Underlying Assumptions in Comparable Valuation

Assume that you are reading an equity research report where a buy recommendation for a company is being based upon the fact that its PE ratio is lower than the average for the industry. Implicitly, what is the underlying assumption or assumptions being made by this analyst?

a. The sector itself is, on average, fairly priced b. The earnings of the firms in the group are being measured consistently c. The firms in the group are all of equivalent risk d. The firms in the group are all at the same stage in the growth cycle e. The firms in the group are of equivalent risk and have similar cash flow patterns f. All of the above

9bl._ - pe.xls: There is a dataset on the web that summarizes PE ratios and PEG ratios by industry group in the United States for the most recent quarter.

b. Adjusting for more than one variable

When firms differ on more than one variable, it becomes difficult to modify the multiples to account for the differences across firms. We can run regressions of the multiples against the variables and then use these regressions to find predicted values for each firm. This approach works reasonably well when the number of comparable firms is large and the relationship between the multiple and the variables is stable. When these conditions do not hold, a few outliers can cause the coefficients to change dramatically and make the predictions much less reliable.

Illustration 12.15: Price to Book Value Ratios and Return on Equity: European Banks

Table 12.9 lists price/book value ratios of European banks and reports on their returns on equity and risk levels (measured using the standard deviation in stock prices over the previous 5 years):

Table 12.9: European Banks: Price to Book Value Ratio - 2003


PBV Ratio

Return on Equity

Standard Deviation

Bayerische Hypo-Und Vereinsb

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