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Ever wonder why two investment analysts will have conflicting views on a particular stock? One says the stock is undervalued while the other says it is overvalued. The answer has to do with the fact that valuation is more art than science. Financial analysts across the globe employ sophisticated financial models to determine what the fair value of a company’s stock price should be, but ultimately it is the underlying assumptions that determine the end result. To gain a better understanding, let’s consider one of the two widely used valuation models, the Comparable Multiple model.

The Comparable Multiple model is one of the most user-friendly valuation models. The beauty of it is its simplicity. In fact, a CEO can sit down with an investment banker and craft a plan to sell a company…all on a cocktail napkin. Here’s how it works: Alpha Co.’s CEO is meeting with a banker from an esteemed Wall Street bank. Alpha’s CEO mentions to the banker that the Alpha board is interested in a sale. The banker says, “Good idea. We can sell your company for $24 per share. Given that you have one million shares outstanding, we should be able to sell the entire company for $24 million.”

The CEO asks, “How can you be so sure?”

The banker replies, “Simple: comparables.”

So what just happened? The banker simply did a quick and dirty Comparable Multiple analysis. To understand this type of model, it is important to consider its components: industry competitors, stock price for each competitor, earnings per share (or some variation on earnings) for each competitor and current earnings per share (or variation on earnings) for Alpha Co. The banker, based on his extensive knowledge of the industry, is aware that Alpha Co.’s competitors have average price to earning (P/E) multiples of 12. In other words, their stock prices are 12 times their earnings per share. The banker then applies this multiple to the earnings per share number for Alpha, which happens to be $2. In order for Alpha to trade in line with the industry, its stock price should be $24. Multiplying that number by the total shares outstanding, in this case one million, gives us the expected company value of $24 million.

Stay tuned for Part II in which we discuss the other popular method of valuation, the Discounted Cash Flow model.

This entry was posted on Friday, November 13th, 2009 at 9:00 am by Reuben Advani and is filed under Corporate Finance, Valuation. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.