1. Lecture 2Basic valuation and fin. statements: Method of ComparablesReadingCh.3 Penman.Papers: Imam S., Barker R., and Clubb C. (2008). The Use of Valuation Models by UK Investment Analysts. European Accounting Review. Vol. 17. No.3, pp.503-535. Demirakos E., Strong N., and Walker M. (2004). What Valuation Models Do Analysts Use? Accounting Horizons. Vol. 18. No.4, pp.221-240.

2. Simple (single-period) valuation techniques1. Method of Comparables2. Asset-Based Valuation no forecasting required only little accounting info is needed cheap and quick to apply

3. 1. Method of Comparables Price multiple is the ratio of the stock price to a particular financial statement number. E.g. P/E, P/B, EV/EBITDA, P/S, EV/CF, (P- BV)/R&D. The price multiple is a single number summary of the valuation relationship between a stocks price and a value driver. It makes comparisons possible among different stocks. It gives the price to purchase one unit of value: e.g., P/S=2 means that it takes 2 to buy 1 of sales. The economic rationale underlying the method is the law of one price: two identical assets should sell at the same price.

4. How to apply this method:1. Identify comparable firms (same sector, similar size, etc)2. Identify measures for the comparable firms in their fin. statements (e.g. earnings, book value, sales, cash flow) or use other important value drivers (e.g. sq. feet for stores, oil/gas proven reserves, number of website clicks, number of passengers)3. Make adjustments if necessary Unleveraging (the higher the leverage, the higher is the cost of capital and the lower is the cash/earnings available for ordinary shareholders. => downward biased multiple) dilute EPS Make adjustments for accounting-induced differences4. calculate price multiples of those measures for comparable firms (but exclude abnormal firms), and use their mean or median5. Apply these price multiples to the corresponding measures for the target firm to get that firms value

5. The Method of Comparables Example:Dell, Hewlett Packard, and Lenovo, 2008

6. Double-check your inputs and assumptions:Assess whether differences between the actual and benchmark values of the multiple are explained by differences in the fundamental determinants of the price multiples. E.g.: If the subject stock has higher-than-average expected earnings growth, a higher P/E than the benchmark P/E is justified. If the subject stock has higher-than-average operating or financial risk, a lower P/E than the benchmark P/E is justified.Things to be careful about: What if the selected multiple is inappropriate? What if the traded stock is an outlier or the multiple is affected by factors other than mispricing (e.g., risk)? What if the market remains mispriced for a long time? You may be trading with someone who knows much more.

7. Most widely used valuation methods and multiples

8. Most commonly used multiples in different sectors: Industry Most commonly used multiplesAutomobiles P/S; P/Cash EarningsBanks P/BPaper, Chemicals, P/B; EV/EBITDA; EV/S; P/Cash Earnings; P/Levered FreeMetals & Mining, Cash Flow; P/FCF; EV/EBITDA; P/EConstructionBusiness Services EV/EBITDA; ROCE; P/Levered Free Cash Flow; P/E; PEGEngineering, Defence P/E; EV/EBITDA; EV/SFood, Drink & EV/EBITDA; P/E; PEG; EV/Cash Earnings; ROCETobaccoHealthcare P/E; EV/EBITDAInsurance P/TALeisure EV/EBITDAMedia P/E; EV/EBITDAOil & Gas P/E; EV/CEReal Estate EV/EBITDARetail & Consumer P/E relative to market and sector; EV/EBITDA; PEG; EV/STechnology P/ETelecoms EV/E to EBITDA growth; EV/S; P/customerTransport EV/EBITDA; P/SUtilities P/E; P/Cash earnings

9. Unlevered (or Enterprise) Multiples (that are Unaffected by the Financing of Operations) Market Value of Equity + Net DebtUnlevered Price/Sales Ratio = Sales Market Value of Equity + Net DebtUnlevered Price/ebit = ebit Market Value of Equity + Net DebtUnlevered Price/ebitda = ebitda Market Value of Equity + Net DebtEnterprise P B = Book Value of Equity + Net Debt

10. Variations of the P/E Ratio Price per share Trailing P/E = Last annual Eps Price per shareRolling P/E = Sum of Eps for most recent four quarters Price per share Forward P/E = Forecast of next years Eps Dividend-Adjusted P/E Rationale: Dividend affects prices but not earnings

11. Typical Values for Common Multiples (US) Multiple Enterprise Trailing Forward Unlevered Unlevered UnleveredPercentile P/B P/B P/E P/E P/S P/S P/CFO P/ebitda P/ebit 95 7.9 12.7 Negative 49.2 8.9 8.1 Negative 30.1 Negative earnings cash flow ebit 75 2.9 2.7 23.5 19.1 1.7 2.0 18.8 10.6 15.3 50 1.7 1.5 15.2 13.1 0.8 0.9 9.9 7.0 9.9 25 1.0 1.0 10.3 9.2 0.3 0.5 5.6 4.8 6.6 5 0.5 0.6 5.9 5.6 0.1 0.2 2.3 2.5 3.3

12. Test your understanding: P/B P/E P/S Unlev P/CF Unlev Share Equity BV ER Sales CF debt ered ered Price (in Market P/S P/CF pence) value (in millions)M&S 344 5662.7 2081.9 398.8 8302 285 1578Morrison 204.8 5442.3 2046 333.9 4944 534.6 96.4Tesco 316.8 24434 9773.6 1163.5 30814 2279 8061Sainsbury 272.3 4629 4583.2 348 17141 731.3 1908mean value of ratios:Iceland * actual 94.25 323.8 281.6 28.9 5152 119 242Valuationbased on: mean P/B mean P/E mean P/S mean P/CF Average value:

13. Problems with Method of Comparables:Conceptual problems: Circular reasoning: Price is ascertained from price (of the comps) Violates the tenet: When calculating value to challenge price, dont let price enter the calculation If the market is efficient for the comparable companies....Why is it not for the target company ?Implementation problems: Finding the comparables that match precisely Different accounting methods for comps and target Different prices from different multiples What about negative denominators?Applications: IPOs; firms that are not traded (to approximate price, not value)

14. P/E pros and consPros: Earnings is a chief driver of investment value and the chief focus of security analysts attention. P/E is widely recognized and used by investorsCons: Earnings can be negative => P/E does not make sense The ongoing or recurring components of earnings are the most important in determining intrinsic value. Earnings often have volatile, transient components, which make the analysis difficult Management can manipulate earnings. Distortions can affect the comparability of P/Es across firms.

15. P/B pros and consPros: P/B is only slightly less popular than P/E, but sectors matter BV is generally positive and more stable than earnings, => P/B more meaningful when earnings are abnormal or highly volatile. BV is appropriate for firms composed of liquid assets or natural resources (e.g., financials, mining, oil & gas). BV is a better proxy for valuing firms that are not a going concern.Drawbacks: Other unrecorded assets may be critical valuation factors. E.g., skills, knowledge, know-how, reputation, customer loyalty. P/B Accounting treatment of shareholders investment in the company. E.g., BV understates shareholders investment as a result of the expensing of investment in R&D, advertising, etc. Yet R&D or advertising may create value in the long term BV largely reflects the historical costs of assets, as well as accumulated accounting depreciation. Inflation and technological change (time effect) distorts the BV from the market value of assets. The accounting treatment of both inventories and long-term contracts is also a suspect.

16. P/S pros and consPros: Sales less subject to distortion or accounting manipulations, as it is prior to any expenses. But revenue recognition practices must be examined. Sales are always positive => P/S can be used when P/E or P/B is negative. Sales are more stable than earnings, which reflect operating and financial leverage. => P/S more stable than P/E. May be more appropriate for shares of mature and/or cyclical firms.Cons: High growth in sales is not a sign of high growth in earnings or profitability. Earnings and growth in earnings is what creates value. Unlevered P/S is affected by capital structure. P/S ignores differences in cost structure among different firms. P/S normal levels vary sharply across sectors.

17. Stock screening & use of price multiples Technical screens: identify positions based on trading indicators: Price screens Small stock screens Neglected stocks screens Seasonal screens Momentum screens Insider trading screens Fundamental screens: based on price multiples: Price/Earnings (P/E) ratios Market/Book Value (P/B) ratios Price/Cash Flow (P/C) ratios Price/Dividend (P/d) ratios Any combination of these methods is possible Try Googles stock screener: http:// www.google.com/finance/stockscreener

18. Stock screening using price multiples1. Identify a multiple on which to screen stocks.2. Rank stocks on that multiple, from highest to lowest.3. Buy stocks with the lowest multiples and (short) sell stocks with the highest multiples.What are the implied assumptions?

19. Fundamental Screening: Fundamental Screening: Returns to P/E Screen Returns to P/B Screen Two-way Screening: P/E and P/B

20. Technical Screening: Technical Screening: Returns to Size Returns to Beta (is Beta dead?) Source: Fama and French (1992)Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Size and Beta Groups

21. Returns to two fundamental screens Value GlamourSource: Lakonishok, Shleifer, & Vishny, Contrarian Investment, Extrapolation,and Risk, Journal of Finance, Vol. 49, No. 5. (Dec., 1994), p 1554.

22. Year by Year Returns: Value Minus GlamourSource: Lakonishok, Shleifer, & Vishny, Contrarian Investment, Extrapolation,and Risk, Journal of Finance, Vol. 49, No. 5. (Dec., 1994), p 1566.

23. P/B and P/V Ratios: The Dow Stocks during 1979-96Source: Lee, Myers &Swaminathan, What is theIntrinsic Value of the Dow,Journal of Finance, (Oct., 1999).

24. Problems with Screening You could be loading up on a risk factor You need a risk model You are in danger of trading with someone who knows more than you You need a model that anticipates future payoffs A full-blown fundamental analysis supplies this

25. 2. Asset Based Valuation Values the firms assets and then subtracts the value of debt: The balance sheet does this calculation, but imperfectly: Shareholders Equity = Total Assets -Total Liabilities Problems with this approach: Getting the value of operating assets when there is not a market for them Identifying value in use for a particular firm Getting the value of omitted intangible assets (brand names, R&D, monopolistic position, etc.) Getting the value of synergies of assets being used together Applications: Asset-based firms such as oil and gas and mineral products Calculating liquidation value

26. Investment decision: cost of capital vs. expected return infoHewlett-Packard Company: Measuring (expected) returns for 1991 Required return (i.e. cost of capital) is 12%Price forecast at end of 1991 $50.375 1991 dividend forecast .480Price at end of 1990 46.000 => Expected rate of return = ? Should we buy, hold or sell this stock?

27. Investment decision: the no arbitrage condition P + d1 P0 = 1 If the price paid for a stock is (expected payoff discounted at the required payoff per dollar, ), the stock is appropriately priced: the market price is efficient Or, price is efficient if it equals the expected return capitalized at the required rate-of-return: P +d P P0 = 1 1 0 1 Or, todays price (P0) must be such that the required rate-of-return, - 1, will equal the (expected) rate-of-return: P + d1 P0 1 = 1 P0 Required Rate-of Return = Expected Rate-of-Return

28. Investment decision: arbitrage trading strategies If no arbitrage holds, the market is efficient for that stock: there is no arbitrage opportunity Any discrepancy between expected and required rate-of-return, is an arbitrage opportunity that, if exploited, will profit the arbitrage trader. An arbitrage opportunity arises if If P1 + d1 P0 > 1 then BUY P0 If P + d1 P0 1 < 1 then SELL P0The difference is called the expected abnormal return and the rule can be restated as: BUY if the expected abnormal return is positive, and SELL if negative. If it is zero, do nothing (HOLD)

29. Investment decision: multiyear equity investments These concepts apply to an investment for more than one period with two modifications: The multiperiod rate-of-return will be the compounded annual rate. Dividends for the intermediate years can be reinvested at . For a T-year period and a flat term structure, the required payoff is T For a changing term structure it would be: 1* 2* 3** T The accumulated value at year T of reinvested dividends is called terminal value of dividends at T: T T t d t t =1 Adding the selling price will get the cum dividend payoff or cum- dividend terminal price: T PT + T t d1 t =1 And the T-period cum dividend return will be: T PT + T t d t P0 t =1

30. Example: Hewlett Packard five-year Return 1990 1991 1992 1993 1994 1995 d91=0.24 d92=0.36 d93=0.45 d94=0.55 d95=0.70 0.70 0.55 x 1.12 0.62 0.45x 1.122 0.56 0.36 x 1.123 0.51 0.24 x 1.124 0.38 5 5 d t t E = 1.57 2.76x 1.12 -5 2.77 = d t =1 t 5t E t =1 (1990 value) (1995 value)Terminal value of dividends in 1995 2.77Price payoff in 1995 (PT) 84.00Total Payoff 86.77Purchase price in 1990 (P0) 13.00Five-year Return 73.77Five-year rate-of-return 567.38%Normal rate-of-return (12% p.a.) 76.23%Abnormal rate-of-return 491.15%