Earnings-Based and Relative Valuation Models for CA Final AFM

Understand Earnings-Based and Relative Valuation Models

Key rules to remember

P/E ratio

P/E = Market price per share ÷ EPS

Use EPS of the same period (trailing or forward) for the target and the comparables.

Value using P/E

Value per share = EPS × Industry P/E

Equity value = Net profit after tax (available to equity) × P/E.

Earnings yield

Earnings yield = EPS ÷ Market price × 100 = 1 ÷ P/E × 100

It is the inverse of P/E. Value = EPS ÷ Earnings yield.

Price-to-book ratio

P/B = Market price per share ÷ Book value per share

Book value per share = Net worth ÷ Number of equity shares.

Value using P/B

Value per share = Book value per share × Comparable P/B

Use net worth available to equity shareholders only, excluding preference capital.

Enterprise value

EV = Market capitalisation + Debt + Preference capital − Cash and cash equivalents

Add minority interest if given. Net debt = Debt − Cash.

Value using EV/EBITDA

EV of target = EBITDA × Comparable EV/EBITDA; Equity value = EV − Net debt

Divide equity value by number of shares for value per share.

P/E from growth model

P/E = Payout ratio × (1 + g) ÷ (ke − g), or with next year's EPS, P/E = Payout ratio ÷ (ke − g)

Use only if the question gives a constant growth rate g below ke.

Price-to-sales

P/S = Market price per share ÷ Sales per share

Used when earnings are negative or unstable.

How to solve Earnings-Based and Relative Valuation Models questions

1. 1Read what is asked: value per share, equity value, enterprise value, or whether the stock is over- or undervalued.
2. 2Identify the multiple given or implied (P/E, earnings yield, P/B or EV/EBITDA). If earnings yield is given, convert it to P/E by taking 1 ÷ yield.
3. 3Choose the matching metric of the target: EPS for P/E, book value per share for P/B, EBITDA for EV/EBITDA.
4. 4Compute the metric carefully. For EPS, deduct preference dividend from profit after tax, then divide by equity shares.
5. 5Apply the multiple to get value. For EV multiples, get EV first.
6. 6If you found EV, subtract debt and preference capital and add cash to reach equity value. Then divide by shares.
7. 7Compare the value with the market price, if given. Value above price means undervalued; below means overvalued.
8. 8Write a one-line conclusion and note any assumption, such as comparability of the peer firm.

Quickest way: Match-and-multiply shortcut

Common mistakes in Earnings-Based and Relative Valuation Models

• Using total profit instead of profit available to equity shareholders.

  Students forget the preference dividend when the question lists preference shares.

  Fix: Always compute EPS as (PAT − preference dividend) ÷ number of equity shares.

• Treating earnings yield as the same number as P/E.

  Both come from the same two inputs, so the difference is overlooked.

  Fix: Remember that earnings yield = 1 ÷ P/E. A yield of 8% means P/E of 12.5.

• Stopping at enterprise value when the question asks for value per share.

  The EV/EBITDA step feels like the final answer.

  Fix: Subtract net debt (and preference capital) from EV, then divide by the equity shares.

• Applying an EV multiple to net profit, or a P/E to EBITDA.

  Students memorise multiples without their base.

  Fix: Pair price multiples with per-share equity figures and EV multiples with pre-interest firm-level figures.

• Using total assets instead of net worth for book value per share.

  Balance sheet items are confused under time pressure.

  Fix: Use equity share capital plus reserves (net worth), excluding preference capital, divided by equity shares.

• Using a peer's P/E without checking it is comparable.

  The peer ratio is given, so students apply it blindly.

  Fix: Mention in your answer that the peer should have similar growth, risk and capital structure, and adjust if the question says so.

Worked examples