Question

One of your first assignments as a financial analyst at Fidelity Investments is to value the stock of a company that has not paid any dividends. You know you can’t apply the dividend discount model, so you must turn to a different method of valuation. Luckily, you remember you can value a stock using the Price-Earnings or P-E ratio. Describe this method and explain how you would use it to value the stock

Answer 1

To value a stock ie to find the intrinsic value of the stock we can use either of the below mentioned valuation techniques:

a) Absolute Valuation - to use absolute valuation, we can use methods like dividend discount model, asset based model, etc.

b) Relative valuation- Relative valuation as the name suggests, we compare similar companies using ratios or multiples or several such factors like comparing the price earning ratio, price to book ratio, price to sales ratio, etc.

In the given question, the company has not paid any dividends, so using any absolute valuation model is not possible.

So, we use relative valuation models.

We can use the price earning ratio of the company and compare it with ratio of similar companies to arrive at the value. Under this method, we select companies of similar standing and compare the price multiples to evaluate if the stock if overvalued or undervalued.

Steps to perform comparable company analysis:

a) Finding the companies with similar characteristics and that cater to the same industry. It is important to compare similar companies for results to be reliable. It wouldn't make sense to compare a pharmaceutical company with a banking company, or a US company with and African company. To find a similar company, a lot of aspects are to be considered, for instance:

i) Industry to which the company belongs

ii) Geography

iii) Demography that it caters to

iv) Size of the organisation

b) Once the companies have been shortlisted based on the criteria mentioned, the next step is to gather financial information related to all the comanies. But the kind of information that you need will largely depend on the industry and the company. Some companies may be well established, while others may be new. The companies in early stage may not have a strong EPS so we can use revenue details. For well established organisations, earnings driven factors like EPS is a reliable factor  

c) Now that you have all the data that you need for the companies, Its time to process that data into formation.This means that the next step is to gather and sort the data obtained in step 2 and filter the relevant information.

d) Based on the information in step c, we conduct analysis by computing various ratios that are comparable. As discussed earlier, these ratios can be revenue driven, earnings driven based on the company facts and circumstances.

e) After calculating the ratio or multiples, a general practice to find the value of company that we need, we take an average of comparable companies' ratios and then apply it to revenue, gross profit, earnings of the company that is to be valued. For instance, if we are using PE ratios as a ratio to compare, we take average of PE ratio of all comparable companies and apply i the average to the company that we need to value.

f) Analysis of the results- a careful analysis should be done of all the information derived and computed so far. We need to analyse if the stock is undervalued/ overvalued and the reasons for the same. It could be because company does not have access to funds to grow or that it has funds but cannot put it to good use which is effecting the growth of the company.

This analysis is very important because the valuation derived from this is used for several purposes and hence, the analyst must take into consideration all the fine details and perform analysis keeping in mind all key factors.