LOS b: Distinguish between the method of comparables and the method based on forecasted fundamentals as approaches to using price multiples in valuation, and discuss the economic rationales for each.

In the DCF valuation method, an analyst makes specific assumptions about each variable, such as growth, risk, payout, etc. The valuation using P/E multiples will be closest to the one obtained using the DCF approach when fundamental data -- for growth, risk, payout, etc. -- is used to estimate P/E multiples.

The use of comparable firms is quite common, because it is conceptually very straightforward. Also, it does not require the analyst to make specific assumptions regarding growth, risk, and other variables. However, it is often difficult to find comparable firms, since even within the same industry different firms can have different business mixes and risk and growth profiles.

The method of forecasted fundamentals relates multiples to company fundamentals using a DCF method. It does not explicitly rely on the Law of One Price. Further, it does not typically focus on benchmarks.

The method of comparables involves using a price multiple to evaluate whether an asset is valued properly relative to a benchmark value of the multiple. It makes no explicit assumptions about fundamentals and does not rely on a DCF model.

The method of forecasted fundamentals is based on the rationale that stock values differ due to differences in the expected values of fundamentals such as sales, earnings, or related growth rates.

Sanford’s adjusted CFO is equal to net income plus depreciation minus the increase in net working capital (excluding cash and notes payable) plus after-tax interest expense:

Sanford is overvalued relative to the industry benchmark because its P/adjusted CFO ratio is higher than the industry median of 2.0, despite slightly higher systematic risk (as measured by beta) and a lower 5-year earnings growth forecast. (Study Session 12, LOS 43.m)

Using relative valuation methods that require the use of comparable firms is challenging in an international context due to differences in accounting methods, cultures, risk, and growth opportunities. Further, benchmarking is difficult because P/Es for individual firms in the same industry vary widely internationally, and country market P/Es can vary significantly. Common differences in international accounting treatment fall into several categories: goodwill, deferred income taxes, foreign exchange adjustments, R&D, pension expense, and tangible asset revaluations.

The usefulness of all price multiples is affected to some degree by differences in international accounting standards. The least affected are price-to-cash flow ratios (including P/adjusted CFO), while P/B, P/E, P/S, P/EBITDA, and EV/EBITDA will be more seriously affected because they are more affected by management’s choice of accounting methods and estimates. (Study Session 12, LOS 43.n)

The first step is to adjust the book value for the actual pension liability, which is equal to the difference between the fair value of the plan assets and the PBO: $1,000 – $1,600 = –$600. The offsetting entry to equity is a decrease of $600(1 – 0.4) = $360. Therefore book value per share for 2008 is:

The value of the common equity according to the single-stage residual income model is:

(Study Session 12, LOS 45.d)

The first step is to adjust the book value for the actual pension liability, which is equal to the difference between the fair value of the plan assets and the PBO: $1,000 – $1,600 = –$600. The offsetting entry to equity is a decrease of $600(1 – 0.4) = $360. Therefore book value per share for 2008 is:

BVPS = (7,189-360) / 500 = $13.66

The implied growth rate can be calculated as:

(Study Session 12, LOS 45.g)