The Art of Valuation Jujitsu : Part 2

Nov 19, 2014 The Art of Valuation Jujitsu : Part 2

As I noted in Part 1, price multiples like P/E can help you determine if a stock is undervalued, fairly valued, or overvalued relative to the company’s peer group. In doing so, we look at how the company’s price multiple “compares” to the average multiple on stocks of other, similar companies. The rationale is that two similar assets should sell at comparable price multiples. We call this the law of one price. If the company you are analyzing has a lower multiple than the peer group, it may be undervalued.

Relative valuation involves three steps: (1) selecting the group of comparable firms, (2) scaling the market value of each company to a common variable such as sales, earnings, or cash flow, and (3) adjusting for differences in companies being compared. Selecting the group of comps is fairly straight forward. You can start with the other companies in the industry. You should cross reference that list with the companies in the competitor section of the company’s 10K filing. With a list of comps, the next step is to jot down (or download) the multiple for the company and its peers. The P/E ratio for a company is available from a variety of free and subscription services. The last step is to adjust for differences in the companies being compared. This is the tricky part. Let’s assume that the company you’re analyzing has a P/E of 9x and the other companies have an average P/E of 12x. Many new investors will look at this scenario and conclude that the stock in question is “undervalued.” Don’t make that mistake! It could be that the company’s earnings are expected to grow at a much lower rate than the peer group, which justifies the lower multiple. When comparing multiples, ask yourself: Is the multiple justified based on the company’s growth rate and risk relative to its peers? Let’s look at a detailed example.

EverConnect provides cloud storage and related services, allowing customers to store their photos, documents, and videos on the cloud, so that they can be accessed from any device with an internet connection. Shares of EverConnect are selling for $50. The company’s earnings for the next 12 months are expected to be $2 per share. Using these two pieces of data, the company’s forward P/E ratio is 25 times ($50 share price / $2 EPS). EverConnect’s competitor, DisConnect, has a P/E of 16x, while the average P/E ratio for firms in the industry is 23 times. Other relevant details are provided below.

Based on this information, it appears that EverConnect is undervalued given the company’s P/E is lower than the industry and it has approximately the same growth rate and risk. Whether DisConnect is under- or overvalued cannot be determined with the information provided above. While the company has a lower P/E than the industry, the lower multiple may be the results of DisConnect’s lower growth forecast (12% vs. 19% for the industry). The takeaway here is that we can’t assume that a company with a lower price multiple is undervalued. Possible explanations of a lower multiple include: (1) the stock is properly valued but has a lower growth rate tan the peer group, (2) the stock is properly valued, but has higher risk than the peer group, or (3) the stock is undervalued.

When selecting a multiple to use for your relative value analysis, make sure that it is consistently defined. By that, I simply mean that the data in the numerator relates directly to the data in the denominator. Let’s look at a simple example. The P/E ratio has market cap (an equity-related value) in the numerator and EPS (an equity-related income item) in the denominator. Similarly, enterprise value-to-EBITDA is consistently defined. Enterprise value measures the market value of the company’s operating assets and EBITDA is the cash flow generated by those operating assets. Price-to-sales (P/S), on the other hand, is not consistently defined since market cap is an equity-related item, but both shareholders and credits can place a claim on sales generated by the company. As a result, highly leveraged companies can look deceptively cheap on a price/sales basis. If you want to use a sales-related multiple, enterprise value-to-sales is consistently defined.

It is also important to use multiple models when conducting a relative value analysis. As Geoff Gannon puts it, limiting yourself to a single approach would be “like gouging out one of your eyes. True, 90% of the time you only need one eye, but sometimes it helps to have depth perception. And for that, two eyes are better than one.” Without question, the most common relative value measure is the price-to-earnings ratio. I also like enterprise value-to-EBITDA (typically denoted EV/EBITDA) for the reasons outlined in Adding EV/EBITDA to Your Relative Value Toolkit. Like P/E, a company’s EBITDA multiple is compared to the peer group. If the peer group multiple is higher than that of the company being analyzed, the company may be undervalued…assuming that the peer group has similar growth prospects (and risks).