Valuation: What's it worth?

 

Valuation: What's it worth?

https://myinvestingnotes.blogspot.com/2009/11/valuation-whats-it-worth.html

Business Valuation: A Practical Guide for Investors

When assessing a business's worth, understand there is no single "right" answer. Valuation is a blend of art and science. Use multiple methods to triangulate a fair value, and always seek independent professional advice. Here are the four core techniques you need to know.

1. Asset Valuation (The Floor Price)

• What it is: The business's liquidation value.

• How it works: Assets – Liabilities = Net Asset Value.

• Investor Insight: This sets the absolute minimum price. It tells you what you could recover if the business closed today. It ignores future profit potential and intangibles like brand reputation (goodwill). Useful for asset-heavy or underperforming businesses, but will understate the value of any profitable, going concern.

2. Capitalised Future Earnings (The Income Standard)

• What it is: The most common method for small businesses. It values the stream of future profits.

• How it works: (Adjusted Average Net Profit ÷ Desired Rate of Return) x 100.

• Investor Insight: This method answers a key question: "What price gives me my target return?" The critical input is your required rate of return, which must reflect the business's risk. A higher risk demands a higher return, which lowers the price you should pay. Compare this return to other investments (e.g., stocks, bonds) to gauge attractiveness.

3. Earnings Multiple (The Market Shortcut)

• What it is: A quick, market-driven method based on a profitability metric.

• How it works: Earnings Before Interest & Tax (EBIT) x Industry Multiple.

• Investor Insight: Its power is simplicity, but the multiple is everything. Multiples range widely (often 1x to 6x for private companies) based on industry, growth potential, and profit stability. Action: Consult brokers to find the current multiple for similar businesses. This method is excellent for cross-checking against the Capitalised Earnings result.

4. Comparable Sales (The Reality Check)

• What it is: The market-based benchmark—what are similar businesses actually selling for?

• How it works: Research recent, arms-length sales of comparable businesses in your sector.

• Investor Insight: This grounds your valuation in market reality. Just like real estate, recent "comps" are the ultimate price determinant. Speak to multiple brokers and scan industry listings. If your calculated value is far from market prices, re-examine your assumptions.

---

Investor Action Plan

1. Calculate All Four: Run the numbers using each method to establish a value range.

2. Weight the Methods: For a profitable service business, emphasize Earnings methods. For a struggling capital-intensive firm, the Asset value may be key.

3. Stress-Test Key Inputs: Vary your required rate of return and earnings multiple. How sensitive is the valuation?

4. Quantify Goodwill: If paying above asset value, identify what you're paying for (customer base, location, brand). Is it transferable?

5. Get the Data: Use Comparable Sales to anchor your offer in the real market.

6. Engage a Professional: A business valuer or broker provides critical, objective analysis and market intelligence.

Final Warning: Valuation is the starting point for negotiation, not the final price. The true "worth" is what a informed buyer is willing to pay and a motivated seller is willing to accept, based on a disciplined analysis of these fundamentals.

How is a P/E multiple used? The Price/Earnings Multiple Enigma

 

How is a P/E multiple used?  The Price/Earnings Multiple Enigma

https://myinvestingnotes.blogspot.com/2009/11/how-is-pe-multiple-used.html

Summary

The article from November 2009 explains the Price-to-Earnings (P/E) ratio and its variants as fundamental tools for stock valuation. Key points include:

1. Definition and Calculation:

   • The P/E ratio is calculated as the market price per share divided by earnings per share (EPS).

   • The trailing P/E uses historical (past year or last four quarters) EPS.

   • The forward P/E uses projected future EPS, which incorporates growth expectations.

2. Usage and Interpretation:

   • P/E reflects the premium investors are willing to pay based on a company’s future growth prospects.

   • It helps assess whether a stock is overvalued or undervalued, but must be compared within context (industry, growth rates, management quality).

   • A higher P/E may indicate higher expected growth or superior company fundamentals, not necessarily overvaluation.

3. Limitations of Historical P/E:

   • Trailing P/E fails to capture recent events (e.g., mergers) or future expectations, making forward P/E more relevant for investment decisions.

4. Introduction to PEG (Price/Earnings-to-Growth) Ratio:

   • PEG refines P/E analysis by dividing the P/E ratio by the expected earnings growth rate (e.g., over the next 2–3 years).

   • A lower PEG suggests a more attractive investment. A rule of thumb:

     • PEG < 0.5: Undervalued

     • PEG = 1: Fairly valued

     • PEG > 2: Overvalued

5. Important Caveats:

   • P/E cannot be used for loss-making companies (no earnings).

   • Qualitative factors (transparency, management quality) influence P/E multiples.

   • Comparisons should account for industry differences (e.g., utilities vs. tech).

---

Discussion and Commentary

The article remains largely relevant today, as P/E and PEG are still widely used in equity analysis. However, some nuances and modern contexts can be added:

Strengths of the Article:

• Clarity on Forward vs. Trailing P/E: It correctly emphasizes that forward P/E is more meaningful for investment decisions, as markets are forward-looking.

• Context Matters: It highlights that P/E cannot be viewed in isolation—industry dynamics, growth rates, and qualitative factors must be considered.

• PEG as a Refinement: Introducing PEG helps adjust for growth, addressing a key limitation of P/E.

Limitations and Additional Considerations:

1. Earnings Manipulation: Both trailing and forward P/E rely on reported or projected EPS, which can be distorted by accounting practices or one-time items. Analysts often use adjusted EPS to mitigate this.

2. Interest Rate Environment: The article briefly mentions macroeconomic factors but does not deeply explore how interest rates affect P/E multiples. In low-rate eras, higher P/Es are more common (and vice versa).

3. Sector Exceptions: While P/E works for most sectors, it is less useful for capital-intensive, cyclical, or high-growth companies (e.g., early-stage tech) where earnings may be volatile or negative. Alternatives like P/S (Price-to-Sales) or EV/EBITDA may be preferred.

4. PEG’s Shortcomings: PEG assumes a linear relationship between P/E and growth, which may not hold for very high or low growth rates. It also depends on the accuracy of growth projections, which are often unreliable.

Modern Context:

• With the rise of FAANG-style tech stocks and unicorns, many investors now tolerate high P/Es (or negative earnings) based on disruptive potential, network effects, or scalability, challenging traditional P/E frameworks.

• Quantitative easing (post-2008) and low-interest-rate regimes have pushed P/E multiples higher globally, making historical averages less reliable benchmarks.

• ESG (Environmental, Social, Governance) factors are increasingly priced into multiples, affecting investor perception beyond pure earnings growth.

---

Conclusion

The article provides a solid foundational understanding of P/E and PEG ratios, emphasizing their utility and limitations. While its core principles endure, investors today must also consider macroeconomic conditions, sector-specific nuances, and alternative metrics—especially in markets dominated by growth and innovation. P/E remains a starting point for valuation, but a holistic approach combining quantitative metrics with qualitative judgment is essential.

****Earnings Multiples by Aswath Damodaran

 

****Earnings Multiples by Aswath Damodaran

https://myinvestingnotes.blogspot.com/2009/11/earnings-multiples-by-aswath-damodaran.html

PE Ratio and Fundamentals

Proposition: Other things held equal, higher growth firms will have higher PE ratios than lower growth firms.

Proposition: Other things held equal, higher risk firms will have lower PE ratios than lower risk firms

Proposition: Other things held equal, firms with lower reinvestment needs will have higher PE ratios than firms with higher reinvestment rates.

Of course, other things are difficult to hold equal since high growth firms, tend to have risk and high reinvestment rates.


PEG Ratios and Fundamentals: Propositions

Proposition 1: High risk companies will trade at much lower PEG ratios than low risk companies with the same expected growth rate.

• Corollary 1: The company that looks most under valued on a PEG ratio basis in a sector may be the riskiest firm in the sector

Proposition 2: Companies that can attain growth more efficiently by investing less in better return projects will have higher PEG ratios than companies that grow at the same rate less efficiently.

• Corollary 2: Companies that look cheap on a PEG ratio basis may be companies with high reinvestment rates and poor project returns.

Proposition 3: Companies with very low or very high growth rates will tend to have higher PEG ratios than firms with average growth rates. This bias is worse for low growth stocks.

• Corollary 3: PEG ratios do not neutralize the growth effect.


Relative PE: Definition

The relative PE ratio of a firm is the ratio of the PE of the firm to the PE of the market.

Relative PE = PE of Firm / PE of Market
While the PE can be defined in terms of current earnings, trailing earnings or forward earnings, consistency requires that it be estimated using the same measure of earnings for both the firm and the market.

Relative PE ratios are usually compared over time. Thus, a firm or sector which has historically traded at half the market PE (Relative PE = 0.5) is considered over valued if it is trading at a relative PE of 0.7.

The average relative PE is always one.

The median relative PE is much lower, since PE ratios are skewed towards higher values. Thus, more companies trade at PE ratios less than the market PE and have relative PE ratios less than one.

=====

Simple Summary:

Think of a company's stock price like the price tag on a car.

1. PE Ratio = Price tag ÷ yearly earnings

• Faster growth = higher price tag (like a newer model)

• More risky = lower price tag (like a car with problems)

• Needs lots of repairs/reinvestment = lower price tag (takes money to maintain)

2. PEG Ratio = (PE Ratio) ÷ growth rate
Tries to be "fair" by considering growth, but has problems:

• Doesn't account for risk (a dangerous but fast-growing company looks cheap)

• Doesn't account for efficiency (a company that spends wastefully looks cheap)

• Doesn't work well for very slow or very fast growers

3. Relative PE = Your car's price ÷ average car price

• Helps see if your car is expensive compared to the market

• Most cars are cheaper than average (because a few super-expensive cars pull the average up)

• Best used to compare over time (is your car more expensive than it usually is?)

Big Picture:
You can't just look at the price tag alone. You need to ask:

• Is it growing fast?

• Is it risky?

• Does it need lots of maintenance spending?

Two companies with the same PE might be completely different—one might be a safe, efficient grower while the other is a risky, wasteful grower. The numbers tell the story only when you understand what's behind them.

Not all growth is created equal.

Good Growth (Valuable) = Higher PE
This is efficient, profitable, and sustainable growth. The company grows its earnings by:

• Reinvesting a smaller amount of money

• Into projects with high returns (like 20-30% returns)

• While taking on reasonable risk

Example: A software company that grows 15% per year simply because its existing customers love the product and pay more (high margins, low extra cost). This deserves a high price tag (high PE).

Bad Growth (Destructive) = Lower PE
This is inefficient, unprofitable, or risky growth. The company grows by:

• Reinvesting a massive amount of money (eating up cash flow)

• Into projects with low or mediocre returns (like 5-8% returns, maybe below its own cost of capital)

• While taking on high risk

Example: A construction company that only grows by taking on huge, low-margin projects with lots of debt. It's growing revenue, but destroying shareholder value. This deserves a lower price tag (low PE).

---

Why the PEG Ratio Fools People:
A company with Bad Growth might look cheap on a PEG ratio because it has a low PE (bad) divided by a high growth rate (seemingly good).

PEG = (Low PE due to bad growth) / (High Growth Rate from risky projects)

The math gives you a small, "attractive" PEG number, tricking you into thinking it's a bargain. In reality, the market has given it a low PE for a good reason—its growth is dangerous or wasteful.

That's why Damodaran says: "Other things are difficult to hold equal." The moment you see high growth, you must immediately ask: "At what cost and at what risk?"

=====

More detailed discussion:

These are key principles from Aswath Damodaran’s work. 

Summary & Core Idea

Damodaran systematically links valuation multiples (PE, PEG, Relative PE) to the three fundamental drivers of value: Growth, Risk, and Reinvestment (which drives cash flows). The central theme is that multiples are not arbitrary but are determined by these underlying financial realities.

---

Elaboration & Commentary

1. PE Ratio and Fundamentals

Damodaran’s three propositions decompose the standard discounted cash flow model into its PE implications:

• Growth ↑ → PE ↑: Because future earnings are more valuable.

• Risk ↑ → PE ↓: Higher discount rate reduces present value.

• Reinvestment Needs ↑ → PE ↓: More capital must be plowed back to sustain growth, reducing free cash flow to equity.

Key Insight: In practice, these variables are correlated. High-growth firms often face higher risk and require high reinvestment, creating a natural tension. A firm with high growth but very high risk and reinvestment may still have a low PE. This explains why a simplistic “high PE = overvalued” approach fails.

2. PEG Ratios and Fundamentals

The PEG ratio (PE / Growth Rate) attempts to standardize for growth, but Damodaran shows its severe limitations:

• Proposition 1: Risk is ignored in PEG. A risky firm with high growth may have a deceptively low PEG, luring investors who don’t adjust for risk (Corollary 1).

• Proposition 2: Reinvestment efficiency (ROIC vs. Cost of Capital) matters. Two firms with 20% growth aren’t equal if one achieves it by investing 50% of earnings at a 40% return, and the other invests 80% at a 25% return. The more efficient firm deserves a higher PEG (Corollary 2 warns of “cheap” PEG traps).

• Proposition 3: PEG is non-linear and skewed. Very low-growth firms (<5%) often have high PEs due to stable cash flows or dividend yields, inflating PEG. Very high-growth firms (>30%) often have high PE due to anticipation of sustained advantage. Thus, comparing a 2% growth firm (PEG=15) to a 25% growth firm (PEG=1) is misleading.

Bottom line: PEG does not neutralize growth and can be dangerously misleading across different risk, return, and growth ranges.

3. Relative PE

Relative PE (Firm PE / Market PE) is a normalization metric to compare across time or against historical norms.

• It controls for market-level interest rates, risk premiums, and macroeconomic conditions affecting all PEs.

• Comparison over time is its strength: If a firm historically traded at 0.8× market PE but now trades at 1.2×, it signals overvaluation relative to its own history, assuming fundamentals haven’t changed.

• Skewness note: Damodaran highlights that the average relative PE is 1.0 (by definition), but the median is less than 1 because the PE distribution has a long right tail (some very high PE firms pull the average up). This means more than half of firms trade below the market PE—a crucial statistical insight often missed.

---

Critical Implications & Practical Use

1. Multiples are proxies for DCF: Every multiple embeds assumptions about growth, risk, and reinvestment. Use them only after understanding what those assumptions are.

2. PEG is flawed but popular: Its simplicity drives its use, but it’s unreliable for cross-sectional comparisons unless firms have similar risk, reinvestment needs, and growth rates. Better to use a PEG adjusted for risk and ROIC.

3. Relative PE for historical context: More useful than absolute PE when judging whether a stock is expensive relative to its own historical range or the market cycle.

4. The “other things held equal” caveat: This is the entire challenge in practice. When comparing multiples, you must ask: Are growth, risk, and reinvestment profiles similar? If not, difference in multiples may be justified.

5. Screening pitfalls: Screening for low PE or low PEG often selects firms with high risk, poor growth prospects, or low efficiency—precisely the “value traps.”

Using Multiples

The use of multiples can increase valuations based on DCF analysis.

There are five requirements for making useful analyses of comparable multiples:

1. value multibusiness companies as a sum of their parts,
2. use forward estimates of earnings,
3. use the right multiple,
4. adjust the multiple for nonoperating items, and,
5. use the right peer group.

1.  Value Multibusinesses companies as a sum of their parts

Multibusiness companies' various lines of business typically have very different growth and ROIC expectations.

These firms should be valued as a sum of their parts.



2,  All Multples should use forward estimates of earnings

All multiples should be forward-looking rather than based on historical data, as valuation of firms is based on expectations of future cash flow generation.


3.  Use the Right Multiples

(a) Value-to-EBITA & P/E Multiples

The right multiple is often the value-to-EBITA ratio.

This measure is superior to the price-to-earnings (P/E) ratio because:

• capital structure affects P/E and 
• nonoperating gains and losses affect earnings.

(b) Alternative Multiples

Alternatives to the value-to-EBITA and P/E multiples include

• the value-to-EBIT ratio, 
• the value-to-EBITDA ratio, 
• the value-to-revenue ratio, 
• the price-to-earnings-growth (PEG) ratio, 
• multiples of invested capital, and 
• multiples of operating metrics.

4.  Adjust the multiples for nonoperating items

All of these ratios should be adjusted for the effects of nonoperating items.



5.  Use the right Peer Group

The peer group is important.

The peer group should consist of companies whose underlying characteristics (such as production methodology, distribution channels, and R&D) lead to similar growth and ROIC characteristics.

Price Multiples - Relative Valuation

Price multiples are ratios that compare the price of a stock to some sort of value.

Price multiples allow an analyst to evaluate the relative worth of a company's stock.

Popular multiples used in relative valuation include:

• price-to-earnings,
• price-to-sales,
• price-to-book, and
• price-to-cash flow.

Business value cannot be precisely determined. Make use of ranges of values.

Business value cannot be precisely determined. 

Not only do a number of assumptions go into a business valuation, but relevant macro and micro economic factors are constantly changing, making a precise valuation impossible. 

Although anyone with a calculator or a spreadsheet can calculate a net present value of future cash flows, the precise values calculated are only as accurate as the underlying assumptions.

Investors should instead make use of ranges of values, and in some cases, of applying a base value. 

Ben Graham wrote:

The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate—e.g., to pro­tect a bond or to justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.

There are only three ways to value a business. 

1.   The first method involves finding the net present value by discounting future cash flows. 

Problems with this method involve trying to predict future cash flows, and determining a discount rate. 

Investors should err on the side of conservatism in making assumptions for use in net present value calculations, and even then a margin of safety should be applied.

2.  The second method is Private Market Value using Multiples. 

This is a multiples approach (e.g. P/E, EV/Sales) based on what business people have paid to acquire whole companies of a similar nature. 

The problems with this method are that comparables assume businesses are all equal, which they are not. 

Furthermore, exuberance can cause business people to make silly decisions. 

Therefore, basing your price on a price based on irrationality can lead to disaster. 

This is believed to be the least useful of the three valuation methods.

3.  Finally, liquidation value as a method of valuation. 

A distinction must be made between a company undergoing a fire sale (i.e. it needs to liquidate immediately to pay debts) and one that can liquidate over time. 

Fixed assets can be difficult to value, as some thought must be given to how customised the assets are (e.g. downtown real-estate is easily sold, mining equipment may not be).

When should each method be employed? 

They can all be used simultaneously to triangulate towards a value. 

In some cases, however, one might place more confidence in one method over the others. 

For example, 

• liquidation value would be more useful for a company with losses that trades below book value, while 
• net present value is more useful for a company with stable cash flows.

Using the methods of valuation described, you can search for stocks that are trading at a severe discount; it is possible, their stock price more than doubled soon after.

Beware of these failures

The failures of relying on a company's earnings per share - too easily massaged.

The failure of relying on a company's book value  - not necessarily relevant to today's value.

The failure of relying on a company's dividend yield - incentives of management to make yields appear attractive at the expense of the company's future.

Read also:

• 
  
• Your investments using Mutual Funds or Money Managers
• Trading and portfolio management from a value investing point of view
• Value Investor's Opportunities in Distressed Securities
• Value Investing Opportunities in the Banking Sector
• Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions
• Where to look for Investment Opportunities
• Business value cannot be precisely determined. Make use of ranges of values
• Central elements to a Value Investing Philosophy
• The Philosophy of Value Investing and Why It Works
• Philosophy of value investing. Need to have clear strategies too
• How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s
• Understanding these changes in the investment world allows investors to earn superior returns
• What's good for Wall Street is not necessarily good for investors
• Speculators, Investors and Market Fluctuations