Download - Equity Chapter6
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MARKET-BASED
VALUATION:
PRICE AND ENTERPRISE
VALUE MULTIPLES
PresenterVenueDate
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VALUATION INDICATORS
PriceMultiples
EnterpriseValue
Multiples
MomentumIndicators
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METHODS FOR PRICE & ENTERPRISE VALUE
MULTIPLES
1) Method of Comparables
Economic rationale is the law of one price
2) Method Based on Forecasted Fundamentals
Reflects firm fundamentals and future cash flows
Justified Price Multiples
Can be determined using either method
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PRICE-TO-EARNINGS MULTIPLE
RATIONALES & DRAWBACKS
Rationales
EPS is driver of value
Widely used
Related to stockreturns
Drawbacks
Zero, negative, or verysmall earnings
Permanent vs.transitory earnings
Managementdiscretion for earnings
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PRICE-TO-EARNINGS MULTIPLE
DEFINITIONS
TrailingP/E
Uses lastyears
earnings
Preferredwhen
forecastedearnings arenot available
ForwardP/E
Uses nextyears
earnings
Preferredwhen trailingearnings arenot reflective
of future
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EXAMPLE: FORWARD P/E
Stock price $20 .002011:Q1 EPS $0 .18
2011:Q2 EPS $0 .25
2011:Q3 EPS $0 .32
2011:Q4 EPS $0 .352011 Fiscal year forecast $1 .10
2012:Q1 EPS $0 .43
2012:Q2 EPS $0 .482012:Q3 EPS $0 .50
2012:Q4 EPS $0 .59
2012 Fiscal year forecast $2 .00
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EXAMPLE: FORWARD P/E
1) Forward P/E based on EPS for the next 4 quarters:
EPS for the next 4 quarters = $0.35 $0.43 $0.48 $0.50 $1.76
Forward P/E based on EPS for the next 4 quarters $20 $1.76 11.4
2) Forward P/E based on EP
S for the NTM (next 12 months):
1 11EPS for the NTM $1.10 $2.00 $1.92512 12
Forward P/E based on EPS for the NTM $20 $1.925 10.4
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EXAMPLE: FORWARD P/E
3) Forward P/E based on the current fiscal year's EPS:
EPS for the current fiscal year $1.10
Forward P/E based on EPS for the current fiscal year $20 $1.10 18.2
4) Forward P/E based on the next fiscal ye
ar's EPS:
EPS for the next fiscal year $2.00
Forward P/E based on EPS for the next fiscal year $20 $2.00 10.0
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ISSUES IN CALCULATING EPS
EPS DilutionUnderlyingEarnings
NormalizedEarnings
Differences
in AccountingMethods
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EXAMPLE: UNDERLYING EARNINGS
Reported EPS from previous four quarters $4 .00
Restructuring charges $0 .10
Amortization of intangibles $0 .15
Impairment charge $0 .20
Stock price $50 .00
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EXAMPLE: UNDERLYING EARNINGS
P/E based on reported earnings $50 $4.00 12.5
Reported core earnings $4.00 $0.10 $0.15 $0.20 $4.45
P/E based on reported core earnings $50 $4.45 11.2
Underlying earnings $4.00 $0.20 $4.20
P/E based on und
erlying earnings $50 $4.20 11.9
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EXAMPLE: NORMALIZED EARNINGS
Year EPS BVPS ROE
2010 $0.66 $4.11 16.1%
2009 $0.55 $3.67 15.0%
2008 $0.81 $2.98 27.2%
2007 $0.73 $2.12 34.4%
2006 $0.34 $1.61 21.1%
2011 stock price $24.00
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EXAMPLE: NORMALIZED EARNINGS
1) Method of historical average EPS
($0.66 $0.55 $0.81 $0.73 $0.34)Average (normalized) EPS $0.618
5
P/E $24.00 $0.618 38.8
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EXAMPLE: NORMALIZED EARNINGS
2) Method of average ROE
(16.1% 15.0% 27.2% 34.4% 21.1%)Average ROE 22.8%
5
Average (normalized) EPS Average ROE Current equity book value per shareAverage (normalized) EPS 22.8% $4.11 $0.937
P E $24.00
$0.937 25.6
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JUSTIFIED FORWARD P/E FROM
FUNDAMENTALS
1
0
0 1 1
1
0
1
1
DV
r g
P D EE r g
P b
E r g
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JUSTIFIED TRAILING P/E FROM
FUNDAMENTALS
00
0 0 0
0
0
0
(1 )
(1 )
(1 )(1 )
D gV
r g
P D g EE r g
P b g
E r g
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EXAMPLE: JUSTIFIED FORWARD P/E
FROM FUNDAMENTALS
Retention ratio 0 .36
Dividend growth rate 4 .0%
Required return on stock 10 .0%
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EXAMPLE: JUSTIFIED FORWARD P/E
FROM FUNDAMENTALS
0
1
0
1
1=
1 0.36= =10.7
0.10 0.04
P b
E r gP
E
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EXAMPLE: JUSTIFIED P/E FROM
REGRESSION ON FUNDAMENTALS
Predicted P/E
11.5 2.2 DPR + 0.03 Beta + 16.2 EGR
Values for subject firm
Dividend payout ratio 0 .40
Beta 1 .20
Earnings growth rate 6 .00%Actual P/E 15 .0
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EXAMPLE: JUSTIFIED P/E FROM
REGRESSION ON FUNDAMENTALS
Predicted P/E
11.5 2.2 DPR 0.03 Beta 16.2 EGR
11.5 2.2 0.4 + 0.03 1.2 16.2 0.06
13.3
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METHOD OF COMPARABLES
Benchmark Value of theMultiple Choices
Industry
peers
Industryor sector
index
Broadmarket
index
Firmshistorical
values
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METHOD OF COMPARABLES
USING PEER COMPANY MULTIPLES
Law of one price
Risk and earnings growth adjustments
PEG limitations:Assumes linear relationship
Does not account for risk
Does not account for growth duration
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EXAMPLE: METHOD OF COMPARABLES
USING P/E AND PEG
Values for subject firm
Five-year EPS growth rate 8 .0%
Consensus EPS forecast $4 .50Current stock price $28 .00
Values for peer group
Median P/E 9 .00
Median PEG 1 .60
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EXAMPLE: METHOD OF COMPARABLES
USING P/E AND PEG
P/E $28.00 $4.50 6.2
PEG 6.2 8.0 0.78
Intrinsic value 9.0 $4.50 $40.50
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METHOD OF COMPARABLES
USING INDUSTRY AND MARKET MULTIPLES
Industry or Sector Index
Mean vs. median
Check industry valuation against market
Broad Market Index
Adjust for differences in fundamentals & size
Use relative values on a historical basis
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METHOD OF COMPARABLES
VALUING THE MARKET
Fed Model: Earnings Yield vs. T-Bond Yield
Does not account for inflation correctly
Relationship between earnings yield &
interest rates is nonlinear Small rate s large s in P/E
Yardeni Model
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METHOD OF COMPARABLES
USING OWN HISTORICAL MULTIPLES
Rationale: Regression to the MeanApproaches:
Average of four middle values over past 10 years
Five-year average trailing P/E
Potential Problems from Changes in
Firm business
Firm financial leverage
Interest rate environmentEconomic fundamentals
Inflationary environment
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USING P/ES FOR TERMINAL VALUE
Justified P/E
P/E=
(D/E)/(rg)
Sensitive to requiredinputs
P/E Based onComparables
Grounded in marketdata
If comp is mispriced,terminal value willbe mispriced
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EXAMPLE: USING P/ES FOR TERMINAL VALUE
Values for subject firm
Required rate of return 11 .0%
EPS forecast for year 3 $2 .50
Values for peer group
Mean dividend payout ratio 0 .40
Mean ROE 8 .0%
Median P/E 9 .00
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EXAMPLE: USING P/ES FOR TERMINAL VALUE
USING GORDON GROWTH MODEL
3 3
3
33
EPS Dividend payout ratio
$2.50 0.40 $1.00
Retention ratio 1 Dividend payout ratio
Retention ratio 1 0.40 0.60
Retention ratio ROE
0.60 8% 4.8%
1 $1.00 1 0.048$16.90
0.11 0.048
D
D
g
g
D gV
r g
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PRICE-TO-BOOK VALUE MULTIPLE
RATIONALES
Book Value Is Usually Positive
More Stable than EPS
Appropriate for Financial Firms
Appropriate for Firms that Will Terminate
Can explain stock returns
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PRICE-TO-BOOK VALUE MULTIPLE
DRAWBACKS
Does Not Recognize Nonphysical Assets
Misleading when Asset Levels Vary
Can Be Misleading Due to Accounting Practices
Less Useful when Asset Age Differs
Can Be Distorted Historically by Repurchases
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ADJUSTMENTS TO BOOK VALUE
IntangibleAssets
InventoryAccounting
Off-Balance-Sheet Items Fair Value
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JUSTIFIED P/B
00 0
PV Expected future residual earnings1
P
B B
0
0
ROE
P g
B r g
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PRICE-TO-SALES
MULTIPLE RATIONALES
Sales Less Easily Manipulated
Sales Are Always Positive
P/S Appropriate For Mature, Cyclical, & Distressed Firms
P/S More Stable Than P/E
Can Explain Stock Returns
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PRICE-TO-SALES
MULTIPLE DRAWBACKS
Sales Earnings & Cash Flow
Numerator & Denominator Not Consistent
P/S Does Not Reflect Cost Differences
P/S Can Be Misleading Due to AccountingPractices
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JUSTIFIED P/S
0 0 0
0
( / )(1 )(1 )
P E S b g
S r g
0
ROE
Sales Total assetsPM
Total assets Shareholders equity
g b
g b
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EXAMPLE: CALCULATING THE ACTUAL & JUSTIFIED
P/E, P/B, & P/S
Stock price $50 .00
EPS $2 .00
Dividends per share $1 .20
Book value of equity per share $6 .25Sales per share $15 .00
ROE 22 .5%
Required return on stock 12 .0%
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EXAMPLE: CALCULATING THE ACTUAL
P/E, P/B, & P/S
0
0
0
0
0
0
$50Actual 25.0
$2
$50Actual 8.0$6.25
$50Actual 3.3
$15
P
E
P
B
P
S
EXAMPLE CALCULATING THE INPUTS FOR
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EXAMPLE: CALCULATING THE INPUTS FOR
THE JUSTIFIED
P/E, P/B, & P/S
Dividend payout ratio $1.20 $2.00 0.60
Retention ratio ( ) 1 0.60 0.40
Growth rate in dividends ( ) 0.40 22.5% 9.0%
b
g
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EXAMPLE: CALCULATING THE JUSTIFIED
P/E, P/B, & P/S
0 0 0
0
( )(1 )(1 ) ($2 $15)(0.6)(1.09)
2.9
0.12 0.09
P E S b g
S r g
0
0
(1 )(1 ) (1 0.60)(1 0.09)21.8
0.12 0.09
P b g
E r g
0
0
ROE 0.225 0.09 4.50.12 0.09
P gB r g
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PRICE-TO-CASH-FLOW
MULTIPLE RATIONALES
Cash Flow Less Easily Manipulated
Ratio More Stable Than P/E
Ratio Addresses Quality of Earnings Issue with P/E
Ratio Can Explain Stock Returns
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PRICE-TO-CASH-FLOW
MULTIPLE DRAWBACKS
Cash Flow Can BeDistorted
FCFE More Volatileand More Frequently
Negative
Cash Flow IncreasinglyManaged by Firms
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DEFINITIONS OF CASH FLOW
Earnings + Depreciation +Amortization + DepletionCF
From statement of cash flowsCFO Most valid but volatileFCFE
Best used with enterprisevalueEBITDA
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JUSTIFIED PRICE-TO-CASH-FLOW RATIO
0
0
FCFE (1 )
g
V r g
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DIVIDEND YIELD
RATIONALES & DRAWBACKS
Rationales
Component of return
Dividends less risky
than future capitalgains
DrawbacksOnly one component of
return
Dividends may displacefuture earnings
Market may not favordividends
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JUSTIFIED DIVIDEND YIELD
0
0
1
D r g
P g
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INVERSE PRICE RATIOS
Price RatioInverse Price Ratio
Price-to-earnings (P/E) Earnings yield (E/P)
Price-to-book (P/B) Book-to-market (B/P)
Price-to-sales (P/S) Sales-to-price (S/P)
Price-to-cash-flow (P/CF) Cash flow yield (C/P)
Price-to-dividends (P/D) Dividend yield (D/P)
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ENTERPRISE VALUE/EBITDA MULTIPLE
RATIONALES & DRAWBACKS
RationalesUseful for comparing firms
of different leverage
Useful for comparing firmsof different capital utilization
Usually positive
Drawbacks
Exaggerates cash flow
FCFF more strongly
grounded
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ISSUES IN USING ENTERPRISE VALUE
MULTIPLES
EV = Market Value of Stock + DebtCashInvestments
Justified EV/EBITDA
Positively related to FCFF growth
Positively related to ROIC
Negatively related to WACC
Comparables May Utilize TIC
Other EV Multiples
EV/FCFF EV/EBITA
EV/EBIT
EV/S
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CROSS-COUNTRY COMPARISONS
Net income higher under IFRS Shareholder's equity lower under IFRS
ROE higher under IFRSUS GAAPvs. IFRS
P/CFO & P/FCFE most comparable P/B, P/E, & EBITDA multiples least
comparableValuationMultiples
Higher inflation
Lower justified pricemultiples
Higher pass-through rates Higher justifiedprice multiples
Inflation
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MOMENTUM INDICATORS:
EARNINGS SURPRISES
EPS EPS UESUEUEEPS EPS
t t
t t
E tt
E t
UE EPS EPS t tEt
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VALUATION INDICATORS IN PRACTICE:
AVERAGING MULTIPLES
Overestimate of index P/EArithmetic
Mean &Weighted Mean
Closer to index P/E but isinfluenced by small outliers
Harmonic Mean
Equal to index P/EWeighted
Harmonic Mean
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VALUATION INDICATORS IN PRACTICE:
STOCK SCREENS
Database Limitations
Variables are predetermined
Does not contain qualitative data
Look-Ahead Bias
Assumes investor has info not yet available
Sector Rotation
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SUMMARY
Method of comparables
Method based on forecasted fundamentals
Price & Enterprise Value Multiples
Rationales: EPS Driver of value; widely used;related to stock returns
Drawbacks: Zero, negative, or very small earnings;
transitory components; management discretion forearnings
Trailing and forward P/Es
Price-to-Earnings Rationales & Drawbacks
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SUMMARY
EPS dilution
Underlying earnings
Normalized earnings
Differences in accounting methods
Issues in Calculating EPS
Industry peers
Industry or sector index Broad market index
Own historical values
Method of Comparables
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SUMMARY
Rationales: Book value usually > 0, more stable than EPS,appropriate for financial firms & firms that will terminate,explains stock returns
Drawbacks: Doesnt recognize nonphysical assets, misleadingif asset levels vary or differ from accounting practices, lessuseful when asset age differs, can be distorted by repurchases
Price-to-Book Rationales & Drawbacks
Intangible assets
Inventory accounting Off-balance-sheet items
Fair value
Issues in Calculating Book Value
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SUMMARY
Rationales: Sales less easily distorted, sales always positive,P/S more stable than P/E, appropriate for many firms,explains stock returns
Drawbacks: Sales Earnings & Cash flow, numerator &denominator not consistent, does not reflect cost differences,can be distorted
Price-to-Sales Rationales & Drawbacks
Rationales: CF less easily manipulated, more stable than
P/E, addresses quality of earnings issue, explains stockreturns
Drawbacks: can be distorted, FCFE more volatile and morefrequently negative, increasingly managed by firms
Price-to-Cash-Flow Rationales & Drawbacks
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SUMMARY
CF: Earnings + Depreciation + Amortization + Depletion
CFO: From statement of cash flows
FCFE: Most valid but volatile
EBITDA: Best used with enterprise value
Measures of Cash Flow
Rationales: A component of return, dividends less risky
than future capital gains Drawbacks: Only one component of return, dividends
may displace future earnings, market may not favordividends
Dividend Yield Rationales & Drawbacks
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SUMMARY
Useful when denominators are small, low, or negative(e.g., earnings)
Earnings yield, book-to-market, sales-to-price, cashflow yield, and dividend yield
Inverse Price Ratios
EV = Market value of stock + DebtCashInvestments
Rationales: Useful for comparing firms of differentleverage & capital utilization, usually positive
Drawbacks: Exaggerates cash flow, FCFF morestrongly grounded
Enterprise Value Multiples
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SUMMARY
P/E: + related to g,related to r
P/B: + related to ROE,related to r
P/S: + related to g& PM,related to r
P/CF: + related to g,related to r
D/P: - related to g, + related to r
EV/EBITDA: + related to gand PM, related to WACC
Justified Multiples
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SUMMARY
IFRS ROE higher than GAAP ROE
P/CFO & P/FCFE most comparable
P/B, P/E, & EBITDA multiples leastcomparable
Higher inflationLower justified pricemultiples
Higher pass-through rates Higherjustified price multiples
Cross-Country Comparisons
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SUMMARY
Unexpected earnings (UE)
Standardized unexpected earnings (SUE)
Relative strength
Momentum Indicators
Database limitations
Potential look-ahead bias
Used in sector rotation
Stock Screens