market-based valuation: price and enterprise value multiples presenter venue date
TRANSCRIPT
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MARKET-BASEDVALUATION:
PRICE AND ENTERPRISE VALUE MULTIPLES
PresenterVenueDate
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VALUATION INDICATORS
Price Multiples
Enterprise Value
Multiples
Momentum Indicators
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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 MULTIPLERATIONALES & DRAWBACKS
RationalesEPS is driver of value
Widely used
Related to stock returns
DrawbacksZero, negative, or very
small earnings
Permanent vs. transitory earnings
Management discretion for earnings
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PRICE-TO-EARNINGS MULTIPLE DEFINITIONS
Trailing P/E
Uses last year’s
earnings
Preferred when
forecasted earnings are not available
Forward P/E
Uses next year’s
earnings
Preferred when trailing earnings are not reflective
of future
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EXAMPLE: FORWARD P/E
Stock price $20 .002011:Q1 EPS $0 .182011:Q2 EPS $0 .252011:Q3 EPS $0 .322011:Q4 EPS $0 .352011 Fiscal year forecast $1 .10
2012:Q1 EPS $0 .432012:Q2 EPS $0 .482012:Q3 EPS $0 .502012:Q4 EPS $0 .592012 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 Dilution Underlying Earnings
Normalized Earnings
Differences in Accounting
Methods
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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
10
0 1 1
1
0
1
1
DV
r g
P D E
E 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 E
E 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 g
P
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 the Multiple Choices
Industry peers
Industry or sector
index
Broad market index
Firm’s historical values
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METHOD OF COMPARABLESUSING PEER COMPANY MULTIPLES
Law of one priceRisk and earnings growth adjustmentsPEG limitations:Assumes linear relationship Does not account for risk Does not account for growth duration
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EXAMPLE: METHOD OF COMPARABLESUSING P/E AND PEG
Values for subject firmFive-year EPS growth rate 8.0%Consensus EPS forecast $4.50Current stock price $28.00
Values for peer groupMedian P/E 9 .00Median PEG 1 .60
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EXAMPLE: METHOD OF COMPARABLESUSING 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 COMPARABLESUSING 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 COMPARABLESVALUING 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 COMPARABLESUSING OWN HISTORICAL MULTIPLES
Rationale: Regression to the Mean Approaches:
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 environment Economic fundamentals Inflationary environment
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USING P/ES FOR TERMINAL VALUE
Justified P/E
P/E =
(D/E)/(r – g)
Sensitive to required inputs
P/E Based on Comparables
Grounded in market data
If comp is mispriced, terminal
value will be mispriced
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EXAMPLE: USING P/ES FOR TERMINAL VALUE
Values for subject firmRequired rate of return 11.0%EPS forecast for year 3 $2.50
Values for peer groupMean dividend payout ratio 0 .40Mean ROE 8.0%Median P/E 9 .00
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EXAMPLE: USING P/ES FOR TERMINAL VALUEUSING GORDON GROWTH MODEL
3 3
3
33
EPS Dividend payout ratio
$2.50 0.40 $1.00
Retention ratio 1 Dividend payout ratioRetention 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
gg
D gV
r g
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EXAMPLE: USING P/ES FOR TERMINAL VALUEUSING COMPARABLES
3 3P/E EPS
9.0 $2.50 $22.50
V
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PRICE-TO-BOOK VALUE MULTIPLERATIONALES
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 MULTIPLEDRAWBACKS
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
Intangible Assets
Inventory Accounting
Off-Balance- Sheet Items Fair Value
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JUSTIFIED P/B
0
0 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 Accounting Practices
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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 .00EPS $2 .00Dividends per share $1 .20Book value of equity per share $6 .25Sales per share $15 .00ROE 22.5%Required return on stock 12.0%
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EXAMPLE: CALCULATING THE ACTUALP/E, P/B, & P/S
0
0
0
0
0
0
$50 Actual 25.0
$2
$50 Actual 8.0
$6.25
$50 Actual 3.3
$15
P
E
P
B
P
S
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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 JUSTIFIEDP/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 gS r g
0
0
(1 )(1 ) (1 0.60)(1 0.09)21.8
0.12 0.09
P b gE r g
0
0
ROE 0.225 0.094.5
0.12 0.09
P g
B 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 Be Distorted
FCFE More Volatile and More Frequently
Negative
Cash Flow Increasingly Managed 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 enterprise
valueEBITDA
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JUSTIFIED PRICE-TO-CASH-FLOW RATIO
00
FCFE (1 )
g
Vr g
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DIVIDEND YIELDRATIONALES & DRAWBACKS
Rationales
Component of return
Dividends less risky than future capital
gains
DrawbacksOnly one component of
return
Dividends may displace future earnings
Market may not favor dividends
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JUSTIFIED DIVIDEND YIELD
0
0
1
D r g
P g
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INVERSE PRICE RATIOS
Price Ratio Inverse 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 firms of 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 + Debt – Cash – Investments
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 IFRS
US GAAP vs. IFRS
• P/CFO & P/FCFE most comparable• P/B, P/E, & EBITDA multiples least
comparable
Valuation Multiples
• Higher inflation Lower justified price multiples
• Higher pass-through rates Higher justified price multiples
Inflation
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MOMENTUM INDICATORS: EARNINGS SURPRISES
EPS EPS UESUE
UEEPS EPS
t t
t t
E t t
E t
UE EPS EPS t tEt
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MOMENTUM INDICATORS: RELATIVE STRENGTH
Past Performance
Relative to an Index
Inherently Self-Destructing
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VALUATION INDICATORS IN PRACTICE: AVERAGING MULTIPLES
• Overestimate of index P/EArithmetic Mean &
Weighted Mean
• Closer to index P/E but is influenced by small outliersHarmonic 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 for earnings
• 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: Doesn’t recognize nonphysical assets, misleading if asset levels vary or differ from accounting practices, less useful 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 stock returns
• Drawbacks: can be distorted, FCFE more volatile and more frequently 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 favor dividends
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, cash flow yield, and dividend yield
Inverse Price Ratios
• EV = Market value of stock + Debt – Cash – Investments
• Rationales: Useful for comparing firms of different leverage & capital utilization, usually positive
• Drawbacks: Exaggerates cash flow, FCFF more strongly 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 g and 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 least
comparable• Higher inflation Lower justified price
multiples• Higher pass-through rates Higher
justified 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