Estimated study time: 60 minutes
Content:
Market-based (relative) valuation compares a company's price or enterprise value to a fundamental metric — earnings, book value, sales, or cash flow — and benchmarks this multiple against comparable companies, historical norms, or justified fundamental values. At CFA Level 2, candidates must understand why multiples differ across companies (the economic drivers of valuation multiples), how to select appropriate comparables, how to adjust for differences in leverage and accounting, and how to apply both trailing (based on past results) and forward (based on next-year estimates) multiples. Market-based valuation is the dominant practical approach in equity research and M&A, used both for primary valuation and as a cross-check on DCF estimates.
The Price-to-Earnings (P/E) ratio is the most widely used equity multiple. Forward P/E = Current Price / Next Twelve Months EPS; Trailing P/E = Current Price / Last Twelve Months EPS. The fundamental drivers of P/E are derived from the DDM: justified P/E = D1/E1 / (r - g) = payout ratio / (r - g). This shows that P/E is positively related to payout ratio and growth (g) and negatively related to required return (r). Companies in the same industry may trade at very different P/E multiples due to differences in growth prospects, quality of earnings, leverage (financial risk), and management quality. The P/E ratio can be distorted by: non-recurring items (write-downs, gains on asset sales); negative earnings (the ratio is undefined); cyclical earnings (automotive and commodity companies should use normalized or mid-cycle EPS); and different depreciation or accounting policies.
The Price-to-Book (P/B) ratio compares market value to accounting book value of equity. Fundamental drivers: justified P/B = (ROE - g) / (r - g). This shows that P/B > 1 is justified when ROE > r (the firm earns above its cost of equity), and P/B < 1 is appropriate when ROE < r. P/B is useful for financial companies (banks, insurers) where assets are largely at or near fair value, making book value a meaningful anchor. Key distortions of P/B: intangible-intensive companies have understated book value (patents, brands, human capital are not on the balance sheet), making P/B appear artificially high. Companies with many past write-downs may have very low book value and correspondingly high P/B even if the underlying business is not particularly profitable.
Enterprise Value (EV) multiples strip out the effect of capital structure differences, making them more comparable across firms with different leverage. EV = Market Cap + Debt - Cash. The most common EV multiples are EV/EBITDA and EV/Sales (EV/Revenue). EV/EBITDA is widely used in M&A analysis because it approximates the pre-tax, pre-depreciation, pre-interest operating value of the business. It is less affected by depreciation method differences than P/E. Key drivers of EV/EBITDA: capital-light businesses with high free cash flow conversion deserve premium multiples; capital-intensive businesses with high maintenance capex deserve discount multiples, as EBITDA overstates true cash generation for these companies. The EV/Sales multiple is most useful for pre-profit companies (start-ups, companies in turnaround) where EBITDA and earnings are zero or negative.
When applying comparable company analysis (comps), the analyst selects a peer group with similar business characteristics (industry, size, growth, margin, leverage) and computes the median or mean multiple of the peer group as a benchmark. The target company is then valued by applying the peer multiple to its own metric (e.g., next-year EPS). Premiums or discounts to the peer median are justified by specific differences in growth rate, margin profile, competitive position, management quality, and ESG factors. In practice, comps yield a range (using 25th to 75th percentile multiples) rather than a point estimate. Precedent transaction multiples — derived from M&A deal values — typically trade at a 20-30% premium to public market comps because they include a control premium.
Key Terms:
Quiz Questions:
Q1. An analyst is comparing two retailers: Company X trades at a P/E of 22x with earnings growth of 12% and ROE of 18%. Company Y trades at a P/E of 18x with earnings growth of 8% and ROE of 14%. Both have similar risk profiles (r = 10%) and payout ratios of 40%. Which company appears more attractively valued using justified P/E analysis?
A) Company Y is cheaper at 18x; it is always preferable to buy at a lower multiple. B) Company X's justified P/E = 0.40/(0.10-0.12) — undefined because g > r; Company X is overvalued. C) Company X's justified P/E = 0.40/(0.10-0.12) is problematic; for Company Y: justified P/E = 0.40/(0.10-0.08) = 20x vs. trading P/E of 18x — Company Y appears undervalued. D) Neither company can be valued without dividend data.
Answer: C — For Company Y: g = 8%, r = 10%, payout = 40%. Justified P/E = 0.40/(0.10 - 0.08) = 0.40/0.02 = 20x. Company Y trades at 18x vs. a justified 20x — it appears undervalued. For Company X: g = 12% > r = 10%, making the single-stage GGM inapplicable (perpetual growth above discount rate is unsustainable). A multi-stage model would be needed for Company X. Company Y's lower multiple relative to its justified value makes it more attractive, assuming the growth rates are sustainable and the risk profiles are truly comparable.
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Q2. Company A (low leverage, D/E = 0.1) trades at EV/EBITDA of 8x. Company B (high leverage, D/E = 1.5) in the same industry trades at a P/E of 10x. The analyst wants to compare the two on a capital-structure-neutral basis. Which statement is most appropriate?
A) Company B's P/E of 10x is lower, so it is cheaper than Company A. B) EV/EBITDA is the appropriate capital-structure-neutral multiple; converting Company B's equity value to EV reveals its true operating multiple for comparison with Company A's 8x. C) P/E and EV/EBITDA are interchangeable; the comparison is valid as stated. D) Company A's lower leverage always makes it worth a premium.
Answer: B — P/E is affected by leverage (higher debt increases financial risk, lowering P/E, or increases EPS through leverage, raising P/E). EV/EBITDA is designed to be capital-structure-neutral because EV includes the value of all capital providers and EBITDA is pre-interest. To compare the two companies, the analyst should convert both to EV/EBITDA or both to P/E, adjusting for leverage. Comparing one company's EV/EBITDA to another's P/E is an apples-to-oranges comparison.
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Q3. A cyclical steel producer reports EPS of $8.00 at the peak of a commodity cycle, when historical mid-cycle EPS averaged $3.50. The stock trades at $35. A naive forward P/E based on peak EPS gives 4.4x. An analyst using normalized earnings gets a P/E of 10x. Which valuation is more appropriate for a long-term investment decision?
A) The 4.4x P/E based on current earnings — the analyst should use the most current data. B) The 10x normalized P/E — for cyclical companies, using peak earnings dramatically underestimates true P/E because current earnings are unsustainably high; normalized earnings better reflect through-the-cycle profitability. C) Both are equally valid; investors should average the two P/E estimates. D) Neither is appropriate; P/E is not useful for cyclical companies.
Answer: B — For cyclical companies, using current peak earnings to compute P/E dramatically understates the true valuation because current earnings are inflated by cyclical tailwinds. A cyclical company at a 4.4x P/E may look cheap but is actually at full cycle-average valuation when normalized earnings are used. The analyst should use normalized (mid-cycle) EPS to compute a P/E that is comparable across time and to peers. This is a fundamental principle in valuing cyclical industries (steel, energy, autos, chemicals).
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Q4. An analyst is valuing an acquisition target using a comparable transactions approach. The M&A peer group has median EV/EBITDA of 9.0x. The target has EBITDA of $50M. What is the estimated acquisition price if the analyst applies the median multiple and assumes 25% of the target's value is funded by $30M in existing cash (cash not needed for operations)?
A) EV = 9.0x * $50M = $450M; Equity value = $450M + $30M (cash) = $480M; no debt assumed. B) EV = $450M; Equity value (assuming no debt) = $450M + $30M cash = $480M; the control premium is already embedded in M&A precedent multiples. C) EV = 9.0x * $50M = $450M, which is the price an acquirer pays for the entire business; adjust downward for the $30M cash (acquirer "gets" the cash upon acquisition, reducing net cost to $420M enterprise value ex-cash). D) Acquisition price = $50M * 9.0 / 0.25 = $1,800M.
Answer: B — In M&A, the EV represents the total acquisition cost for the whole business, paid to all capital providers. EV = $9.0 * $50M = $450M. To find equity value (what shareholders receive), bridge: Equity Value = EV + Cash - Debt. If the company has no debt and $30M cash: Equity Value = $450M + $30M = $480M. The acquirer pays $480M for equity; upon closing, they receive the $30M cash, making the net cost $450M (the EV). M&A precedent multiples already embed control premiums relative to public market comps.
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Q5. Which of the following situations makes EV/Sales the most appropriate primary valuation metric?
A) A mature bank with stable earnings and a predictable dividend growth rate. B) A pre-revenue biotech startup awaiting FDA approval. C) A high-growth software-as-a-service company that has yet to reach EBITDA profitability despite strong revenue growth. D) A commodity chemical company with volatile but consistently positive EBITDA.
Answer: C — EV/Sales is most appropriate when EBITDA and earnings are zero, negative, or not yet meaningful — preventing the use of EV/EBITDA or P/E. A high-growth SaaS company that is investing heavily in customer acquisition may have negative EBITDA despite strong revenue growth and a proven business model. EV/Sales allows comparison to profitable SaaS peers and implies a view on eventual margin convergence. A bank is better valued on P/B or P/E. A pre-revenue biotech has no sales either and is valued on probability-weighted pipeline NPV. The commodity chemical company has positive EBITDA and EV/EBITDA is appropriate.
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