equity chapter6

8/11/2019 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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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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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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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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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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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


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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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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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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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


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

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


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

equity chapter6

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