3 relative valuation

RELATIVE VALUATION

Professor Liu YangMGMT 231CUCLA Anderson School

Relative Valuation is Pervasive

Most valuation on Wall Street are relative valuationsAbout 85% of equity research reports and 50% of the

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About 85% of equity research reports and 50% of the acquisition valuations are based on relative valuation

While there are more DCF valuations in consulting and corporate finance, they often use components from relative valuation

The terminal value in a significant number of DCF gvaluations is estimated using a multiple.The objective in many DCF valuations is to back into a number that has been obtained by using a multiple.

MGMT 231C: Relative Valuation

What is Relative Valuation?

The value of an asset is compared to the values assessed by the market for similar or comparable

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assessed by the market for similar or comparable assets.

To do relative valuation , we need to1. Identify comparable assets and obtain market values

for these assets,k l i d di d l2. Convert market values into standardized value

(multiples), and3. Compare the multiple for comparable assets and the

asset being analyzed, controlling for any differences


Types of Multiples

Quantity x Multiple = Value Terminology

EBITDA EV/EBITDA EV EBITDA M l i l

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EBITDA x EV/EBITDA EV EBITDA Multiple

EBIT x EV/EBIT EV EBIT Multiple

EPS x P/EPS P PE Ratio

Sales x EV/Sales EV Sales Multiple

BV of Asset x EV/BVA EV Book Multiple

# of Customers

x EV/#Customer

EV Customer Multiple

Sq. Ft. x EV/Sq. Ft. EV Sq. Ft. Multiple


Trading versus Transaction Multiples

Trading multiples are based on a set of comparable publicly traded firms

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publicly traded firms.

Transaction multiples are based on prices that have been paid for comparable firms in a merger or acquisition.

The transaction multiple usually exceeds the trading multiple due to potential synergy between the acquirer and the target.


Example: Trading Multiples

Company EV (in $m) EV/SALES EV/EBITDA EV/EBIT

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Starbucks $17,070 1.75x 12.78x 22.10x

McDonald’s $75,620 3.39x 10.07x 11.94x

Yum! Brands $19,110 1.76x 9.11x 12.37x

Burger King $3,320 1.33x 7.74x 10.01x

Peet’s Coffee $420 1.41x 11.29x 20.69x


Source: Yahoo! Finance (Jan. 12th 2010)

Example: Transaction Multiples

DateAnnounced

Target Acquirer EV(in $m)

EV/EBITDA

EV/EBIT

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Announced (in $m) EBITDA EBIT

4/24/2008 Wendy's International

Triarc Cos Inc2,680 9.31 15.60

1/16/2007 Smith & Wollensky

Landry's Restaurants 88 10.66 27.13

8/16/2007 RARE Hospitality

Darden Restaurants 1,370 11.81 17.53


Price Earnings Ratio: Definition

PE = Price per Share / Earnings per Share8

Price: Current price or the average price

EPS = Earnings / # of sharesEarnings

Time frame: earnings in the most recent financial year (Current PE), in the last 4 quarters (Trailing PE), and expected earnings in the next q ( g ), p gfiscal year(Forward PE)

Number of sharesCurrent shares outstanding (Primary EPS) or all possible shares (Diluted EPS)


PE Ratio: Descriptive Statistics9

Current PE = 18.91Trailing PE = 17.48Forward PE = 20.04


PE Ratio: The Fundamentals

Assume that a firm has a stable growth rate g and a cost of equity ke

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**RR: Reinvestment Rate

h h h ld l ll b h h f

( ) ( ) ( )

( ) ⎟⎟⎠

⎞⎜⎜⎝

⎛−+

=

−+××

=−+

=

gkg1

RR‐1EP

gkg1RR‐1E

gkg1FCFE

P

e0

0

e

0

e

00

Other things held equal, PE ratio will be higher forHigher growth rateLower cost of equity (or lower risk)Lower reinvestment needs


Example: Implied PE(Stable Growth)

Firm A expects to have a stable growth rate of 5% and a reinvestment rate of 50%. It has an estimated beta of 1. The

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risk‐free rate is 6% and market risk premium is 5.5%. What is its implied PE ratio based on DCF?Cost of equity = 6.0% + 1 (5.5%) = 11.5%PE = (1 – RR) (1 + g) / (ke – g)

= (1‐ 50%) (1 + 5%) / (11.5% ‐ 5%) = 8.07

The firm is trading at a PE of 12. Would you recommend to buy its stocks?


Example: Implied PE(Two‐Stage Growth)

Firm B expects to have high growth in the first 5 years, followed by stable growth with the following information:

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First 5 years After 5 yearsGrowth Rate 25% 5%Reinvestment 80% 50%Beta 1.2 1.0Risk‐free rate = 6% Market risk premium = 5.5%

Estimate the implied PE ratio for Firm B. Firm B is currently trading at a PE of 22, would you recommend to buy its stocks?


Cost of equity (hg) = 6.0% + 1.2 (5.5%) = 12.6%

Cost of equity (sg) = 6.0% + 1 (5.5%) = 11.5%

Current Earning $1g

YearGrowth rate Earning

Reinvestment FCFE

Terminal Value Ke PV

1 25% 1.25 80% 0.25 12.6% 0.222 25% 1.56 80% 0.31 12.6% 0.253 25% 1.95 80% 0.39 12.6% 0.274 25% 2.44 80% 0.49 12.6% 0.305 25% 3.05 80% 0.61 24.65 12.6% 13.95


5 25% 3.05 80% 0.61 24.65 12.6% 13.95

6 5% 3.20 50% 1.60 11.50%

PE = 15.00

PE Ratios: Direct Comparison

Choose a group of comparable firms, and

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Company Name Trailing PECoca‐Cola Bottling 29.18Molson Inc 'A' 43 65comparable firms, and

Calculate the average PE ratio for this group,

PE > average (PE) over‐valued

Molson Inc. A 43.65Anheuser‐Busch 24.31Corby Distilleries 16.24Chalone Wine Group 21.76Andres Wines 'A‘ 8.96Todhunter Int'l 8.94Brown‐Forman 'B' 10.07Coors (Adolph) 'B' 23.02PepsiCo, Inc. 33.00C C l 44 33PE < average (PE)

under‐valued

Coca‐Cola 44.33Boston Beer 'A' 10.59Whitman Corp. 25.19Mondavi (Robert) 'A' 16.47Coca‐Cola Enterprises 37.14Hansen Natural Corp 9.70Industry Mean 22.66Industry Median 22.39

PE Ratio: Other Factors15

Company Name Trailing PE Exp. Growth STDEV(RET) Coca‐Cola Bottling 21.98 9.50% 20.58%M l I L d 'A' 43 65 15 50% 21 88%Molson Inc. Ltd. 'A' 43.65 15.50% 21.88%Anheuser‐Busch 24.31 11.00% 22.92%Corby Distilleries Ltd. 16.24 7.50% 23.66%Chalone Wine Group Ltd. 21.76 14.00% 24.08%Andres Wines Ltd. 'A' 8.96 3.50% 24.70%Todhunter Int'l 8.94 3.00% 25.74%Brown‐Forman 'B' 10.07 11.50% 29.43%Coors (Adolph) 'B' 23.02 10.00% 29.52%PepsiCo, Inc. 33.00 10.50% 31.35%Coca‐Cola 44.33 19.00% 35.51%Boston Beer 'A' 10.59 17.13% 39.58%Whitman Corp. 25.19 11.50% 44.26%Mondavi (Robert) 'A' 16.47 14.00% 45.84%Coca‐Cola Enterprises 37.14 27.00% 51.34%Hansen Natural Corp 9.70 17.00% 62.45%

PE Ratios: Regression Approach

In contrast to the “direct comparison” approach, the information in the entire cross‐section of firms can be used

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to predict PE ratios.

Estimate the predicted PE ratio based on a multivariate regression, with the PE ratio as the dependent variable, and proxies for risk, growth and payout forming the independent variables.

Compare the actual PE ratio with the predicted PE ratio.If actual PE > predicted PE Over‐valued (sell)If actual PE < predicted PE Under‐valued (buy)


Example: PE Regression17

Dependent variable: Current PEThis is based on US stocks in Jan, 2008

R‐square = 0.419

Model Coefficent t SignificanceConstant 2.741 3.00 0.003Expected growth in EPS (for the next 5 years) (in %)

0.669 35.40 0.000


y ) ( )Payout ratio (in %) 0.090 4.73 0.000Beta (from 3‐yr regression) 0.021 1.15 0.249

*Payout ratio = 1 – Reinvestment Rate

Example: PE Regression (cont.)

Wal‐mart has an expected growth rate of 11.46%, a beta of 0.28 and a reinvestment rate of 74%. Estimate

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Wal‐mart’s the predicted PE ratio.Predicted PE = 2.741 + 0.669 (11.46) + 0.09 (100 ‐ 74)

+ 0.02 (0.28) = 10.44

Wal‐mart is currently trading at a PE of 15. What is your recommendation on its stocks?


Problems with Regression Methodology

The OLS regression assumes a linear relationship between PE ratios and financial proxies, and that might

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not be appropriate.

The basic relationship between PE and financial variables might not be stable. If it shifts from year to year, the predictions from the model may not be reliable.

The independent variables are correlated with each other. The resulting multi‐collinearity problem makes the coefficients from the regressions unreliable.


PEG Ratio: Definition

PEG = PE / Expected Growth Rate in Earnings (in %)

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The EPS used in the denominator of the PE ratio should be the base on which growth is estimated.

No double counting: If the estimate of growth in EPS i f h i ld b i l diEPS is from the current year, it would be misleading to use forward EPS in computing PEG.


Adjusting for Growth21

P/E (Trailing) Exp. Growth (5 )

PEG(5yr)

GOOG 27.19 20.91% 1.30

MSFT 16.66 11.00% 1.51

McDonalds 15.73 9.43% 1.67

Starbucks 22.83 16.57% 1.38


Source: Yahoo Finance (Jan 4th. 2009)

PEG Ratio: Distribution22

Mean(PEG)=1.42


Example: PEG Ratio – Direct Comparison23

Company Name Trailing PE Exp. Growth STDEV(RET) PEGCoca‐Cola Bottling 21.98 9.50% 20.58% 2.31Molson Inc. Ltd. 'A' 43.65 15.50% 21.88% 2.82Molson Inc. Ltd. A 43.65 15.50% 21.88% 2.82Anheuser‐Busch 24.31 11.00% 22.92% 2.21Corby Distilleries Ltd. 16.24 7.50% 23.66% 2.17Chalone Wine Group Ltd. 21.76 14.00% 24.08% 1.55Andres Wines Ltd. 'A' 8.96 3.50% 24.70% 2.56Todhunter Int'l 8.94 3.00% 25.74% 2.98Brown‐Forman 'B' 10.07 11.50% 29.43% 0.88Coors (Adolph) 'B' 23.02 10.00% 29.52% 2.30PepsiCo, Inc. 33.00 10.50% 31.35% 3.14Coca‐Cola 44.33 19.00% 35.51% 2.33Boston Beer 'A' 10.59 17.13% 39.58% 0.62Whitman Corp. 25.19 11.50% 44.26% 2.19Mondavi (Robert) 'A' 16.47 14.00% 45.84% 1.18Coca‐Cola Enterprises 37.14 27.00% 51.34% 1.38Hansen Natural Corp 9.70 17.00% 62.45% 0.57Industry Mean 22.21 13% 33% 1.95Industry Median 21.98 12% 30% 2.19

PEG Ratio: The Fundamental Factors

Assume a firm has stable growth rate g and a cost of equity k

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equity ke .

( )

( )( )g‐kg

g1 RR) ‐ (1g/EP

PEG

g‐kg)+(1RR‐1 E

=P

e

00

e

00

+==

×

The same factors, growth, risk, and reinvestment ratios continue to affect PEG ratio.


EV Earning Multiples

While PE ratios look at the market value of equity relative to earnings to equity investors EV/Earning

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relative to earnings to equity investors, EV/Earning ratios look at the market value of the operating assets (Enterprise Value) relative to operating earnings.

EBITDA Multiple: EV/EBITDA

EBIT Multiple: EV/EBIT or EV/EBIT(1‐t)

FCFF Multiple: EV/FCFFp /

Enterprise value = MVD + MVE – Cash & Cash‐equivalent


Example: Earning Multiples

MCI Communications had an EBIT of $3,356 million in 1994 and a net income after tax of $855 million.

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1994 and a net income after tax of $855 million.

It had capital expenditures of $2,500 million and depreciation of $1,100 million, and its working capital increased by $250 million.

The Enterprise Value of MCI is about $15,577 million.p ,

Calculate the EBITDA, EBIT, EBIT(1‐t), and FCFF multiples


Example: Earning Multiples (cont.)

EBIT =3,356 EBIT (1 t) = 3 356 (1 0 36) = 2 148

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EBIT (1‐t) = 3,356 (1‐0.36) = 2,148EBITDA = 3,356 + 1,100 = 4,456FCFF = EBIT(1‐t) – (CapEx – DA) ‐ ΔNWC

= 2,148 – (2,500 – 1,100) – 250 = 498

EV/EBITDA = 15 577 / 4 456 = 3 50EV/EBITDA = 15,577 / 4,456 = 3.50EV/EBIT = 15,577 / 3,356 = 4.64EV/FCFF = 15,577 / 498 = 32.28


Advantages of Using EBITDA Multiple

It can be computed even for firms are reporting net losses.

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For firms that require a substantial investment in infrastructure, EBITDA multiple seems to be more appropriate than the PE ratio.

EBITDA measures cash flows from operations that is before any discretionary spending.y y p g

EBITDA is independent of debt level, and therefore allows for comparison across firms with different financial leverage.


EV/EBITDA Multiple29

EV/EBIT = 6.14EV/EBITDA = 5.05


The Determinants of EV/EBITDA30

( )have we then model, growth stable a Assume

EV/EBITDA ratio is higher for firms with

( ) ( )( )[ ]

( ) ( )⎥⎦⎤

⎢⎣⎡ −+

−−+

=

−−+−−−

+=

−+

=

EBITDAtDAΔNWCCapex

t1g‐WACC

g1EBITDAEV

ΔNWCCapexDAt1DAEBITDAgWACC

g1gWACCg1FCFF

EV


/ gLower riskHigher growthLower reinvestment needsHigher depreciation and lower tax rate

Sales Multiples

EV/Sales: The Enterprise Value per $ of sales

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Fundamental factors

( )( )( )( )( )

( )gWACCg1RR1 t‐1 Margin Op. Sales

g‐WACCg)FCFF(1

EV

−+−

=

+=


( )( )( )( )( )gWACC

g1 RR1 t‐1 Margin Op. SalesEV

−+−

=⇒

Book Multiples

Book multiple for equity or firmMVE / BVE or EV/BVA

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Determinants of book multiples

( ) ( ) ( ) ( )

h/ROERRSi

gk

RR‐1 ROE

BV

P

gk

RR‐1ROE BV

gk

RR‐1 EP

e0

0

e

0

e

10 −

×=⇒

−××

=−

×=


[ ]gkgROE

gkg/ROE‐1 ROE

BVP

havewe g/ROE,RR Since

ee0

0

−−

=−

×=

=

3 relative valuation

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