should be.
Justified leading P/E = payout / (r - g); trailing = leading x (1 + g); justified P/B = (ROE - g) / (r - g).
Match price with equity measures and EV with pre-interest measures; convert EV to equity by deducting claims and adding cash.
P/B suits banks; EV/EBITDA suits capital-intensive firms; P/S and EV/sales suit loss-makers.
Peer groups should share growth, risk and profitability drivers; use sum of the parts for conglomerates.
Forward multiples suit fast-changing firms; normalized earnings suit cyclicals.

This free module has 4 lessons, 12 practice questions with full explanations.

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