Learning outcomes, after watching this video, you will be able to use the forward PE ratio of comparable firms to value a stock, relate the forward PE ratio to the company's dividend payout rate and earnings growth rate. Valuation based on comparable firms, one way to calculate stock price is by discounting future dividends. In this video, we will look at an alternate way to calculate stock prices, namely valuation based on comparable firms. In the matter of comparables rather than discounting future cash flows, we estimate the stock price of a firm by looking at the valuation of a set of comparable firms which generate very similar cash flows. This is just another way of using the law of one price. Remember, the law of one price says that assets that generate identical cash flows must be worth exactly the same. In reality, identical companies do not exist. Even firms in the same industry or sector, while similar in many ways, will differ in scale or size. We will adjust prices in different ways to adjust for these differences which will help us compare similar forms. We will look at a couple of valuation multiples which is the ratio of the company's value to some measure of its scale. The most common valuation multiple is the price-to-earnings ratio, PE ratio in short. It is calculated as the ratio of its current share price to its earnings per share. The idea behind this ratio is that when you buy a stock, you buy the right to receive the firm's future earnings. You will proportionately be willing to pay more if its earnings are expected to be higher. We can estimate a firm's stock price by multiplying its current earnings per share by the average PE ratio of its comparable firms. There are two types of PE ratios. One is the trailing PE ratio, and the other is the forward PE ratio. Trailing PE ratio uses the prior 12 months' earnings. Whereas forward PE ratio uses the expected earnings over the next 12 months. it is preferable to use a forward PE ratio as we are more worried about the future than the past. Let's interpret the forward PE ratio in terms of the garden growth model. The forward PE is P sub 0 over EPS sub 1, which equals D sub 1 over EPS sub 1 divided by (r sub E- g). D sub 1 over EPS sub 1 is the dividend payout rate. So our forward PE ratio now is the dividend payout rate over (r sub E- g). This tells us that two stocks having the same dividend payout rate, the same level of risk, and the same EPS growth rates, should have identical forward PE ratios. Let's look at a simple example. A company is expected to have an earnings per share of $5 next year. Comparable firms have a forward PE ratio of 6. What must be the stock's current price? The current price is simply the earnings per share of $5 times the forward PE ratio of 6, which gives us $30. Notice that the PE ratio depends on the dividend payout rate, the expected return, and the earnings growth rate. However, these go hand in hand. High growth rate firms typically tend to be riskier which means higher expected returns and also have low dividend payout rates. As a way to address this problem, practice now stand to compare the PE issue to the growth rate in earnings. How we go about this is what we will discuss next time.