Method of Comparables

Suppose that you want to use a price multiple, like price-to-earnings (P/E) to find out if the stock you are valuing, Lincoln's Lasers (LL), is overvalued, undervalued, or fairly valued. What could you compare LL's P/E to in order to help you determine its relative value?

Good work! The P/E ratio just scales current stock price by earnings per share. By itself, you can't determine anything about relative value for LL, but looking at the P/E of similar firms can help. One common way to determine relative value is known as the __method of comparables__. The method of comparables uses the price multiples of firms that are similar to the firm you are valuing to determine relative valuation.

Incorrect. The P/E ratio just scales current stock price by earnings per share. By itself, you can't determine anything about relative value for LL, but looking at the P/E of similar firms can help. One common way to determine relative value is known as the __method of comparables__. The method of comparables uses the price multiples of firms that are similar to the firm you are valuing to determine relative valuation.

What characteristics do you think you should focus on when finding firms that may match the one you are valuing?

Incorrect. Stock ticker similarity will not help you to make sure that the comparable firm is in fact similar in ways that matter for valuing a firm. Characteristics that matter are related to firm fundamentals like industry, size, profitability, and risk.

Yes! Characteristics that matter for firm value are related to firm fundamentals like industry, size, profitability, and risk.

Suppose that you find one firm that is very similar to LL in terms of fundamentals. The other firm, Truman's Lasers (TL), also makes lasers, is about the same size, and is roughly as profitable. You find that LL's P/E is 15 while TL's P/E is 10. What would you conclude about the relative valuation of LL in this case?

Incorrect. If LL was fairly valued, you would expect the P/E for LL and TL to be about the same.

Incorrect. Although the P/E ratios indicate a mispricing, they do not indicate that LL is undervalued.

Exactly! The market is paying $15 per every $1 per share of earnings for LL while it is only paying $10 per every $1 per share of earnings for TL. Since the two firms are comparable in terms of their business, the market should be paying about the same for earnings of each. But, the market is paying more for LL's earnings which means that LL is relatively overvalued.

In summary: [[summary]]

The P/E of similar firms

The number 0—if the P/E is positive, then overvalued, and if negative, undervalued

Stock ticker similarity

Firm fundamentals

LL is fairly valued

LL is undervalued

LL is overvalued

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