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CFA® Level II · Equities · free lesson
Market-Based Valuation: Price and Enterprise Value Multiples
Multiples are the language of equity markets: analysts, bankers and investors quote P/E, P/B and EV/EBITDA far more often than discounted cash flow values. This module contrasts the method of comparables with justified multiples derived from fundamentals, calculates and adjusts the main price and enterprise value multiples, uses regressions, PEG ratios and momentum indicators, and shows how to summarise a peer group without being misled by outliers. Level II item sets combine these steps into a full relative valuation with traps in every adjustment.
What you will learn
1. Contrast the method of comparables with the method based on forecasted fundamentals, and explain the economic rationale for each.
- Comparables: value = benchmark multiple x company metric; rationale is the law of one price.
- Comparables give relative value only; a mispriced peer group misleads.
- Forecasted fundamentals: justified multiples derived from a present value model, giving an absolute benchmark.
- Differences in growth, risk and profitability can justify different multiples among peers.
- Use both: comparables show market pricing, fundamentals test whether it is reasonable.
2. Calculate and interpret P/E, P/B, P/S, price to cash flow and dividend yield, including normalised and underlying earnings, and explain the strengths and weaknesses of each multiple.
- Use underlying EPS excluding non-recurring items, and normalised EPS for cyclical companies.
- Normalised EPS: historical average EPS, or average ROE x current book value per share (reflects current size).
- Rank on earnings yield (E/P) when EPS is negative.
- P/B suits banks and asset-heavy firms; use tangible book and adjust for off-balance-sheet items.
- P/S works with losses but ignores costs; P/CF is less exposed to accrual choices; dividend yield ignores capital gains.
3. Derive justified P/B, P/S, P/CF and dividend yield from fundamentals, use cross-sectional regressions and the PEG ratio, and set terminal values with multiples.
- Justified P/B = (ROE - g)/(r - g); P/B exceeds 1 only if ROE exceeds r.
- Justified P/S = (E0/S0)(1 - b)(1 + g)/(r - g) = profit margin x justified trailing P/E.
- Justified D/P = (r - g)/(1 + g).
- Cross-sectional regressions predict multiples from fundamentals but suffer from multicollinearity and instability.
- PEG = P/E / growth (%): ignores risk and the duration of growth; terminal multiples should match stable-stage fundamentals.
4. Calculate enterprise value multiples and evaluate EV/EBITDA, and explain cross-border comparability problems and momentum valuation indicators.
- EV = market value of equity + debt + preferred + noncontrolling interests - cash and short-term investments.
- EV/EBITDA suits comparisons across different leverage and depreciation policies; it ignores capex, working capital and taxes.
- IFRS 16 raises EBITDA relative to US GAAP for lessees; adjust before comparing across borders.
- SUE = (actual EPS - expected EPS) / standard deviation of past surprises.
- Momentum indicators (surprise, SUE, relative strength) are timing and screening tools, not intrinsic value estimates.
5. Summarise a peer group's multiples with the appropriate mean or median, and judge whether a share is mispriced using several multiples together.
- Arithmetic mean is distorted by large outliers; the median is robust and is the usual default.
- Harmonic mean = n / sum(1/X); it dampens large outliers but amplifies small ones.
- The weighted harmonic mean gives a portfolio or index P/E.
- Investigate outliers before averaging; check whether fundamentals explain a gap to peers.
- Several multiples pointing the same way give a stronger, but still relative, signal.
Module at a glance
- Comparables apply a peer benchmark (law of one price); justified multiples come from present value models.
- Use underlying EPS and, for cyclicals, normalised EPS; the average ROE method reflects current size.
- Justified P/B = (ROE - g)/(r - g); justified P/S = margin x payout x (1 + g)/(r - g); justified D/P = (r - g)/(1 + g).
- PEG adjusts P/E for growth but ignores risk and duration; regressions are period-specific.
- EV adds debt, preferred and noncontrolling interests and subtracts cash; EV/EBITDA suits differing leverage.
- Adjust for IFRS 16 versus US GAAP lease accounting before comparing EBITDA across borders.
- Median for skewed peer groups; harmonic mean dampens large outliers but amplifies small ones.
This free module has 5 lessons, 16 practice questions with full explanations.