Valuation Methods

Methods of Corporate Valuation

Asset-Based Methods Using Comparables Free Cash Flow Methods Option-Based Valuation

Asset-Based Methods

Balance sheet approach: Cash and working capital (book value close to its

realizable value) Property, Equipment, and Land (appraisal value) Intangibles.

Book value of equity vs market value of equity

Relative Valuation

What is relative valuation? What is the logic underlying relative

valuation? Using comparables

What is relative valuation?

Relative to revenues or cash flows Relative to Earnings Relative to the Book Value of Equity

Relative to Revenue

Price/Sales (PS) Value/Sales (VS) Usually used in valuing retailing firms

Relative to Earnings Price/Earnings Ratio (PE) Trailing Price/Earnings Ratio (trailing PE)

A trailing PE is a price-earnings ratio based on the most recent 12 months' results. U.S. companies report quarterly, so a trailing PE is computed based on the most recent four quarters.

Forward Price/Earnings Ratio (forward PE) Also called estimated PE. Forward PE divides a stock's

current price by its estimated future earnings per share. Forward PE is often used to compare a company's current earnings to its estimated future earnings.

Relative to the Book Value of Equity

Price/Book Value (PBV) Market to book Value (MB)

Advantages to using multiples in valuation analysis

Require fewer explicit assumptions than DCF

Easy to compute and don’t require forecasting

Commonly quoted and used by management and press

Disadvantages to using multiples in valuation analysis

Require more implicit assumptions than DCF

Logic behind valuation analysis is often misunderstood

Identification of comparable firms is subjective

What is logic underlying relative valuation? P/E ratio Think about a basic DCF model (Gordon’s

Growth Model)

Divide both sides by earnings per share

10Value of Equity

e n

DPSP

r g

0 1

0 0

1

e n

P DPSPE

EPS EPS r g

0n

0

1(Payout Ratio) 1+g

e n

PPE

EPS r g

Comparing two PE ratios across firms assumes …

Identical payout ratio Identical cost or equity Identical expected stable-growth rate

What is logic underlying relative valuation? Price to book value

Divide both sides by book value of equity

10Value of Equity

e n

DPSP

r g

0 1

0 0

1

e n

P DPSPBV

BV BV r g

0 1 1

0 0 1

1

e n

P EPS DPSPBV

BV BV EPS r g

00 n

0

1(Payout Ratio) 1+g

e n

PROE PBV

BV r g

Comparing two PE ratios across firms assumes …

Identical payout ratio Identical cost or equity Identical expected stable-growth rate Identical ROE

What is logic underlying relative valuation? Price to sales

Divide both sides by sales

10Value of Equity

e n

DPSP

r g

0 1

0 0

1

e n

P DPSPS

Sales Sales r g

0 1 1

0 0 1

1

e n

P EPS DPSPS

Sales Sales EPS r g

00 n

0

1Gross Profit Margin (Payout Ratio) 1+g

e n

PPS

Sales r g

Comparing two PE ratios across firms assumes …

Identical payout ratio Identical cost or equity Identical expected stable-growth rate Identical Gross profit margin

Using comparables

Construct the multiple for the set of comparable firms

Average the multiple across the set of comparable firms

Compare individual firm to this average Differences may be attributed to differences in

underlying logic of multiple Differences may be attributed to inefficient

markets (price)

Remember to control for differences between firms

Growth Payout Risk ROE Profit Margin

Ways to control for differences between firms Sample firms and sort according to attributes (Growth,

Payout, Risk, ROE, Profit) Requires a large number of potential comparables Compare your firm to subset of comparables with similar

attributes Modify the multiples to make them more comparable

Divide the PE ratio by the expected growth rate in EPS (PEG Ratio)

Divide PBV ratio by the ROE (Value Ratio) This assumes firms are comparable on all other attributes

Run regression of multiples on attributes

Use coefficient values from regression and attributes for the firm to predict the correct multiple for the firm.

0 1 2 3PE growth payout risk

Regression-based multiple analysis

Damodaran ran regressions on 2,475 firms using data from 1998

PE=291.27*Growth+37.74*Payout+21.62*Beta PBV=3.99*Payout-0.79*Beta+60.65*growth+31.56*ROE PS=11.56*Growth+1.41*Payout-1.42*Beta+11.93*Margin

Free cash flow method

Free cash flows to equity Free cash flows to firm

Basic case Firms with insufficient valuation data Acquisition valuation

Option base valuation

Real option approach in valuing firm