Relative Valuation Methods

Car Example

How much are you willing to pay for a new Lexus?

Pricing a New Lexus

• Direct Pricing Measure: Can determine all of the features and add a price for each feature to get the total you are willing to pay.

• Relative Pricing Measure: Can price a Lexus relative to other luxury cars or relative a Toyota to determine the total you are willing to pay.

Pricing a New Lexus

Relative Pricing: • Are willing to pay 2 times as much for a fully

loaded Lexus as for a fully loaded Toyota Corolla.

• Are willing to pay 1.4 times as much for a fully loaded Toyota Camry as for a fully loaded Toyota Corolla.

Pricing a Stock

Direct Measure: Determine the future “cash flows”. Determine the future riskiness of the cash flows and discount them back by the appropriate discount rate.

Relative Measure: Can price a stock relative the stock market, relative its industry, or relative its closest competitor.

RELATIVE VALUATION METHODS

P/E Multiplier P/CF Multiplier P/S Multiplier P/BV Multiplier

P/E Multiplier Method

How much are you willing to pay per dollar of EPS of Firm A?

P/E Multiplier Method: A Relative Valuation Model

• Are you willing to pay more or less per dollar of EPS of Firm A than for an average company in the industry?

• Are you willing to pay more or less per dollar of EPS of Firm A than for an average stock in the S&P 500?

Estimate P/E Multiplier

Predict Multiplier: Estimate [P0/E1]

P0 is the unknown.Predict the ratio here not the components of the ratio!

Drivers of P/E Multiplier

2 Main Drivers of P/E Multiplier:

1. Long Run Growth Rate in EPS: Increases (decreases) lead to increases

(decreases) in the P/E ratio

2. Long Run Riskiness of EPS: Increases (decreases) lead to decreases

(increases) in the P/E ratio

Drivers of P/E Multiplier

Time Value of Money:

PV = Value = f(future cash flows,

riskiness of future cash flows)

P/E Multiplier = f(future EPS,

riskiness of future EPS)

Relative Measure: Done at Various Levels

Compare Estimates of Future Growth and Risk:

The Company versus its Closest Competitor

The Company versus its Industry

The Company versus the Stock Market

Predicting Growth in EPS g

g = (1 – Predicted DPS/EPS) X (Predicted ROE) g = (Ret.Rate) X (NI/S X S/TA X TA/C.Eq.)

DPS/EPS = Dividend Payout RatioNI/S = Net ProfitabilityS/TA = Total Asset Turnover TA/C.Eq. = Financial Leverage

Predicting Growth in EPS = g

Each of the ratios break down into finer increments that can be predicted.

Example:

NI/S = f(GP/S, OP/S, Interest Expense)

Predicting Growth in EPS: Company A

g = RR X [NI/S X S/TA X TA/C.Eq.]

Using Ratio Values Last Year:

g 0= (1- .27) X [.015 X 4.20 X 3.62] = 16.6%

Using Our Predicted Avg. Ratio Values for Next Few Yrs:

gfuture = (1- .25) X [.006 X 3.8 X 4.0] = 6.8%

Predicting Growth in EPS

Estimate of Growth Using Ratios Last Year:

Company A:

g0 = (1 - .27) X [.015 X 4.20 X 3.62] = 16.6%

Industry:

g0 = (1 - .10) X [.021 X 2.62 X 5.45] = 27.0%

Predicting Growth in EPS

Prediction for Company A Over Next Several Yrs:

gfuture = (1 - .25) X [.006 X 3.8 X 4.0] = 6.8%

Prediction for Industry Over Next Several Yrs:

gfuture = (1 - .10) X [[.026 X 3.2 X 5.2] = 38.9%

Growth Analysis: Implies a lower [P0/E1] for Company A than the industry.

Predicting Future Risk

Business Risk Financial Risk Liquidity Risk Exchange Rate Risk Political Risk

Predicting Future Risk

CAPM View:

Future Beta =

f(future business risk, financial risk, liquidity risk, exchange rate risk, political risk)

Predicting Future Risk

1. Historic Risk Assessment: Assess whether the risk has been higher or lower than the industry in the recent past.

2. Future Risk Assessment: Predict what will happen to risk for the company and the industry in the future.

Business Risk

Business Risk: Variability in annual percentage changes in operating income.

Measure: CV in % Change in Op Income

%Chg Op Inc

CV in Op Inc = -------------------

Mean%Chg Op Inc

Business Risk

• CV in % Change in Op. Income (past 3 years) Company A = 4.39

• CV in % Change in Op. Income (past 3 years) Industry = 1.47

Industry has had lower business risk than Company A. Predict no changes in this relationship in the future.

Financial Risk

Financial Risk: Increased variability in EPS due to the use of debt.

Measures of Financial Risk:

Debt Ratios

Interest Coverage Ratios

Financial Risk

• Average TA/C.Eq. Company A (past 3 years) = 2.95

• Average TA/C.Eq. Industry (past 3 years) = 6.01

Industry has had higher financial risk than Company A using this ratio. Predict financial risk of Company A will increase, while that of the Industry will decrease.

Liquidity Risk

Liquidity Risk: Inability to sell the stock quickly at a known price.

Measures of Liquidity Risk:

# Stockholders

#Shares Outstanding

#Average Daily Volume of Shares Traded

#Institutional Holdings

Liquidity Risk

Measures of Liquidity Risk: Are similar for Company A and for its industry.

Industry has had similar liquidity risk. Predict this relationship will stay the same.

Beta

• Current Beta Company A = .58

• Current Beta Industry = .45

Company A currently has more systematic risk than the industry. Given we predict no change in business risk or liquidity risk, but an increase in financial risk for Company A relative the industry, we predict the relative beta will rise for Company A in the future.

Drivers of P/E Multiplier

Growth: • Historic relative growth lower than industry.• Predict relative growth will drop further.

Risk: • Historic relative risk higher than industry.• Predict relative risk will rise further.

Drivers of P/E Multiplier

• Growth Assessment: Predict [P0/E1] for Company A will be lower than for the industry.

• Risk Assessment: Predict [P0/E1] will be lower for Company A than for the industry.

• Overall: Predict [P0/E1] will be lower for Company A than for the industry

Forecast [P0/E1]

• Industry: Analysts using [P0/E1] = 10.0

• Should use less than 10 for Company A. Decide to use 7.0.

• Implies a Relative P/E of 7.0/10.0 = .70

P/E Multiplier Method

Take the product of the estimated P/E multiplier (ratio) and estimated EPS1.

[P0/E1] X [E1] = Estimated P0

Estimated P0 = Intrinsic Value0

Predict EPS Next 12 Months

Next Step:

Predict EPS for the next 12 months: [E1]

Forecast E1

Method 1:

g = RR1 X [NI/S1 X S/TA1 X TA/C.Eq.1] Company A: Ratios from Past Year:

g0 = (1- .27) X [.015 X 4.20 X 3.62] = 16.6%

Company A: Predictions for Next Year:

g1 = (1- .25) X [.007 X 3.8 X 3.70] = 7.4%

Forecast E1

Method 2:

Create a set of proforma financial statements for Company A for the next 12 months and use the estimate of [E1] from the proforma income statement.

Forecast E1

Company A

E0 = $1.35

Predicted E1= 1.35 (1.074) = $1.45

Intrinsic Value Company A

• Estimated Intrinsic Value Company A Today = 7.0 X $1.45 = $10.15

• Stock is currently trading at $16.15

• We issue a “sell” recommendation.

Implied P/E Ratio

• Can see the current price of Company A of $16.15 and the market consensus forecast for E1 of $1.47.

• This results in an implied P0/E1 ratio of

$16.15/1.47 = 10.98 times.

• We predict a [P0/E1] of 7.0 times and E1of $1.45.

Estimate Target Price1

[P1/E2] X E2= Estimate of P1 = Target Price1 where

[P1/E2] = forecasted multiplier 12 months from today.

E2 = forecasted EPS for 12 month period starting one year from today.

P/E Multiplier Trailing vs Standard

Often analysts also examine

[P0/E0] = The Trailing P/E Ratio

For valuation we ultimately want [Po/E1]or [P1/E2]!!

Trailing P/E

Trailing P/E Ratios:

• Company A = $16.15/1.35 = 11.96

• Industry = $18.08/1.26 = 14.35

• S&P 500 = 21.50

Relative P/E = 11.96/14.35 = .83 (industry)

Relative P/E = 11.96/21.50 = .56 (market)

Typical in Analyst Report

I. Table: Show the following for: Company, Industry (or closest competitor) and Market Proxy

• Trailing P/E • Prediction of P0/E1

• Prediction of P1/E2

• Prediction of E1 and Intrinsic Value0

• Prediction of E1 and Target Price1

• Relative P/E Ratios

Typical in Report

II. Discussion

Discussion of the drivers of growth and risk for the company versus its competitors and/or the market.