Ultimate Study Notes: NISM Series XV Research Analyst - Chapter X: Valuation Principles (Part 2)

Earnings-Based Valuation Metrics

Earnings-based valuation metrics focus on the profitability and revenue-generating power of a business. These metrics are widely used by market participants to determine whether a stock is trading at a premium or discount relative to its earnings capacity.

1. Price to Dividend Ratio (Dividend Yield)

This metric measures the relationship between the market price of a stock and the dividend income it generates.

• Conceptual Definition: Dividend Yield is the annual dividend paid per share divided by the market price per share, expressed as a percentage. It reflects the cash return an investor receives solely from dividends.
• Formula (Simple Line Format): Dividend Yield = Dividend Per Share / Market Price Per Share

2. Price to Earnings Ratio (PE Ratio)

The PE ratio is the most popular valuation multiple in the equity markets. It indicates how much investors are willing to pay for every rupee of a company's earnings.

• Conceptual Definition: It represents the market price of a share relative to its annual earnings per share (EPS).
• Formula (Simple Line Format): PE Ratio = Market Price per share / Earnings per Share Where: Earnings per Share (EPS) = Net Profit / Number of Outstanding Shares

3. Growth Adjusted PE Ratio (PEG Ratio)

Since high-growth companies naturally command high PE ratios, looking at the PE ratio in isolation can be misleading. The PEG ratio adjusts the PE multiple for the company’s expected growth rate.

• Conceptual Definition: It measures the relationship between the PE ratio and the expected annual growth rate of the earnings. A lower PEG ratio (typically below 1.0) indicates that the stock might be undervalued given its growth profile.
• Formula (Simple Line Format): PEG Ratio = PE Ratio / Expected Earnings Growth Rate

4. Enterprise Value to EBITDA Ratio (EV/EBITDA)

EV/EBITDA is a capital structure-neutral valuation metric. EBITDA represents earnings before interest, tax, depreciation, and amortisation.

• Conceptual Definition: This multiple compares the total value of the operating business (Enterprise Value, which includes both debt and equity) to the cash operating profits it generates. It is highly useful when comparing companies with different levels of debt or tax structures.
• Formula (Simple Line Format): EV to EBITDA Ratio = Enterprise Value / EBITDA Where: Enterprise Value (EV) = Market Capitalization + Debt - Cash on Balance Sheet

5. Enterprise Value to Sales Ratio (EV/Sales)

The EV/Sales ratio is particularly useful for valuing early-stage companies, cyclical industries in a downturn, or companies that are temporarily loss-making but possess strong revenue models.

• Conceptual Definition: This multiple assesses the total valuation of the business against its top-line revenue.
• Formula (Simple Line Format): EV to Sales Ratio = Enterprise Value / Annual Net Sales

Asset-Based Valuation Metrics

Asset-based metrics value a firm based on the underlying assets it owns, rather than just its annual profit stream. These are critical when analyzing capital-intensive sectors or asset-heavy financial firms.

1. Return on Equity (ROE)

ROE measures how efficiently a company uses its shareholders' equity to generate profits.

• Conceptual Definition: It communicates how a business allocates its equity capital and generates returns for its equity shareholders.
• Formula (Simple Line Format): Return on Equity = Net Profit / Shareholders Equity * 100

2. Return on Capital Employed (ROCE)

ROCE is a broader return metric that evaluates the efficiency of all capital providers (both debt and equity).

• Conceptual Definition: This ratio uses Earnings Before Interest and Taxes (EBIT) and calculates it as a percentage of the total capital employed in the firm. A higher ROCE indicates more efficient utilization of capital.
• Formula (Simple Line Format): Return on Capital Employed = EBIT / Capital Employed * 100 Where: Capital Employed = Shareholders Equity + Debt

3. Price to Book Ratio (PB Ratio)

The PB ratio compares the market value of a firm to its accounting book value.

• Conceptual Definition: It shows how much premium investors are paying for the net assets of the company.
• Formula (Simple Line Format): Price to Book Value Ratio = Net Worth / Number of Outstanding Shares (Note: This represents the Book Value per share as stated in the notes, against which market price is compared).

4. Enterprise Value to Capital Employed Ratio

This metric focuses on the entire valuation of the firm relative to the total capital invested in the business.

• Conceptual Definition: It evaluates how the market values the total capital base of the firm relative to the enterprise as a whole.
• Formula (Simple Line Format): EV to Capital Employed Ratio = Enterprise Value / Capital Employed

5. Net Asset Value (NAV) Approach

• Conceptual Definition: This approach calculates the total value of a company’s assets minus its liabilities. It is the classic method for determining the intrinsic worth of investment trusts, mutual funds, real estate companies, or liquidation-scenario firms.

6. Specialized Asset-Based Metrics

Different sectors require specialized metrics to capture their operational realities:

• Price / Embedded Value (PEV): This is the industry-standard valuation metric for insurance companies, where future policy profits are estimated and discounted to the present.
• Price / Adjusted Book Value: Commonly used for banking and financial institutions to account for non-performing assets (NPAs) by adjusting the book value of the loan book.
• EV / Capacity: Used to value heavy manufacturing, cement, or power companies. It measures the enterprise value relative to production capacity (e.g., EV per megawatt of power or EV per ton of cement).

Relative Valuation (Trading and Transaction Multiples)

Relative valuation is highly intuitive and mirrors how decisions are made in everyday life, such as comparing technical specifications and prices of similar phone brands before purchasing.

Core Principles of Relative Valuation

• Basis of Worth: Under relative valuation, an analyst determines the value of an asset by looking at how the market currently prices similar or comparable assets.
• Methodology: Peer group analysis is performed by analyzing multiples (such as PE, PB, or EV/EBITDA) of comparable listed competitors within the same industry.
• Evaluation: Comparing historical average multiples against the current peer group multiples helps build a perspective on whether a particular stock is relatively cheap or expensive.

Trading Multiples vs. Transaction Multiples

• Trading Multiples: These are multiples calculated from the current public trading prices of comparable companies in the stock market. They reflect minority share pricing under normal market conditions.
• Transaction Multiples: These are multiples calculated from actual historical mergers and acquisitions (M&A) transactions of comparable companies. They are typically higher than trading multiples because they often include a "control premium" paid by the acquirer to gain full ownership of the target business.

Sum of the Parts (SOP) Valuation

For complex business structures, a single valuation model is often inadequate.

Understanding SOP Valuation

• Concept: Several large corporations operate as a cluster or bundle of diverse businesses under one corporate umbrella rather than a single operating entity (e.g., conglomerates like ITC or L&T).
• Methodology: The most accurate way to value such conglomerates is to value each distinct business division or subsidiary separately using its most relevant industry multiple, and then add those individual valuations together to arrive at the total enterprise value.

Key Terms and Exam-Relevant Definitions

• Relative Valuation: Valuing an asset based on how the market prices similar or comparable assets.
• EBITDA: Earnings Before Interest, Tax, Depreciation, and Amortisation; a key proxy for operational cash generation.
• Sum of the Parts (SOP): A valuation method where each business segment of a conglomerate is valued independently and then summed to determine the total corporate value.
• Embedded Value: The present value of future profits plus adjusted net asset value, used specifically for valuing insurance businesses.
• Transaction Multiples: Valuation multiples derived from corporate acquisition deals rather than daily stock market trading prices.