2023 Curriculum CFA Program Level II Equity Investments Show
IntroductionAmong the most familiar and widely used valuation tools are price and enterprise value multiples. Price multiples are ratios of a stock’s market price to some measure of fundamental value per share. Enterprise value multiples, by contrast, relate the total market value of all sources of a company’s capital to a measure of fundamental value for the entire company. The intuition behind price multiples is that investors evaluate the price of a share of stock—judge whether it is fairly valued, overvalued, or undervalued—by considering what a share buys in terms of per share earnings, net assets, cash flow, or some other measure of value (stated on a per share basis). The intuition behind enterprise value multiples is similar; investors evaluate the market value of an entire enterprise relative to the amount of earnings before interest, taxes, depreciation, and amortization (EBITDA), sales, or operating cash flow it generates. As valuation indicators (measures or indicators of value), multiples have the appealing qualities of simplicity in use and ease in communication. A multiple summarizes in a single number the relationship between the market value of a company’s stock (or of its total capital) and some fundamental quantity, such as earnings, sales, or book value (owners’ equity based on accounting values). Among the questions we will study for answers that will help in making correct use of multiples as valuation tools are the following:
Multiples may be viewed as valuation indicators relating to individual securities. Another type of valuation indicator used in security selection is momentum indicators. They typically relate either price or a fundamental (such as earnings) to the time series of its own past values or, in some cases, to its expected value. The logic behind the use of momentum indicators is that such indicators may provide information on future patterns of returns over some time horizon. Because the purpose of momentum indicators is to identify potentially rewarding investment opportunities, they can be viewed as a class of valuation indicators with a focus that is different from and complementary to the focus of price and enterprise value multiples. We first put the use of price and enterprise value multiples in an economic context and present certain themes common to the use of any price or enterprise value multiple. We then present price multiples. The treatment of each multiple follows a common format: usage considerations, the relationship of the multiple to investors’ expectations about fundamentals, and using the multiple in valuation based on comparables. The subsequent sections present enterprise value multiples, international considerations in using multiples, and treatment of momentum indicators. We then discuss several practical issues that arise in using valuation indicators. Learning OutcomesThe member should be able to:
SummaryWe have defined and explained the most important valuation indicators in professional use and illustrated their application to a variety of valuation problems.
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