Business Valuation 103 – RELATIVE VALUATION MODELS

When businesses have grown to a size that the ‘rule of thumb’ approach is no longer appropriate, then some form of market-based pricing methodology must be used. The principle here is to find some standard variable within companies which appear to be consistently priced by the capital market. 

As expected, there are a large number of such variables, including annual earnings, sales turnover, book value, fixed asset value, and net worth. The variable to be used depends on the type of company. The three most commonly used in practice are:

  • Price Earnings (P/E) multiples 
  • Market to net worth (Tobin’s Q)
  • Market to book (M/B) value ratios

103.1 Price Earnings Multiples

The price-earnings ratio is calculated as the ratio of the price per share divided by the underlying earnings per share. 

Usually, a company publishes it’s earning per share under a number of different bases: basic earnings per shares which is simply the published earnings divided by the numbers of shares in issue. 

If the company has a number of share options in issue to its employees and directors, then it will also produce a ‘diluted’ earnings per share calculated on the basis that all options are taken up.

Analysts can use different variants of the PE ratio. Some prefer to use a historical PE using the average of quoted figures over the last 12 months. This historical or ‘trailing’ PE ratio is claimed to remove price ‘noise’ (the random fluctuation) from the share price. Other analysts prefer a ‘leading’ PE ratio being the estimate from forecasts of the next twelve months earnings figures.

The magnitude of the PE ratio indicates the degree of volatility attaching to the firm’s earnings stream. A low ratio suggests a low value is being placed on the earnings stream and hence (other things being equal) the higher its volatility and vice versa.

The Challenges to using PE methods

The challenges of using the PE method are as follows:

  • First, it is reliant upon an accounting estimate of earnings. As we outlined earlier, the accounting model makes a number of assumptions about the temporal matching of cash flows to time periods which even though firms may be acting quite consistently in their application of the Generally Accepted Accounting Principles (GAAP) can result in quite different outcomes across and between industries. 
  • Second, is that the model avoids the valuation issue in that it is transferring the problem of valuation to the market in assuming that a benchmark PE say for the market as a whole, or an industrial segment, however, constructed, represents an appropriate price for earnings either across the market or across the industry.  
  • Third, it assumes that the market does in fact value earnings rather than some other aspect of the companies financial output such as dividends, or growth in earnings or indeed risk and the market is an efficient market. 

103.2 Market to net worth (Tobin’s Q)

This particular ratio has an impeccable academic pedigree. It was first proposed by the Nobel Prize-winning economist James Tobin in 1969 and since that time has developed a small but influential following. 

Its principal advantage as a metric is that it would appear to allow us to determine whether a market is over or undervalued. However, its use at the individual stock level is more questionable.

Tobin defined Q as the ratio of total capital value (equity plus debt) to the replacement (or reproduction cost) of all capital market assets. The long-run equilibrium for this ratio is one. Taking this ratio to the firm level:

Following Modigliani and Miller’s proposition 1 that total market capitalisation is the sum of the value of equity and the value of debt, then an ‘equity version of Q can be defined as:

When viewed this way all that Tobin’s Q is saying is that the rate of return the firm generates on the replacement cost of its net assets is equal to the rate of return required by equity investors. To see this, let us assume that the market value of the firm’s equity is the capitalised value of the economic earnings of the business (E):

However, the economic profit of the business is the replacement cost of the firm’s net assets (CR) multiplied by the rate of return on that invested capital (rRC):

As a result, Q becomes:

If Q = 1, then this ratio simply asserts that at long-run equilibrium the rate of return on invested capital must equal the firm’s cost of capital (i.e., the required rate of return on equity) or, to put it another way, the rate of return on new capital invested in firms (the internal rate of return on the capital invested) is equal to the rate of return on existing capital traded in the market (the required rate of return on equity). We have met this concept already in that, in the long run, the net present value of an internal investment is driven down to zero, i.e., the point at which the internal rate of return on the firm’s investments equals the firm’s cost of capital. This is important (even if it is a rather unsurprising result) for reasons we return to when we discuss the problems of estimating the growth rate of the firm. 

To what extent can Tobin’s Q and the implied relationship between equity value and a firm’s net worth be used for prediction purposes?  Smithers and Wright (2000) have conducted studies on the properties of their equity version of Q. They demonstrate that over time, and at the level of the market Q exhibits strong mean reversion. This is what we would expect if at the market level, the internal rate of return on invested capital was markedly different from the prevailing market required rates of return. Firms that earned greater than the market rate would attract investors, and hence their equity prices would rise, and firms earning a lower than the market rate would find their share price falling.  

There is some evidence that Q is also a superior leading indicator for share price changes than either the P/E ratio (where earnings are the fundamental lead indicator) or dividend yield (where dividends are the fundamental lead indicators). In causality tests, Smithers and Wright report that net worth (the fundamental in the Q ratio) has only a 1.4per cent probability of no predictive power, whilst dividends and earnings have 43.8 per cent and 88.6 per cent probability respectively. They also found that net worth only really works as a predictor when used as a ratio with equity value rather than on its own.

In practice, the application of Tobin’s Q invariably relies upon the use of accounting information as a proxy for replacement cost. This leads to a more measurable market to book ratio. 

103.3 Market to book (M/B) value ratios

The market to book ratio is a pragmatic interpretation of Tobin’s Q. This ratio assumes that there is a consistent relationship between market value and the net book value of the firm, or to put it another way that the market prices one Unit (pound, dollar, shilling, dinar, riyal, dirham) of book value in one firm, the same as in another.  

Summary and Conclusion 

Like with all other valuation methods, this method is suited to particular situations and has fundamental assumptions, which need to hold, which would due to market inefficiencies not always hold. Therefore it is an indicative value subject to negotiation. It should be noted that the concept can be applied to the valuation of non-quoted companies too. 


Published by Mohamed Ebrahim, MBA, CeMap, MLIBF, MCSI

Mohamed Ebrahim Mohamed is an author of books related to Islamic Finance, Financial Reporting, Accountancy, and related topics. Mohamed, is currently based in Birmingham, West Midlands, England, United Kingdom and is a Co-founder, CEO and Director of a Start-up Everest Fin Edu Tech Limited. He utilises his training and experience of over 25 years to find funding solutions for individuals, businesses and property buyers, investors and developers especially for the SME'S. Mohamed, is a Senior Partner with Ace Associates LLP - Certified Public Accountants & CEO of Ace Financial Advisory Limited, he is a CPA Kenya and holds an MBA from The University of Manchester (UK) and B.A (Hons) from Manchester Metropolitan University, He has worked for over 25 years with firms in Kenya -Ernst & Young – Assurance Advisory Business Service & Tax Service lines, PKF Kenya Audit Senior, and Devani –Devani & Co. United Arab Emirates -Group Financial Controller - Credo Investments FZE. Canada – Mc Tavish & Co. CPA’s. A member Institute of Directors (Kenya) and Non-Executive Directors Association (UK). He served on the ICPAK Coast Branch, Executive Council as Secretary and CPD Convener (2013-15) and from May 2016 to May 2018. Vice-Chair May 2018 to June 2020. He was commended by ICPAK in June 2015 for his services to the Accounting profession by ICPAK. Furthermore, Mohamed Ebrahim was awarded a Fellowship of the Institute of Certified Public Accountants of Kenya on.11th December 2020. Educational & Professional details. Mohamed speaks English, Gujerati, Hindi, Urdu, Swahili. Born in an Indian immigrant family from Gujerat India, settled on the Swahili Coast of East Africa for four (4) generations, Bachelor of Arts (Hons) – Sustainable Performance Management Manchester Metropolitan University Master of Business Administration The University of Manchester – Manchester Business School Certified Islamic Finance Executive (CIFE) Advanced. Certified Islamic Finance Executive in Islamic Accounting Ethica Institute of Islamic Finance, Dubai, UAE. ACMA, CGMA, Member, Chartered Institute of Management Accountants and Association of International Certified Professional Accountants, registered as a CIMA Member in Practice. CPA, Practicing member Institute of Certified Public Accountants of Kenya FCFIP, Fellow Member -International Institute of Certified Forensic Investigation Professionals FCT, Fellow Member, Fellow Chartered Treasurer FFA – Fellow of the Institute of Financial Accountants MCIArb - Chartered Institute of Arbitrators, Full Member. MCSI: Member, Chartered Institute of Securities & Investments Institute of Internal Auditors - Member Currently, a Doctoral Student at the Edinburgh Business School, completed the Coursework stage, working on the doctoral thesis Interim Award - Post Graduate Certificate in Business Research methods Short Courses and MOOC’s • The World Bank Group's MOOC on Financing for Development. • Financial Markets an online non-credit course authorized by Yale University, facilitator being Professor Robert Shiller – 2013 recipient of Nobel Prize in Economic sciences • Principles of Valuation: Time Value of Money authorized by University of Michigan • Islamic Financial & Capital Markets -101 - & Structure and Trading of Sukuk102 – by Islamic Research and Training Institute • Islamic Finance & Banking 101 & 102 – Islamic Modes of Finance - by Islamic Research and Training Institute • University Teaching MOOC on Coursera by Hong Kong University. • Oxford Brookes University Business School – Online mentoring Course • ICPAK - Training of Trainers PRESENTATIONS AND PUBLICATIONS Professional Conference paper IICFIP 2014 Global Conference “Creating a Business Culture based on ethics” MBA Dissertation Risk Management in Islamic Financial Institutions Publications in Professional Journals The Accountant – Journal of the Institute of Certified Public Accountants of Kenya • Tax Reforms 1 – Time for a Flat Tax system in Kenya – February- March 2012 issue • Tax Reforms 2 – Specific Tax Simplification Reforms – April –May 2012 Issue • Risk Management in Islamic Financial Institutions – December-January 2013 issue Africa Islamic Finance Report (Volume 1 no, 2)- April- June 2016 • A case for Islamic Sharia Compliant Real Estate Investment Trust (Islamic REITS) in Kenya Others Islamic Home Financing

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