valuation: principles and practice 11/29/05. valuation techniques relative valuation the value of an...
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Valuation: Principles and Practice
11/29/05
Valuation techniques
Relative valuation the value of an asset is derived from the
pricing of 'comparable' assets, standardized using a common variable such as earnings, cash flows, book value or revenues.
Discounted cash flow valuation The value of an asset is the discounted
expected cash flows on that asset at a rate that reflects its riskiness.
Relative valuation
The value of the firm is determined as:Comparable multiple * Firm-specific denominator value
A firm is considered over-valued (under-valued) if the calculated price (or multiple) is greater (less) than the current market price (comparable firm multiple)
Assumption: Comparable firms, on average, are fairly valued, i.e., multiples are the same across comparable firms.
Relative valuation
Examples of relative valuation multiples Price/Earnings (P/E)
Earnings calculations should exclude all transitory components
variants include EBIT multiples, EBITDA multiples, Cash Flow multiples
Price/Book (P/BV) Book value of equity is total shareholders’s equity –
preferred stock
Price/Sales (P/S)
Advantages and drawbacks of P/E
Advantages: Earnings power is the chief driver of investment value Main focus of security analysts The P/E is widely recognized and used by investors Differences in P/E may be related to long-run differences in
average return (low P/E outperform) Drawbacks
If earnings are negative, P/E does not make economic sense
Reported P/Es may include earnings that are transitory Earnings can be distorted by management
Assumption: Required rate of return, retention ratio and growth rates are
similar among comparable firms
Advantages and drawbacks of P/BV
Advantages Since book value is a cumulative balance sheet amount, it is generally
positive BV is more stable than EPS, therefore P/BV may be more meaningful
when EPS is abnormally low or high P/BV is particularly appropriate for companies with primarily liquid
assets (financial instituitions) Disadvantages
Human capital is not considered Differences in firm size can lead to incorrect comparable values Differences in asset age among companies may make comparing
companies difficult Assumption:
Required rate of return, return on equity, retention ratio and growth rates are similar among comparable firms
Advantages and drawbacks of P/S
Advantages Sales are generally less subject to distortion or manipulation Sales are positive even when EPS is negative Sales are more stable than EPS, therefore P/S may be more
meaningful when EPS is abnormally low or high P/S is particularly appropriate for valuing mature companies
Disadvantages High growth in sales may not translate to operating
profitability P/S does not reflect differences in cost structure
Assumption: Required rate of return, profit margin, retention ratio and
growth rates are similar among comparable firms
Benchmarks for comparison
Peer companies Constituent companies are typically similar in their
business mix Industry or sector
Usually provides a larger group of comparables therefore estimates are not as effected by outliers
Overall market
Own historical This benchmark assumes that the firm will regress to
historical average levels
Leading and trailing P/E
Trailing (or current) P/Es is calculated using the firm’s current market price and the four most recent quarters’ EPS.
Leading P/Es is calculated using the firm’s current market price and next year’s expected earnings.
PEG Ratio
When comparable firm P/Es are used to calculate the value of a firm, the assumption is that the firm has characteristics that are similar to that of the average comparable firm.
However, differences may exist. For example, a higher P/E for a particular firm may be justified because the firm has higher growth.
The Price/Earnings-to-Growth (PEG) accounts for differences in the growth in earnings between companies.
PEG is calculated as: P/E divided by expected earnings growth (%).
Discounted cash flow valuation: Equity valuation The value of equity is obtained by discounting
expected cash flows to equity, i.e., the residual cash flows after meeting all expenses, tax obligations and interest and principal payments, at the cost of equity, i.e., the rate of return required by equity investors in the firm.
where,CF to Equityt = Expected Free Cash Flow to Equity in period tre = Cost of Equity
=t
1=tt
e
t
)r+(1
Equity toCF =Equity of Value
Discounted cash flow valuation: Equity valuation Since we cannot estimate cash flows forever,
we estimate cash flows for a “growth period” and then estimate a terminal value, to capture the value at the end of the period
Ner
alValueTer
)1(
min
)r+(1
Equity toCF =Equity of Value
N=t
1=tt
e
t
Valuation steps
Estimate the discount rate
Estimate the current cash flow to equity
Estimate a growth rate(s) to estimate future cash flows
Compute the firm’s equity value
Discount rate and CF to equity
Discount rate: The appropriate discount rate in valuing equity is the cost of equity
which can be estimated using the CAPM.
CF to equity (FCFE): We will use the estimated FCFE equation to calculate CF to equity as
this provides a better long run estimate. Non-recurring items should be excluded from net income calculations
Tax rate
The choice is between the effective (taxes paid / taxable income) and the marginal tax rate.
In doing projections, it is far safer to use the marginal tax rate since the effective tax rate is really a reflection of the difference between the accounting and the tax books.
If you choose to use the effective tax rate, adjust the tax rate towards the marginal tax rate over time.
Estimating growth (in EPS)
A key assumption in all discounted cash flow models is the period of high growth, and the pattern of growth during that period. In general, we can make one of three assumptions: there is no high growth, in which case the firm is
already in stable growth there will be high growth for a period, at the end of
which the growth rate will drop to the stable growth rate (2-stage)
there will be high growth for a period, at the end of which the growth rate will decline to a lower growth rate and then decline further after a period of time to a stable growth rate(3-stage)
Current growth
The current growth rate in earnings can be used as an estimate of futures earnings growth during the first high-growth stage of the firm.
gEPS = Retained Earningst-1/ NIt-1 * ROE
= Retention Ratio * ROE = b * ROE
Determinants of length of high growth period Size of the firm
Success usually makes a firm larger. As firms become larger, it becomes much more difficult for them to maintain high growth rates
Current growth rate While past growth is not always a reliable indicator
of future growth, there is a correlation between current growth and future growth. Thus, a firm growing at 30% currently probably has higher growth and a longer expected growth period than one growing 10% a year now.
Determinants of length of high growth period Barriers to entry and differential advantages
Ultimately, high growth comes from high project returns, which, in turn, comes from barriers to entry and differential advantages.
The question of how long growth will last and how high it will be can therefore be framed as a question about what the barriers to entry are, how long they will stay up and how strong they will remain.
Firm characteristics as growth changesVariable High Growth Firms Stable Growth
tend to Firms tend to
Risk be above-average risk be average risk
Dividend Payout pay little or no dividends pay high dividends
Net Cap Ex have high net cap ex have low net cap ex
ROC earn high ROC earn ROC closer to WACC
Leverage have little or no debt higher leverage
Estimating stable growth inputs
Start with the fundamentals: Profitability measures such as return on equity, in stable
growth, can be estimated by looking at industry averages for these measure, in which case we
assume that this firm in stable growth will look like the average firm in the industry
cost of equity, in which case we assume that the firm will stop earning excess returns on its projects as a result of competition.
Average industry retention ratios or firm retention ratios can also be used
Calculating equity value
During the high-growth stage(s), future cash flows are estimated individually and discounted.
Terminal value (commencing in period N+1) is calculated as:
where g is the stable growth stage growth rate.
se
sN
gr
gCFtoEquity
)1(*
DCF vs. relative valuation
DCF valuation assumes that markets make mistakes in estimating value (i.e., current price is not an accurate reflection of the value of the firm) and these mistakes tend to be corrected over time and can occur over entire sectors.
Relative valuation assumes markets are correct on average (i.e., comparables on average are correctly priced)