sec analysis_lec 5

7/31/2019 Sec Analysis_Lec 5

1/37


2/37

Residual income valuation

&Relative valuation

Amit Obhan


3/37



4/37

Streams of Expected Cash Flows

Residual


5/37

1. Residual income

Residual income (RI), or economic profit, is the net income of afirm less a charge that measures stockholders opportunity cost ofcapital

The rationale for the residual income approach is that it recognizesthe cost of equity capital in the measurement of income

This concept of economic income is not reflected in traditionalaccounting income, whereby a firm can report positive net incomebut not meet the return requirements of its equity investors

Accounting net income includes a cost of debt (i.e., interestexpense), but does not reflect dividends or other equity capital-related funding costs

This means that accounting income may overstate returns from theperspective of equity investors. Conversely, residual incomeexplicitly deducts all capital costs


6/37

2. Economic value added


7/37

3. Market value added

Market value added (MV A) is the differencebetween the market value of a firms long-term debt and equity and the book value of

invested capital supplied by investors It measures the value created by

managements decisions since the firmsinception

MVA is calculated as:

oMVA = market value invested capital


8/37

About RI Models

There are several commercially available

residual income-based valuation models

Models, like EV A and MVA, usually apply the

concept of residual income to the

measurement of managerial effectiveness and

executive compensation

Thus we will focus on Residual income models


9/37

Forecasting residual income


10/37

Valuation using residual income

The residual income valuation model breaks theintrinsic value of a stock into two elements:

1. current book value of equity and

2. present value of expectedfuture Residual income:


11/37


modelcontd

The general residual income models make noassumptions regarding the long-term future earningsor dividend growth

However, if we make the simplifying assumption of a

constant dividend and earnings growth rate, we candevelop a residual income model that highlights thefundamental drivers of residual income

This model is actually just another version of the Gordon growth model, soif you can use the same inputs, both models will give you the same valueestimates

The first term is the book value and the second term is the present value

of expected future residual income


12/37

Multi-stage residual income

As we modeled in DDM, we can also forecast residualincome in multi-stage depending on the assumption aboutindustry and firms competitive advantage over the longerterm

It involves forecasting residual income over a short-termand then make simplifying assumptions about the patternof residual income growth over long term Residual income is expected to persist at its current level forever

Residual income is expected to drop immediately to zero

Residual income is expected to decline to a long-run averagelevel consistent with a mature industry

Residual income is expected to decline over time as ROE falls tothe cost of equity (in which case residual income is eventuallyzero)

V0 = B0 + (PV of interim high-growth RI) + (PV of continuing residual income)


13/37

RI vs. DDM vs. FCFE

DDM and FCFE models measure value by discounting a stream of expected cash flowswhere as the residual income model starts with a book value and adds to this the presentvalue of the expected stream of residual income

Theoretically, the intrinsic value derived using expected dividends, expected free cash flowto equity, or book value plus expected residual income should be identical if the underlyingassumptions used to make the necessary forecasts are the same

In reality, however, it is rarely possible to forecast all of the common inputs with the same

degree of accuracy, and the different models yield different results

It may be helpful though, to use a residual income model alongside a DDM or FCFE modelto assess the consistency of results. If the different models provide dramatically different

estimates, the inconsistencies may result from the models underlying assumptions


14/37

Strengths and weakness of RI Model

Strengths

Terminal value does not dominate theintrinsic value estimate, as is the case

with dividend discount and free cashflow valuation models

Residual income models useaccounting data, which is usually easyto find

The models are applicable to firms thatdo not pay dividends or that do nothave positive expected free cash flows

in the short run The models are applicable even when

cash flows are volatile

The models focus on economicprofitability rather than just onaccounting profitability

Weakness

The models rely on accounting datathat can be manipulated bymanagement

Reliance on accounting data requiresnumerous and significant adjustments

The models assume that the cleansurplus relation holds or that its failureto hold has been properly taken intoaccount


15/37

Selection of residual income model

Residual income models are appropriate under thefollowing circumstances:

A firm does not pay dividends, or the stream of payments is toovolatile to be sufficiently predictable

Expected free cash flows are negative for the foreseeable future

The terminal value forecast is highly uncertain, which makesdividend discount or free cash flow models less useful

Residual income models are not appropriate under thefollowing circumstances:

The clean surplus accounting relation is violated significantly

There is significant uncertainty concerning the estimates ofbook value and return on equity


16/37

Relative valuation


17/37

Relative valuation techniques

Relative valuations are based on current equityvaluations in the market

Multiples of an industry or a firm is compared to thatof comparable industry or firm

Relative valuation techniques are most appropriatewhen the market itself is neither severely over- orundervalued

Most valuations on Wall Street are relative valuations

Almost 85% of equity research reports are based upon amultiple and comparables

More than 50% of all acquisition valuations are basedupon multiples

Rules of thumb based on multiples are not only common

but are often the basis for final valuation judgments


18/37

To do relative valuation

compare the standardized value or multiple for the asset being analyzedto the standardized values for comparable asset, controlling for any

differences between the firms that might affect the multiple, to judge

whether the asset is under or over valued

convert these market values into standardized values, since theabsolute prices cannot be compared, this process of standardizing

creates price multiples

Identify comparable assets and obtain market values for theseassets


19/37

Price Multiples

Price to Earnings (P/E)

Price to Book Value (P/BV)

Price to Sales (P/S)

Price to Cash Flow (P/CF)


20/37


Rational for using P/E ratio in valuation

Earnings power, measured by EPS is the primary determinant ofinvestment value

The P/E ratio is popular in the investment community

Empirical research shows that stocks with low P/E have given higherreturns

Drawbacks of using P/E ratio

Earnings can be negative which produces useless P/E ratio The volatile, transitory portion of earnings makes the interpretation

of P/E difficult

Management discretion within allowed accounting practices candistort reported earnings and thereby lessen the comparability of P/Eratios across firms


21/37


We can define 2 versions of P/E ratio

Trailing P/E: Uses earnings over the most recent

12 month in the denominator

Leading P/E: Uses next years expected earnings

which is defined as either expected EPS for thenext four quarter or next fiscal year


22/37

Price to Book Value (P/BV)

Advantages of P/BV ratio

Book value is cumulative amount that is usually positive,even when the firm reports a loss and EPS is negative

BV is more stable than EPS, thus it is more useful when EPS

is volatile BV is an appropriate measure of net asset value for firms

that primarily hold liquid assets. For e.g. finance,investment, insurance and banking firms

It can be used to value companies that are expected to goout of business

Empirical research shows that P/BV ratios help explaindifferences in long-run average return


23/37

Price to Book Value (P/BV)Contd

Disadvantages of using P/BV P/BV ratios do not recognize the value of non physical

assets such as human capital

P/BV ratios can be misleading when there are

significant differences in the assets due to differentproduction methods

Different accounting conventions can obscure the trueinvestment in the firm made by shareholders, whichreduces the comparability

Inflation and technological changes can cause thebook and market value of assets to differ significantly,thus book value may not be an accurate measure ofshareholders investment


24/37

There are a few adjustments we must consider

Use tangible book value i.e. BV of equity intangible asset

(It includes goodwill, patent) Adjust for significant off-balance-sheet assets and liabilities

Adjust for differences in fair and recorded value of assets

and liabilities

Adjust for different accounting method for comparability

Price to Book Value (P/BV)Contd


25/37

Price to Sales (P/S)

The rationales for using the price to sales ratio include P/S is meaningful even for distressed firms, since sales

revenue is always positive. This is not the case with P/E &P/BV which can be negative

Sales revenue is not as easy to manipulate or distort as EPSor BV, which are significantly affected by accountingconventions

P/S ratios are less volatile

Appropriate for valuing stocks in mature or cyclical

industries and for start-up companies with no record ofearnings

Like P/E and P/BV ratios, empirical research has shown thatdifferences in P/S are significantly related to differences inlong-turn average return


26/37

Price to Sales (P/S)Contd

The disadvantages of using P/S ratios

High growth in sales does not necessarily indicateoperating profits as measured by earnings and cash flows

P/S ratios do not capture difference in cost structure across

companies While less subject to distortion than earnings or cash

flows, revenue recognition practices can still distort salesforecast


27/37

Price to Cash Flow (P/CF)

Rational for using price to cash flow ratio Cash flow is more difficult for managers to manipulate than

earnings

It is more stable than price to earnings

Reliance on cash flow rather than earnings addresses theproblem of differences in the quality of reported earnings

Empirical research has shown that differences in P/CF ratios aresignificantly related to differences in long-run average stockreturn


28/37

Price to Cash Flow (P/CF)Contd

Drawbacks of price to cash flow ratios

Some items affecting actual cash flow from operationsare ignored when the EPS plus noncash chargesestimate is used. For example, noncash revenue and

net changes in working capital are ignored

From a theoretical perspective, free cash flow toequity (FCFE) is probably preferable to cash flow.However, FCFE is more volatile than straight cash flow


29/37

Method of comparables vs. forecasted

fundamental

Method of Comparables:

The method of comparables, values a stock based on the average price multiple ofthe stock of similar companies

The economic rationale for the method of comparables is the Law of One Price,

which asserts that two similar assets should sell at comparable price multiples(e.g., price-to-earnings)

This is a relative valuation method, so we can only assert that a stock is over- orundervalued relative to benchmark value

Method of forecasted fundamental:

This method values a stock based on the ratio ofits value from a discounted cashflow (DCF) model to some fundamental variable (e.g., earnings per share)

The economic rationale for the method of forecasted fundamentals is that thevalue used in the numerator of the justified price multiple is derived from a DCFmodel: value is equal to the present value of expected future cash flows

discounted at the appropriate risk-adjusted rate of return


30/37

Benchmarking the multiples

The method of comparables approach to valuationcompares a stocks price multiple to a benchmark ofthe multiple using the following steps:

1. Select and calculate the multiple that will be used

2. Select the benchmark and calculate the mean or medianof its multiple over the group of comparable stocks

3. Compare the stocks multiple to the benchmark

4. Examine whether any observed difference between the

multiples of the stock and the benchmark are explainedby the underlying determinants of the multiple, andmake appropriate valuation adjustments


31/37

Overvalued, undervalued or fairly

valued

The basic idea of the method of comparables is tocompare a stocks price multiple to that of abenchmark portfolio

Firms with multiples below the benchmark are

undervalued, and firms with multiples above thebenchmark are overvalued

However, the fundamentals of the stock shouldbe similar to the fundamentals of the benchmark

before we can make direct comparisons and drawany conclusions about whether the stock isovervalued or undervalued


32/37

P/E-to-growth ratio (PEG)

The relationship between earnings growth and P/E iscaptured by the P/E-to-growth (PEG) ratio:

The PEG is interpreted as P/E per unit of expected growth

Remember that the growth rate is one of the fundamentalfactors that affect P/E (P/E is directly related to the growthrate)

The PEG ratio, in effect, standardizes the P/E ratio forstocks with different expected growth rates

The implied valuation rule is that stocks with lower PEGsare more attractive than stocks with higher PEGs, assumingthat risk is similar


33/37

Drawbacks to using PEG ratio

The relationship between P/E and g is not

linear, which makes comparisons difficult

The PEG ratio still doesnt account for risk

The PEG ratio doesnt reflect the duration of

the high-growth period for a multistage

valuation model, especially if the analyst uses

a short-term high-growth forecast


34/37

Use of price multiples in DCF

A terminal value that is projected as of the end ofthe investment horizon should reflect theearnings growth that a firm can sustain over thelong run, beyond that point in time

Analysts often use terminal price multiples likeP/E, P/B, P/S, and P/CF to estimate terminal value

No matter which ratio is used, terminal value is

calculated as the product of the price multiple(e.g., P/E ratio) and the fundamental variable(e.g., EPS) i.e. P/E X EPS


35/37

EV/EBITDA

EBITDA is a flow to both equity and debt, it should be related to anumerator that measures total company value

EV = market value of common stock + market value of preferredequity + market value of debt + minority interest cash andinvestments

The rationale for subtracting cash and investments is that anacquirers net price paid for an acquisition target would be lowered

by the amount of the targets liquid assets. Thus, EV /EBIT DAindicates the value of the overall company, not equity

EBITDA = recurring earnings from continuing operations + interest +taxes + depreciation + amortization

Or EBITDA = EBIT + depreciation + amortization


36/37

Advantages / Disadvantages of

EV/EBITDA

EV /EBITDA is useful in a number of situations:

The ratio may be more useful than P/E when comparing firms withdifferent degrees of financial leverage

EBITDA is useful for valuing capital-intensive businesses with high levels

of depreciation and amortization EBITDA is usually positive even when EPS is not

EV /EBITDA has a number of drawbacks as well:

If working capital is growing, EBITDA will be overstated in comparison to

actual cash flow to the firm. Further, the measure ignores how differentrevenue recognition policies affect Cash flows

Because FCFF captures the amount of capital expenditures, it is morestrongly linked with valuation theory than EBITDA. EBITDA will be anadequate measure if capital expenses equal depreciation expenses


37/37

Multiples use for Stock Screening

A stock screen is a method for selecting attractivelypriced stocks from the large universe of potentialequity investments For example, the objective might be to identify growth

stocks, income stocks, or value stocks

Valuation indicators, such as those we have described inthis topic review, can be used to identify a subset ofavailable stocks for further analysis

Analysts often use multiple valuation, momentum, andfundamental criteria in a stock screen

E.g., (P/E < 15; PEG > 1.5; Mcap > 1bn)

An analyst can use back testing to examine whichstocks a screen would have identified in the past andhow they would have performed

sec analysis_lec 5

Documents