Part 2 – Lesson 9

Overview


Relative valuation is a methodology built on valuing companies relative to its peers / competitors.  By comparing commonly used valuation multiples across comparable companies, an investor can determine which companies appear to be relatively more or less expensive.  For example, if an investor is researching a luxury goods retailer, a relative value analysis would compare the valuation multiple (such as P/E) of several luxury goods retailers to see which are being valued most to least expensive by the market.  While DCF valuations are a very useful tool, the use of relative valuation is widespread amongst the investment community due to its simplicity of use vs. a DCF analysis.

The method of performing a DCF analysis vs. a relative value analysis is different, but the principles and inputs that drive the valuations are very similar.  A valuation multiple should implicitly incorporate many of the same inputs that drive a DCF valuation.  For example, higher growth in the form of higher financial projections in a DCF will lead to a higher value per the DCF.  Similarly, higher growth companies should be awarded with higher relative valuation multiples.

The commonly used relative value multiples are 1) Price to Earnings, 2) Price to Cash Flow, and 2) Enterprise Value to EBITDA.  There are several other valuation multiples including PEG ratio (Price to Earnings to Growth), Enterprise Value to Unlevered Cash Flow, Enterprise Value to Sales, Dividend Yield, and Price to Book to name a few.

You can think of relative valuation similarly to how single-family homes are purchased.  If you are evaluating the purchase of a home in a particular neighborhood, you will evaluate the sales prices of recently sold homes in the same neighborhood.  You will adjust the price of the home based on the quality of the construction vs. neighboring homes, the size of the home vs. neighboring homes, the view from the house vs. other homes, etc.  Similarly, an investor analyzing the value of Verizon stock will compare the valuation multiples of Verizon vs. its peers including AT&T, Sprint, and T-Mobile.

The investor will judge whether the valuation multiple is fair, undervalued, or overvalued by making judgments on the growth of Verizon, market share, margins, competitive position, etc vs. its peers.

There are several advantages of using relative value multiples.  First, it is simple.  It is quick to calculate valuation multiples, and for an analyst that is evaluating hundreds of companies, it is much faster to value a company through multiples rather than performing a DCF on each company.  Second, the power of using multiples improves with the experience of the investor.  An investor that has been following certain companies or industries for many years will be intimately familiar with the historic valuation multiples of that company or industry.  For example, when the valuation multiple of Verizon drops to a very low level, it will be easy and quick for an experienced investor to recognize that the valuation multiple is extremely low vs. history.  Third, valuation multiples are less prone to calculation error.  DCF valuations have numerous inputs that can dramatically change the answer.  Using an incorrectly calculated beta or perpetual growth rate can dramatically influence the DCF value, leading to an incorrect assessment of value.

While there are several advantages of relative valuation, multiples are far from perfect.  First, valuation multiples are typically only used on near-term financial metrics.  For companies that are in a very high growth phase, the near-term valuation metrics may look very expensive, while long-term valuation metrics may look more attractive.  This could lead to investors missing out on attractive long-term opportunities.  Second, valuation multiples are prone to broad over-valuation or broad under-valuation during periods of stock market extremes.  This is when the experience of the investor becomes important in recognizing broad over or undervaluation.  Third, relative value multiples also depend on comparing valuation multiples to peers.  For companies that do not have closely related peers, a relative value analysis can present challenges.

Below, we will discuss three of the commonly used valuation multiples.

Price to Earnings (P/E)


The price to earnings ratio of a company is calculated as:

P/E ratio = Stock Price / Earnings Per Share

The P/E ratio is an expression of what an investor is willing to pay for each unit of earnings.  For example, if Company A has $1 of earnings per share and the stock trades at $12, then, the P/E ratio is 12x.  Another way of expressing P/E is to look at the reciprocal (Earnings / Price).  This is referred to as the earnings yield or return on equity.  In this case, the earnings yield would be 8.3% ($1 of EPS / $12 stock price).  In other words, if we buy Company A stock at $12, then, we will earn an 8.3% return.  If you refer to Part 2, Lesson 7, you will recall that the return on equity to the investor is also the cost of equity to the company.  Therefore, this 8.3% is also equal to the cost of equity for Company A.

The P/E ratio can be expressed based on the previous twelve months of earnings (referred to as “Last Twelve Months” or “Trailing Twelve Months”), year 1 earnings, year 2 earnings, etc.  Let’s look at a few simple examples of how an investor would compare P/E ratios of a few competitors.

In the above chart, we compare the P/E ratios of three different companies over three different time periods (LTM, 2018, and 2019).  Let’s consider a few of the takeaways from this P/E comparison:

  1. Company A shows a growth in EPS of 33% from the LTM period to 2019. Thus, the P/E multiple becomes “cheaper” over time due to the growth in EPS.

  2. Company B shows a decline in EPS of 25% from LTM to 2019, so the Company B P/E multiple becomes more expensive as time goes on.

  3. Company C shows very little growth in EPS, so the P/E multiple stays the same over time, which would imply that the yearly return on equity essentially stays the same.

  4. Just looking at these EPS growth rates and the P/E ratios, which company would you want to own all else being equal? Our choice would be biased towards owning Company A.  Even though Company A has the most expensive P/E ratio today, the strong trajectory in EPS implies that the returns for this company will improve over time.

  5. When calculating the industry P/E multiple, it is often better to use the median rather than the average to avoid having unusually high or unusually low P/Es throw off the industry average multiple.

Let’s now compare Verizon’s P/E ratio to some of its peers.  The Excel file can be downloaded here (Part 2 Excel Download).

In the above chart, we have compared the P/E of Verizon to its wireless peers: AT&T, T-Mobile, and Sprint.  Let’s review a few of the takeaways from this analysis:

  1. Verizon and AT&T show similar growth rates in EPS, but Verizon trades at modest premium on P/E relative to AT&T. Why is this the case?  In recent years, AT&T acquired DirectTV and recently closed on the acquisition of a television media conglomerate, Time Warner.  As of July 2018, investors are concerned about the health of the pay TV market with consumers cutting the cord and moving to online video services, such as Netflix.  Verizon has less exposure to pay television, so the P/E multiple premium is likely due to the difference in business mix of Verizon vs. AT&T

  2. T-Mobile trades at a premium to Verizon and AT&T. Why is that the case?  Verizon and AT&T are growing EPS in the 2-4% range into 2019, whereas T-Mobile is growing EPS 20% into 2019.  Generally, higher P/E ratios are awarded to companies showing higher growth.  An investor is generally willing to pay a higher multiple for the same level of earnings if that earnings is growing at a faster rate.  This results in returns that are expected to become incrementally better in future years.

  3. Sprint shows a very high P/E ratio of 80x 2018 EPS and 43x 2019 EPS primarily because of a close to zero EPS level. P/E ratios are generally less useful for companies with negative or close to zero level of earnings.  If Sprint continues to grow, its P/E ratio may normalize in future years, but as of now, the P/E ratio for Sprint is a less meaningful metric due to the insignificant net income level of Sprint.  However, it is important to note that just because Sprint does not have meaningful earnings today doesn’t mean that Sprint equity does not have value.  Remember, the value of a company’s equity is the discounted value of all future years’ cash flow.  This is where a DCF analysis of Sprint’s cash flows may be a more useful tool in determining the value of Sprint’s equity vs. using P/E ratios.  Alternatively, we may look at other metrics, such as an Enterprise Value / EBITDA multiple to compare the valuation of Sprint vs. its peers.

Price to Cash Flow (P/CF)


Price to free cash flow (cash flow) is calculated by dividing the share price by the cash flow per share:

P/CF Ratio = Stock Price / Cash Flow per Share

Many investors prefer using P/CF over P/E ratios since P/CF provides a clear understanding of how much cash a business generates.  Often, EPS metrics can be distorted by non-cash expenses such as large depreciation and amortization expenses and non-cash write downs or by GAAP expenses that don’t match the cash expenses.  For example, a company’s cash taxes (the amount actually owed to the IRS) can be significantly different than the GAAP taxes reported on the income statement due to differences in tax accounting vs. GAAP accounting.

Similar to earnings yield, investors often discuss “free cash flow yield,” which is the reciprocal of P/CF.  If Company A earns $2 in CF/share and the stock trades at $20, then, the free cash flow yield is 10% while the P/CF ratio is 10x.  The cash flow yield tells us that for every dollar invested, an investor earns 10 cents in cash flow per year.

Importantly, when calculating P/CF ratios, an investor must use cash flow to the equity holder (after interest expense).  Please refer to Part 1, Lesson 12 for a review on calculating cash flow.

Let’s now compare Verizon’s P/CF ratio to some of its peers:

Below are a few of the takeaways from this P/CF comparison:

  1. We have used the EBITDA – Interest Expense – Taxes – Capex methodology for calculating free cash flow. This is a short-cut that many investors use to quickly calculate cash flow for a company.

  2. Similar to earnings, Sprint also shows a negative cash flow for 2019, so the P/CF ratio is not meaningful for Sprint.

  3. Verizon trades at premium to AT&T on a P/CF basis in addition to P/E. The premium cash flow valuation multiple is likely due to the same reasons why Verizon trades at premium on a P/E basis (due to the business mix of Verizon vs. AT&T).

  4. Although we have not shown 2020 cash flow growth for T-Mobile, the premium cash flow multiple for T-Mobile is due to the higher growth rate of cash flow for T-Mobile relative to Verizon and AT&T.

Enterprise Value / EBITDA (EV / EBITDA)


Enterprise value is the total market value of a company’s business, inclusive of both equity and debt.  From a present value perspective, enterprise value is the present value of all the future unlevered cash flows of the business.  It is calculated as:

Enterprise Value = Market Capitalization + Net Debt

Net Debt = Gross Debt – Cash

Why do we subtract cash from gross debt when calculating enterprise value?  Including cash in the calculation of enterprise value would be double counting since cash can only come from two sources: debt and equity.  Let’s imagine that we have a company that has an enterprise value of $1 billion.

Company A Enterprise Value = $500mm market cap + $500mm gross debt – $0 cash
Company A Enterprise Value = $1Bn

Now, let’s assume this company issues $1Bn of new debt, which will of course increase the cash balance to $1Bn.  If we did not subtract cash from the equation, we could calculate the enterprise value as follows:

Company A Enterprise Value = $500mm market cap + $1,500mm gross debt
Company A Enterprise Value = $2Bn

This calculation is clearly incorrect because the value of the business should not double from $1Bn to $2Bn because the company issued $1Bn of new debt.  The value of the business should go up from increasing the future cash flows of the business.  When the company issues debt, the value of the business should stay exactly the same.  Therefore, we should calculate enterprise value as follows:

Company A Enterprise Value = $500mm market cap + $1,500mm gross debt – $1,000mm cash
Company A Enterprise Value = $1Bn

The Enterprise Value to EBITDA multiple is simply expressed as:

EV / EBITDA ratio = Enterprise Value / EBITDA

This ratio is also commonly referred to as the “EBITDA multiple.”  There are several advantages of looking at EBITDA multiples.  For example, the EBITDA multiple normalizes for differences in capital structure.  If we are comparing the valuations of high leveraged companies (companies with a lot of debt) vs. low leverage companies, the P/E ratios or P/CF ratios may show differences due to the different risk profiles of high vs. low leverage.  Also, EBITDA multiples can often be used when P/E and P/CF multiples cannot be used due to zero or negative earnings/cash flow.

The disadvantage of EBITDA multiples is that an investor does not get as accurate a sense of underlying earnings and cash flow that a P/E or P/CF multiple would provide.  Additionally, EBITDA multiples can be skewed due to differences in EBITDA calculation between companies.  Since EBITDA is not an official GAAP metric, it can be prone to increased calculation error vs. cash flow (which is hard to manipulate).

Let’s now evaluate the EBITDA multiple of Verizon vs. its peers:

From the above chart, we can draw the following observations:

  1. Interestingly, the EBITDA multiple for Verizon and AT&T are the same, while Verizon’s cash flow multiple and earnings multiple are higher than AT&T. Why is this the case?  It is the job of an investor to discern answers from observations that don’t always have a clear explanation.  Our theory for the higher P/E and P/CF valuation for Verizon was due to the more attractive business mix of Verizon vs. AT&T (Verizon has less exposure to the challenged pay television market).  If this were the case, we should have also seen the EBITDA multiple for Verizon trade at a slight premium to AT&T.One explanation could be in the methodology of calculating EBITDA of Verizon vs. AT&T.  In recent years, wireless companies have shifted their business model towards leasing handsets to their customers vs. subsidizing handsets due to increasing costs of iPhones (it became too expensive for wireless carriers to offer to pay for new iPhones for their customers).  This shift in the business model led to significant differences in the timing of cash flows and calculation of EBITDA.  If the AT&T and Verizon EBITDA is not being calculated on an apples to apples basis, this could lead to EBITDA metrics that are not directly comparable between the two companies.However, differences in the calculation of EBITDA should not affect the underlying cash flow of the business.  Another explanation for the difference in EBITDA multiples vs. cash flow multiples could be in the financial leverage of AT&T vs. Verizon.  AT&T has more debt (2.9x EBITDA / Net Debt) vs. Verizon (2.5x EBITDA / Net Debt).  The higher leverage level could be contributing to a modestly lower cash flow multiple at AT&T due to the higher risk profile with increased debt.

  2. T-Mobile trades at a discount on EBITDA but a premium on cash flow vs. AT&T and Verizon. This may be due to the higher capex intensity (capex as a % of sales) at T-Mobile vs. AT&T and Verizon.  All else equal, a company with higher capex needs should trade at a slight discount on EV / EBITDA vs. a company with lower capex needs due to the lower conversion to free cash flow.  Additionally, the lease accounting of handsets may be detracting from the comparability of EBITDA vs. peers.

  3. Sprint trades at a meaningful discount on EBITDA vs. its peers. The explanation for Sprint’s low multiple is clear cut.  Sprint has struggled in recent years to retain customers and attract new subscribers.  The company has struggled with a large debt load, lower network quality vs. peers, and zero to negative cash flow.  Due to these difficulties, Sprint’s stock should justifiably trade at a discount vs. peers.

What are the contributing factors to low vs. high valuation multiples?


Let’s evaluate various drivers and how each driver affects valuation multiples.

1. Growth – Higher growth is generally associated with higher valuation multiples as long as the high growth rate is viewed as sustainable. For example, a company that consistently grows cash flow or earnings at 20% may see a valuation multiple in the high teens to low twenties.  However, a company that grows cash flow or earnings at 5% will likely see a lower valuation multiple (possibly low double digits).

Higher growth is less likely to affect the valuation multiple if that high growth is not viewed as sustainable.  For example, if Company A expects its EPS to go from $1 in 2018 to $2 in 2019 to $1 in 2020.  It is unlikely investors will reward Company A with a higher valuation multiple on 2019 EPS.  Instead, the valuation multiple on 2019 EPS will likely contract to reflect the coming decline in earnings in 2020.

Low to negative growth companies are typically associated with very low valuation multiples.  Many of these companies are referred to as “value traps.”  Value traps are companies that appear to offer very attractive valuation multiples, but because the company is in decline, the cheap valuation multiple of today can become an expensive valuation multiple in the future.  Let’s look at an example:

In this example, you can see that this company starts off with an 8.0x P/FCF multiple in 2018.  However, with FCF / share declining 20% per year, this P/FCF multiple starts to look a lot more expensive over time.  By 2022, this company will be trading at a 19.5x FCF multiple based on today’s $16 stock price, which is an expensive multiple for a declining growth rate.  This is a classic “value trap,” which is a company that appears cheap today, but due to deteriorating fundamentals, the investor is unlikely to earn an attractive return.  The P/FCF multiple would only increase in future years if the stock price stayed the same while the FCF/share decreased.  In reality, it is more likely that the P/FCF multiple would stay the same, while the stock price decreases to reflect the ongoing decrease in FCF/share.

You may have noticed something else in the above chart.  We used “P/FCF” instead of “P/CF.”  Many investors use these terms interchangeably and are generally referring to the same thing regardless if investors say “cash flow” or “free cash flow.”

2. Industry / Competition – The industry and competitive positioning of a company is a significant driver of company valuations. For example, companies that are in the consumer staples industry typically trade at high valuation multiples because these investors like owning companies that sell products that consumers need in both good and bad economic times.  Investors view consumer staples as being a defensive industry with less risk of material declines in the business during economic slowdowns.  In a DCF, less risk means lower discount rate which means higher value.  With relative valuation, less risk means higher multiple which means higher value.

Additionally, a company’s competitive positioning within that industry is an important determining factor for the valuation multiple.  For example, Google trades at a healthy valuation multiple partially because there are very few companies that can compete against Google.  Facebook and Amazon can compete for ad dollars, but even these mega cap companies have limited ability to supplant many of Google’s core products, such as Search, YouTube, Google Maps, etc.  Conversely, if you look at a company like Yahoo (while it was still public), this company always traded at a very low multiple since investors viewed Yahoo as a share loser to Google long-term.  This again boils down to risk.  Industry leaders or companies with strong competitive positioning are viewed as having less risk, which leads to a higher multiple.

3. Management Team – Companies with strong management teams are often rewarded with higher valuation multiples. A CEO with a successful track record and strong vision provides investors with confidence about the outlook.  Investor confidence in the management team often manifests itself in premium multiples due to the perception of reduced risk or increased probability of higher growth outcomes.  For example, despite Amazon never having earned a meaningful profit, the company continues to trade at premium earnings and EBITDA multiples.  Part of the reason for the premium valuation is likely due to the fact that Jeff Bezos, the visionary founder and CEO, is still at the helm.  If Mr. Bezos were to step down someday, it is quite possible that the Amazon valuation multiple would take a hit.

4. Margins – The level of EBITDA margin or profit margin often influences the valuation multiple, but it is our belief that the exact margin percentage does not directly influence the valuation multiple. Instead, the valuation multiple is influenced by what the current margin levels signals.

For example, if Company A has a 35% EBITDA margin that is unlikely to change and Company B has a 40% EBITDA margin hat is unlikely to change, then, all else being equal, it is rather unlikely that Company B will trade at a higher EV/EBITDA multiple just because its margin is 5% higher.  However, if investors believe that Company A has identified a credible opportunity to close the margin gap from its current 35% level to 40%, then, investors are likely to bid up the stock of Company A to reflect this potential opportunity.

In the above example, you will see that if Company A is able to close the gap in EBITDA margin to 40%, then, this would imply that their EBITDA would increase from $1,225 to $1,400.  Assuming Company A maintains their EBITDA multiple of 7.0x would imply that Company A’s enterprise value could trade up to $1,400.  However, in financial markets, the stock price will often react before the fundamental change occurs as investors anticipate the coming changes.  Therefore, if the stock trades up such that Company A’s enterprise value hits $1,400 before the actual EBITDA margin improvement, then, the EV/EBITDA multiple would expand to 8.0x temporarily (in anticipation of the EBITDA increase).  Once the EBITDA increases to $1,400, then, the EV/EBITDA multiple would return to 7.0x.

In addition to anticipated changes in margin levels, margins can also provide signals on risk based on the volatility of past margins.  For companies that have large swings in margins from year to year, investors become nervous about the financial outlook and have less confidence that their forecasts will be correct.  Like many of the other factors in this list, less confidence equals higher risk equals higher discount rate equals lower multiple.  Conversely, if a company has very stable margins every year, investors are likely to reward a higher valuation multiple due to their increased confidence that their future expectations will come to fruition.

5. Capex Intensity – Capex intensity is measured as capital expenditures divided by total revenues. It is a measure of how much capex a company must deploy for every $1 of revenue.  Capex intensity is a factor that influences EBITDA and earnings multiples.  Let’s look at an example:

In this example, we present two companies with the same level of EBITDA.  The only difference between the two companies is the amount of capex.  Company A has a capex intensity of 13% vs. Company B with a 28% capex intensity.  The lower capex at Company A leads to a higher FCF/share of $4.75 vs. $3.25 for Company B.  If we assume that Company A and Company B is identical in every other regard (competitive positioning, growth rates, leverage, quality of management team, etc), then, these two companies should theoretically trade at a very similar FCF multiple.

We have assumed that Company A and Company B both trade at a 12.0x FCF multiple, resulting in two different stock prices.  Based on these stock prices, we calculate a higher enterprise value for Company A vs. Company B and therefore a higher EBITDA multiple for Company A vs. Company B.  Company A trades at higher EBITDA multiple because it converts more of its EBITDA to cash flow vs. Company B.  In other words, Company B needs more EBITDA to achieve the same level of free cash flow as Company A, thus the lower EBITDA multiple.

6. Financial Leverage – Financial leverage is typically defined as net debt divided by EBITDA. Companies with high financial leverage (high amounts of debt relative to EBITDA) are sometimes perceived to carry more risk vs. companies with low financial leverage.

Let’s assume Company A and Company B both earn $2 of FCF/share, but Company A has 8.0x leverage and Company B has 1.0x leverage.  All else being equal, which company carries more risk?  A company with 8.0x leverage (which is quite high) clearly has more risk than a company with very little leverage (1.0x leverage), so it is quite likely that Company B will trade at a higher FCF multiple relative to Company A.

7. Interest Rates – If you recall from our discussion of DCF analyses, the risk-free rate (interest rate on long-term US government debt) is a direct input into the cost of equity and cost of debt. Therefore, lower interest rates mathematically lead to higher present value of cash flows.  Lower interest rates in the economy should theoretically manifest itself in higher valuation multiples, and higher interest rates should lead to lower valuation multiples.

Warren Buffett has frequently commented on the role of interest rates in determining stock valuations.  Below is a quote from Buffett in 2017, a year marked by very low interest rates:

“The most important item over time in valuation is obviously interest rates.  If interest rates are destined to be at low levels, it makes any stream of earnings from investments worth more money. The bogey is always what government bonds yield.”

8. The Economic Cycle – The overall economic environment is also a very important factor in determining overall valuation multiples. Generally, during periods of high uncertainty (bad economic times), the S&P 500 valuation multiple compresses as investors become unwilling to take significant risk given nervousness on the economy and broad declines in the equity markets.  Conversely, during good economic times, investors become more confident about the outlook and become more willing to take on increased risk, which typically manifests itself in higher valuation multiples.

Theoretically, there is an argument to be made that during bad economic times, valuation multiples should increase since the low level of earnings is likely to rebound once the recession passes.  Closer to the end of the economic cycle, there is also an argument that valuation multiples should compress in anticipation of the economic cycle coming to an end, resulting in lower earnings in the near future.  However, in reality, investors cannot reliably predict the timing of the start and end of economic cycles.  Instead, investor fear tends to drive lower valuation multiples during bad times and investor greed drives higher valuation multiples during good times.

The above list is not a comprehensive list of every factor affecting valuation multiples.  As you gain experience with investing, you will certainly come across other factors that drive valuation multiples.

Which valuation methodology is better: DCF or Relative Valuation?


Every investor will answer this question differently.  Some investors prefer DCF valuations.  Some prefer relative valuations, and some investors like doing both DCF and relative valuations.

As discussed earlier in the lesson, there are advantages and disadvantages to both valuation methodologies.  It is important to become comfortable with both methodologies and decide over time for yourself if you prefer one method over the other.

While we recognize many of the advantages of DCFs, our personal preference is to rely on relative valuation methods in deriving price targets for stocks.  This is primarily due to the speed, simplicity, and lower odds of calculation error.  Additionally, as an investor gains experience in particular industries, an investor becomes very familiar with historic multiples.  For example, if we know Company A has traded in a P/E ratio range of 10x – 20x over the last 20 years, then, we are able to quickly identify when there are good buying opportunities in Company A stock.