6.2 Relative Valuation Multiples, Residual Income & Economic Value Added

6.2 Relative Valuation Multiples, Residual Income & Economic Value Added

1. Relative Valuation Multiples & Multi-Factor Comparables

Relative valuation assesses whether an asset is attractively priced relative to comparable companies, industry benchmarks, or historical averages.

+-----------------------------------------------------------------------------------------+
|                               RELATIVE VALUATION MULTIPLES                              |
+-----------------------------+-----------------------------+-----------------------------+
| Enterprise Value Multiples  | Price (Equity) Multiples    | Growth-Adjusted Multiples   |
| - EV / EBITDA               | - Price / Earnings (P/E)    | - PEG Ratio (P/E to Growth) |
| - EV / EBIT                 | - Price / Book (P/B)        | - EV / Sales                |
| - EV / Invested Capital     | - Price / Cash Flow (P/CF)  | - Dividend Yield            |
+-----------------------------+-----------------------------+-----------------------------+

Key Multiple Metrics & Analytical Mechanics

1. Price-to-Earnings (P/E) Ratio:

   • Trailing P/E: Current Stock Price / Diluted EPS over the trailing 12 months (TTM). Subject to accounting distortions, one-time charges, and cyclical peak/trough bias.
   • Forward P/E: Current Stock Price / Consensus estimated EPS over the next 12 months (NTM). Reflects forward earnings power but subject to analyst forecast optimism.
   • Fundamental Drivers of Justified P/E: Under the Gordon Growth model, the justified forward P/E is expressed as: $\frac{P_0}{E_1} = \frac{1 - b}{r - g}$ P/E expands when the dividend payout ratio ($1-b$) or growth rate ($g$) rises, and compresses when the required return ($r$) or cost of capital increases.

2. The Price/Earnings-to-Growth (PEG) Ratio: $\text{PEG} = \frac{\text{P/E Ratio}}{\text{Expected EPS Growth Rate (as a whole percentage)}}$ Example: A stock with a forward P/E of 20.0 and expected EPS growth of 10.0% has a PEG of $20.0 / 10.0 = 2.0$. A PEG below 1.0 is traditionally viewed as attractive value relative to growth, while a PEG above 2.0 indicates an expensive growth premium. Limitation: Assumes a strictly linear relationship between P/E and growth, ignoring differences in risk ($eta$) and return on capital.

3. Enterprise Value to EBITDA (EV/EBITDA): $\text{EV} = \text{Market Capitalization} + \text{Total Debt} + \text{Preferred Stock} + \text{Minority Interest} - \text{Cash and Equivalents}$ $\text{EV/EBITDA} = \frac{\text{Enterprise Value}}{\text{EBITDA}}$

   • Capital Structure Neutrality: Because the numerator (EV) encompasses all capital claimants (equity + debt) and the denominator (EBITDA) measures pre-interest cash earnings, EV/EBITDA is unaffected by changes in financial leverage.
   • Depreciation & Tax Normalization: Removes distortions caused by differing depreciation accounting methods (e.g., accelerated vs. straight-line) and divergent sovereign tax rates, making it the premier metric for comparing cross-border and capital-intensive companies.

4. Price-to-Book (P/B) Ratio: $\text{Justified P/B} = \frac{\text{ROE} - g}{r - g}$ Particularly effective for commercial banks, insurance companies, and balance-sheet-heavy financial institutions where market values of assets approximate carrying values. Less meaningful for modern asset-light technology and pharmaceutical firms whose primary assets (software code, intellectual property, human capital, brand value) are expensed rather than capitalized on the balance sheet.

5. Price-to-Sales (P/S) Ratio: Effective for valuing early-stage growth companies, distressed turnarounds, and cyclical businesses with temporarily negative net income, and immune to accounting accrual manipulation.

Comprehensive Multiples Comparison Matrix

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2. Residual Income Models (RIM) & Economic Value Added (EVA®)

Traditional accounting net income reflects profit after deducting the cost of debt (interest expense), but fails to deduct a charge for the cost of equity capital. Residual Income Models (also known as the Edwards-Bell-Ohlson model) and Economic Value Added (EVA®) correct this fundamental deficiency.

Accounting Perspective:    Revenues - Operating Expenses - Interest - Taxes = Net Income (Ignores Equity Cost)
Economic Perspective:      NOPAT - Capital Charge (WACC × Total Capital)   = EVA / Residual Income

The Residual Income / EBO Model

Residual income ($RI$) is defined as net income minus an equity charge equal to the beginning book value of equity multiplied by the required return on equity ($r_e$):

$\text{RI}_t = \text{NI}_t - (r_e \times B_{t-1}) = (\text{ROE}_t - r_e) \times B_{t-1}$

Intrinsic equity value under RIM is expressed as the sum of current book value ($B_0$) and the discounted present value of all future residual income streams:

$V_0 = B_0 + \sum_{t=1}^{\infty} \frac{\text{RI}_t}{(1 + r_e)^t} = B_0 + \sum_{t=1}^{\infty} \frac{(\text{ROE}_t - r_e) \times B_{t-1}}{(1 + r_e)^t}$

Structural Advantages of Residual Income Valuation

1. Reduced Terminal Value Sensitivity: Unlike DCF or DDM models where terminal value can account for 75%+ of total value, current balance sheet book value ($B_0$) is observable today and captures a significant portion of intrinsic value upfront. Terminal residual income typically converges toward zero over time as competitive forces erode excess economic returns ($\text{ROE} \rightarrow r$).
2. Applicability to Non-Dividend Payers: Works seamlessly for companies with zero dividend distributions or volatile free cash flows.
3. Clean Surplus Accounting Condition: The RIM framework requires that all gains and losses affecting book value pass through the income statement: $B_t = B_{t-1} + \text{NI}_t - D_t$.

Economic Value Added (EVA®)

Developed by Stern Stewart & Co., Economic Value Added (EVA) measures the net economic profit generated across the entire enterprise in excess of the overall cost of capital:

$\text{EVA} = \text{NOPAT} - (\text{WACC} \times \text{Total Invested Capital})$ $\text{EVA} = (\text{ROIC} - \text{WACC}) \times \text{Total Invested Capital}$

Where:

• $\text{NOPAT}$ = Net Operating Profit After Taxes = $\text{EBIT} \times (1 - t)$.
• $\text{ROIC}$ = Return on Invested Capital = $\frac{\text{NOPAT}}{\text{Total Invested Capital}}$.
• $\text{Invested Capital}$ = Total Assets minus non-interest-bearing current liabilities (or Total Debt + Equity).

If $\text{ROIC} > \text{WACC}$, the enterprise generates positive EVA and creates true shareholder wealth. If $\text{ROIC} < \text{WACC}$, growth actually destroys economic value. Market Value Added (MVA) represents the cumulative present value of all expected future EVA streams:

$\text{MVA} = \text{Market Value of Capital} - \text{Total Invested Capital} = \sum_{t=1}^{\infty} \frac{\text{EVA}_t}{(1 + \text{WACC})^t}$