Tell apart valuation by comparables and valuation by forecasted fundamentals
The idea
Relative valuation comes in two forms. The method of comparables prices a share against what the market pays for similar firms, using a multiple such as a peer median P/E, and so answers whether it is cheap or dear relative to those peers; if the whole group is mispriced, the answer inherits the error. The method of forecasted fundamentals instead derives the multiple a firm should command from its own expected growth, payout and required return, for example a justified forward P/E of payout ratio / (r - g). The first reflects market prices and is easy to explain; the second ties the multiple to intrinsic value but depends on forecasts. Comparing the two shows whether a gap comes from the company or from the market's pricing of the whole sector.
A practice question
Under the method of comparables, an analyst concludes that a share is attractive because:
- its multiple is low relative to similar firms — correct
- its price is below the present value of its dividendsWhy not: That is an absolute (intrinsic) valuation conclusion, reached by discounting cash flows, not by comparing multiples with peers.
- its multiple is below the long-run market averageWhy not: A market-wide average ignores differences in growth and risk; comparables benchmark against similar firms, not the whole market.
The method of comparables applies the law of one price: similar assets should trade at similar multiples, so a multiple below the peer benchmark signals relative undervaluation.
A harder one
Hanlow Engineering expects a constant payout ratio of 40%, a required return on equity of 10% and a long-term growth rate of 5%. Its justified forward P/E is closest to:
- 8.4Why not: Multiplies the payout by (1 + g), which gives the justified trailing P/E rather than the forward P/E.
- 12.0Why not: Uses the 60% retention ratio in the numerator instead of the 40% payout ratio.
- 8.0 — correct
Justified forward P/E = payout / (r − g) = 0.40 / (0.10 − 0.05) = 8.0.
The hardest tier
Brellin Tools has just paid a dividend equal to 45% of its latest EPS. Its required return is 11% and dividends are expected to grow at 6% indefinitely. Its justified trailing P/E is closest to:
- 9.00Why not: Omits the (1 + g) factor, which gives the justified forward P/E rather than the trailing P/E.
- 4.34Why not: Divides by the required return alone instead of by the spread between the required return and growth.
- 9.54 — correct
Justified trailing P/E = payout × (1 + g) / (r − g) = 0.45 × 1.06 / (0.11 − 0.06) = 0.477 / 0.05 = 9.54.
In the app: 6 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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