Market Based Valuation

Section: Market-Based Valuation — Price and Enterprise Value Multiples Estimated study time: 60 minutes Content: Market-based (relative) valuation compares a company's price or enterprise value to a fundamental metric — earnings, book value, sales, or cash flow — and benchmarks this multiple against comparable companies, historical norms, or justified fundamental values. At CFA Level 2, candidates must understand why multiples differ across companies (the economic drivers of valuation multiples), how to select appropriate comparables, how to adjust for differences in leverage and accounting, and how to apply both trailing (based on past results) and forward (based on next-year estimates) multiples. Market-based valuation is the dominant practical approach in equity research and M&A, used both for primary valuation and as a cross-check on DCF estimates. The Price-to-Earnings (P/E) ratio is the most widely used equity multiple. Forward P/E = Current Price / Next Twelve Months EPS; Trailing P/E = Current Price / Last Twelve Months EPS. The fundamental drivers of P/E are derived from the DDM: justified P/E = D1/E1 / (r - g) = payout ratio / (r - g). This shows that P/E is positively related to payout ratio and growth (g) and negatively related to required return (r). Companies in the same industry may trade at very different P/E multiples due to differences in growth prospects, quality of earnings, leverage (financial risk), and management quality. The P/E ratio can be distorted by: non-recurring items (write-downs, gains on asset sales); negative earnings (the ratio is undefined); cyclical earnings (automotive and commodity companies should use normalized or mid-cycle EPS); and different depreciation or accounting policies. The Price-to-Book (P/B) ratio compares market value to accounting book value of equity. Fundamental…