Assess a stock with comparables and explain why fundamentals matter when applying that method
The idea
The method of comparables follows a sequence: choose comparable companies, usually in the same industry and similar in size, growth and risk; calculate their multiples and a central value; compare the subject company's multiple with it; and examine whether differences in fundamentals explain any gap. Fundamentals matter because a gap in multiples signals mispricing only when the companies are otherwise alike. A company with higher expected growth, lower risk or higher ROE deserves a higher P/E or P/B. Analysts may also compare a company with its own history, but only if interest rates and business conditions are similar to those in the past. The trap is inferring mispricing from a gap that fundamental differences fully explain.
In the app: 1 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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- Contrast comparables with forecasted fundamentals as ways of applying price multiples when valuing, and set out the economic logic behind each
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- Set out why one might value a stock with dividend yield or alternative price multiples and what can go wrong
- Work out dividend yield and alternative price multiples and explain what they mean
- Work out underlying earnings and explain them, set out ways to normalise earnings per share (EPS), and compute normalised EPS
- Explain earnings yield (E/P) and argue for its use
- Set out the fundamentals that drive dividend yield and alternative price multiples
- Use a cross-sectional regression on fundamentals to predict a P/E, explain the result, and explain where such regressions fall short
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- Work out the PEG (P/E-to-growth) ratio, explain what it means and how it is used in relative valuation
- Work out terminal value for a DCF (discounted cash flow) model with several stages from price multiples and explain this use
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- Work out EV multiples, explain what they mean and assess how useful EV/EBITDA is
- Explain why valuation comparisons across borders can differ
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- Explain how the median, arithmetic mean, harmonic mean and weighted harmonic mean summarise the typical level of a set of multiples