Comparing P/E of a company to the benchmark is very straightforward. The only issue here is the choice of benchmark and interpretation of the results.

Typical steps:

• Select and calculate the multiple (P/E).
• Select the benchmark asset(s) and calculate the mean or median P/E. The result is the benchmark value of the multiple.
• Compare the stock's P/E with the benchmark's P/E.
• Are observed differences between the asset and benchmark P/E explained by underlying determinants of P/E? If not, asset may be mispriced.

Typical relative valuation benchmarks:

• Ratio of closest matched individual stock.
• Average/median ratio for peer group.
• Average/median for sector or industry.
• Value from representative equity index.
• Average historical value for the stock.

In reality, we can rarely find identical companies, therefore the "all else equal" condition may not hold. Therefore, an analyst needs to identify fundamental sources of difference in P/E multiples between two companies. As we have outlined earlier, such difference may be explained by the companies' relative growth, dividend payout policies or their respective risk. For example, we can expect that a company with high risk, low growth and low dividend payout will trade at a relatively low P/E multiple.

Example

Which stock is more attractive?

B is more attractive:

• Historically, B was traded at 120% of industry P/E.
• Currently B is traded at a discount to industry P/E.
• It is undervalued relative to industry and historical average.

P/E-to-Growth (PEG) Ratio

In order to compare companies with very distinct growth rates, an analyst can employ PE-to-growth (PEG) ratio. It can be calculated by dividing the company's P/E multiple by its expected earnings growth rate. The ratio in effect calculates a stock's P/E per unit of expected growth. With PEG ratio we can compare two companies based on their relative valuation, taking into account the expected rate of earnings growth. Holding other parameters equal, an investor should look for stocks with relatively low PEG ratios, since they may be relatively undervalued.

Example

• SGS Inc. leading P/E = 15.
• 5-year consensus growth rate forecast =21%.
• Median industry PEG = 0.90.

Calculate PEG and explain whether the stock appears to be correctly valued, overvalued, or undervalued.

PEG = 15/21% = 0.71 < Industry PEG. Therefore, SGS Inc. is undervalued. It has a lower multiple per unit of expected growth.

However, PEG should be used with care for several reasons:

• It assumes a linear relationship between P/Es and growth. The model for P/E in terms of DDM shows that in theory the relationship is not linear.
• It does not factor in differences in risk which is a very important component of P/Es.
• It does not account for differences in the duration of growth. For example, dividing P/E ratios by short-term (5 year) growth forecasts may not capture differences in growth in long-term growth prospects.

The Fed Model

The Federal Reserve Board uses one such valuation model that relates the inverse of the S&P 500 P/E, the earnings yield, to the yield to maturity on 10-year Treasury Bonds. Earnings yield = E/P, where the Fed uses expected earnings for the next 12 months.

The Fed's model asserts that the market is overvalued when the stock market's current earnings yield is less than the 10-year Treasury bond yield. The intuition is that when Treasury bonds yield more than the earnings yield on the stock market, which is riskier than bonds, stocks are an unattractive investment.

Terminal Value

To perform a multistage DCF analysis an analyst must determine the terminal value of the stock, that is, the stock value in the first period of mature growth (remember that in the mature stage earnings grow indefinitely at a constant rate). Analysts can employ price multiples to estimate terminal values. If an analyst has forecasted earnings for the terminal period or the period immediately after that, he or she can multiply this quantity by a terminal multiple in order to find the terminal value.

Value_n = Trailing P/E Benchmark x E_n

Value_n+1 = Leading P/E Benchmark x E_n+1

where
n: the first period of mature growth.
n+1: the next period after that.

Most frequently, analysts use either price to earnings (P/E), or price to book value (P/B) multiples to determine the terminal value.