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Market Based Valuation - Part 2 (Price-to-Book Value Multiple (Rationales,…

- - - - A firm might be fairly valued within the industry but over- or under-valued relative to the broad market.
        
        Adjust for differences in fundamentals & size
        
        Financial databases often report the average P/E of the market with individual P/Es weighted by the company’s market cap.
        
        Use relative values on a historical basis to verify if the equity index itself is efficiently priced.
        
        Higher market P/E than average of historical market P/E (as in 2001 compared to the average of 1871-2001) is because of either,
        - Lower-than-average interest rates and/or,
        
        Higher-than-average expected growth rate.
        
        The market is as a whole overvalued (as was the case in 2001 which was followed by a sharp downturn in US equities), or
        
        That the earnings are abnormally low.
    - - Law of one price
        
        Risk & earnings growth adjustments for different P/Es
        
        Firms with expected earnings growth higher than the benchmark should sell for higher price multiples.
        
        Firms with higher risk than the benchmark should sell for lower price multiples.
        
        One method of adjusting for differences in expected earnings growth between the firm and the benchmark is to calculate the P/E-to-growth ratio (PEG) – lower PEG is more attractive, lower than 1 are especially attractive. (In other words, a stock with greatest expected growth rate (or lowest risk) is more attractively valued)
        
        When using peer company multiples as a benchmark, we use the average/ median P/E of the most closely matched individual stock as a benchmark.
        
        However, using the average or median of a group of stocks or an equity index in typically expected to generate less valuation error than using a single stock.
        
        Economists & investment analysts often group the companies by similarities and differences in their business operations into sectors or based on their industry classifications.
    - - Rationale: Regression of P/E to the Mean over time
        
        Approaches:
        
        Average of four middle values over past 10 years
        
        Five-year average trailing P/E
        
        Potential Problems from Changes in
        
        Firm business
        
        Firm financial leverage
        
        Interest rate environment
        
        Economic fundamentals
        
        Inflationary environment
    - - Mean vs. median
        
        Check industry valuation against market
    - - Risk-free rate is a component of the required rate of return that is inversely related to value.
        
        Based on the Fed Model, the return on the S&P 500 is predicted on the basis of the relationship between forecasted earnings yields and yields on bonds.
        
        The two yields are closely linked
        
        The earning yield E/P is inverse of Price Earning ratio (P/E)
        
        If the market earning yield (E/P) for S&P 500 is lower than 10-year T-bond yield, the S&P is considered overvalued, because the T-bond offers a higher yield than the stock, making stocks unattractive.
        
        For the same reason, a lower earning yield of the S&P 500 than the 10-year T-bond yield offers an overvalued, less attractive investment in the S&P 500 compared to 10-year bond.