LOS 43.o: Describe the main types of momentum indicators and their use in valuation.

Momentum indicators relate either the market price or a fundamental variable like EPS to the time series of historical or expected value. Common momentum indicators include earnings surprise, standardized unexpected earnings, and relative strength.

Unexpected earnings or earnings surprise is the difference between reported earnings and expected earnings:

earnings surprise = reporred EPS - expected EPS

This is usually scaled by a measure that expresses the variability of analysts' EPS forecasts. The economic rationale for examining earnings surprises is that positive surprises may lead to persistent positive abnormal returns.

Similarly, the standardized unexpected earnings (SUE) measure is defined as:

standardized unexpected earnings (SUE) =-earnings surprise-

standard deviation of earnings surprise

A given size forecast error is more meaningful the smaller the size of the historical forecast errors.

Relative strength indicators compare a stock's price or return performance during a given time period with its own historical performance or with some group of peer stocks. The economic rationale is that patterns of persistence or reversal may exist in stock returns. These are thought to possibly depend on the length of an investor's time horizon.

key concepts

The justified price multiple for rhe method of comparables is an average multiple of similar stocks in the same peer group. The economic rationale for the method of comparables is the Law of One price, which asserts that two similar assets should sell at comparable prices (i.e., multiples). It's a relative valuation method, so we can only assert that a stock is relatively over or undervalued relative to some benchmark.

The justified price multiple for the method of forecasted fundamentals is the ratio of the value of the stock from a discounted cash flow (DCF) valuation model divided by some fundamental variable (e.g., earnings per share). The economic rationale for the method of forecasted fundamentals is that the value used in the numerator of the justified price multiple is derived from a DCF model that is based on the most basic concept in finance: value is equal to the present value of expected future cash flows discounted at the appropriate risk-adjusted rate of return.

A justified price multiple is what the multiple should be if the stock is fairly valued. If the actual multiple is greater than rhe justified price multiple, the stock is overvalued; if the actual multiple is less than the justified multiple, the stock is undervalued (all else equal).

LOS 43.c

Advantages of using P/Es in valuation are:

• Earnings power is the primary determinant of value.

• P/E differences are related to long-run average stock returns.

Disadvantages of using P/Es in valuation are:

• Earnings can be negative.

• The volatile, transitory portion of earnings makes interpretation difficult.

• Management discretion distorts reported earnings.

Trailing and leading P/E ratios are calculated as:

EPS over previous 12 months market price per share forecasted EPS over next 12 months leading P/E =

LOS 43.c (continued)

The following are advantages of using P/B:

• Book value is usually positive, even when EPS is negative.

• Book value is more stable than EPS.

• Book value is an appropriate measure of net asset value for firms that primarily hold liquid assets.

• P/B can be useful in valuing companies that are expected to go out of business.

• P/Bs help explain differences in long-run average stock returns.

The following are disadvantages of using P/B:

• P/Bs do not recognize the value of nonphysical assets.

• P/Bs can mislead when there are significant size differences.

• Different accounting conventions can obscure the true investment in the firm made by shareholders.

• Inflation and technological change can cause the book and market value of assets to differ significantly.

The price to book ratio is calculated as:

„,_ market value of equity market price per share

book value of equity book value per share

The following are advantages of using P/S ratios:

• The ratio is meaningful even for distressed firms.

• Sales figures are not as easy to manipulate or distort as EPS and book value.

• P/S ratios are not as volatile as P/E multiples.

• P/S ratios are appropriate for valuing stocks in mature or cyclical industries and start-up companies with no record of earnings.

• Differences in P/S are significantly related to differences in long-run average stock returns.

The following are disadvantages of using P/S ratios:

• High growth in sales does not necessarily indicate operating profits.

• P/S ratios do not capture differences in cost structures across companies.

• While less subject to distortion than earnings, revenue recognition practices can distort sales forecasts.

P/S multiples are computed as:

market value of equity market price per share

rotal sales sales per share

Advantages of using price to cash flow include:

• Cash flow is harder for managers to manipulate than earnings.

• Price to cash flow is more stable than price to earnings.

• Earnings quality is not as important with cash flow as with earnings.

• Differences in price to cash flow are related ro differences in long-run average stock returns.

Disadvantages of using price to cash flow include:

• The EPS plus noncash charges estimate ignores items affecting actual cash flow from operations.

• FCFE is preferred, but is more volatile than cash flow.

Underlying earnings are earnings that exclude nonrecurring componenrs. Normalized earnings are earnings adjusted for the business cycle using either the method of historical EPS or the method of average ROE. The method of average ROE is preferred.

A high earnings yield (E/P) suggests a cheap security, and a low E/P suggests an expensive security, so securities can be ranked from cheap to expensive based on E/P ratios.

LOS 43.f,g

Justified P/E valuation based on forecasted fundamentals can be used for trailing or leading P/E:

^ , pn (l-b)x(l-t-g) justified trailing P/E = — = ^--^

E1 r"g

The justified P/E ratio is:

« Positively related to the growth rate of expected cash flows.

• Inversely related to the stock's required rate of return, all else equal.

The justified P/B based on fundamentals is calculated as: P0 = ROE-g

• P/B increases as ROE increases, all else equal.

• The larger the spread between ROE and r, all else equal, the higher is the P/B ratio. The justified P/S ratio based on forecasted fundamentals is calculated as:

The P/S ratio will increase, all else equal, if profit margin increases and/or the earnings growth rare increases.

The justified price to cash flow based on fundamentals can be calculated by finding rhe value of the stock using a single-stage FCFE mode! and dividing the result by the chosen measure of cash flow:

P/CF will increase, all else equal, if required return decreases or the growth rate increases.

The justified EV/EBITDA ratio based on forecasted fundamentals is positively related to the growth rate in EBITDA and FCFE and negatively related to the firm's WACC.

Study Session 12

Cross-Reference to CFA Institute Assigned Reading #43 - Market-Based Valuation: Price Multiples LOS 43.f,g (continued)

The dividend yield relative to fundamentals is:

Dividend yield is positively related to the required rate cf return and negatively related to the forecasted growth rate in dividends.

LOS 43.h

Predicted P/E can be estimated from linear regression of historical P/Es on its fundamental variables.

LOS 43.i

Frequently encountered P/E benchmarks include:

• P/E of another stock of a company in a similar industry with similar operating characteristics.

• Average or median P/E of peer group within the company's industry.

• Average or median P/E for the industry.

• Average historical P/E for the stock.

The basic idea of the method of comparables is to compare a stock's price multiple to the benchmark. Firms with multiples below the benchmark arc undervalued, and firms with multiples above the benchmark are overvalued. However, the fundamentals of the stock should be similar to the fundamentals of the benchmark.

LOS 43.k

P/E ratio

The PEG ratio is calculated as PEG ratio =-. Lower PEGs are more attractive g than stocks with higher PEGs, all else equal.

Was this article helpful?

We Are Not To Be Held Responsible If Your Online Trading Profits Start To Skyrocket. Always Been Interested In Online Trading? But Super-Confused And Not Sure Where To Even Start? Fret Not! Learning It Is A Cakewalk, Only If You Have The Right Guidance.

## Post a comment