Question

1.) Explain company valuation using market multiples based on balance sheet measures.

2.) Explain company valuation using market multiples based on income statement measures.

3.) Identify comparable companies for use in company valuation with market multiples.

4.) Interpret and reverse engineer market multiples to assess the reliability of market expectations.

Answer 1

Companies are (fundamentally) valued based on income statement(s) & balance sheet(s).

1.) Some of the key company valuation models/technique used by comparing the balance sheet items of a firm are as as follows: -

A) Current Ratio
Current Ratio = Current Assets ÷ Current Liabilities.
Current ratio of 1.5 or 2 is considered as a standard/healthy. Higher the ratio healthier the company & vice versa.

B) Quick Ratio

Quick Ratio = (Current Assets - Inventories) ÷ Current Liabilities
Investories are removed as not all the inventories are converted into cash. Quick ratio of over 1 is considered as healthy. Higher the ratio better the company & vice versa.

C) Working Capital

Working Capital = Current Assets - Current Liabilities

Working captial can be positive or negative. A positive working capital is considered as healthy while a negative figure is considered as unhealthy.

D) Debt to Equity Ratio

Debt to Equity Ratio=Total Liabilities ÷ Shareholders' Equity

Lower the ratio healthier the company and vice versa. However, a debt-to-quity ration of zero is undesireable as the same is considered to be inefficient.

2.) Some of the key company valuation models/technique used by comparing the income statement items of a firm are as as follows: -

A) Gross Margin
Gross Margin=Gross Profit÷Net Sales
This ratio suggests the sales through which profit margin can be generated for reinvestment/future investments after cost of goods sold is deducted.

B) Profit Margin
Profit Margin=Net income (after tax)÷Net Sales
Profit margin shows profit per sale after all other expenses are deducted.

C) Operating Margin
Operating Margin=Operating income÷Net Sales.
The same is used to show how much revenue is remaining after paying for the variable costs like wages and raw materials.

D) Earnings Per Share (EPS)
Earnings Per Share=Net income-total dividends paid÷Number of shares outstanding.
Earnings Per Share (EPS) is a important factor in calculating Price to earnings ratio.

E) Price-earnings Ratio (P/E)
Price-earnings Ratio (P/E)=Market value per share÷Earnings per share (EPS). This is one of the most widely used stock valuation model and it shows how much investors pay per dollar of earnings.

F) Return on Stockholders' Equity
Return on Stockholders' Equity= Net income (after taxes)÷Weighted average equity.
The same is again one of the most critical techniques in valuation as it indicates percentage of profit after taxes that the corporation earned

3.) Comparable company analysis starts with establishing a peer group consisting of similar companies of similar size in the same industry or region. Investors are then able to compare a particular company to their competitors on a relative basis. This information can be used to determine a company's enterprise value (EV) and to calculate other ratios used to compare a company to those in its peer group.Some of the key company valuation models/technique used in Comparable Company Analysis of a firm are as as follows: -

A) Enterprise value-to-sales
Enterprise value-to-sales=Market Capitalization + Debt + Preferred Shares - Cash and Cash Equivalents÷Sales
Lower the ratio higher company is believed undervaalued hence making it more attractive. However the same can be deceptive sice a lower ratio can signal lower future sales growth making it unattractive too. The same is considered healthy if its between 1 to 3.

B) P/E Ratio
Refer above for explanation

C) Price to book (P/B) Ratio
P/B Ratio=Market price per share÷Book value per share
A lower P/B ratio could mean the stock is undervalued or attractive to be bought. However, it could also mean something is structurally wrong with the company.

D) Price-to-sales (P/S) Ratio
P/S Ratio=Market price per share÷Sales per share
This is the most relevant ration to be considered in comparing a company within the same industry or the sector. A low ratio indicates undervaluation while a ratio that is significantly above the average may suggest overvaluation.

4.) Discounted cash flow (DCF) is also alternatively known as reverse engineer market multiples model. The same is used to predict future cash flows at the specified discount rate at a particular risk rate and a valuation or a stock target price is derived from the same. By working backwards, we can predict how much cash flows a compnany can earn at current valuation/rates. The same is helpful in helping analysts make a decision whether to buy, sell or hold a stock in comparison to its peers. However, it is a less reliable method of determining what the stock is really worth on its own.