Valuation: Principles and Practice

06/04/07Ch. 24

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

where the denominator value can be earnings, book value, sales, etc.

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 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 institutions)

Disadvantages 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

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

Considerations: market efficiency, historical trends, comparable assumptions

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

“I don’t buy stocks with P/E’s over 30. To our Foolish ear, that sounds identical to: I don't buy hydrogenated milk; I am born in May.” Motley Fool

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.

PEG Ratio

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 (%).

"The P/E ratio of any company that's fairly priced will equal its growth rate." Peter Lynch

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 )1(

lueTerminalVa

)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 ROE, 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

Firm’s 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. Typically retention ratios will go down as the firm matures.

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

s

gr

g

)1(*Equity toCF N

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)

Ch 24 topics covered

DCF Valuation: For DCF valuation, our focus will be on using the Free Cash Flow to Equity Discount Model. This topic is introduced on page 774. However, components of other earlier discussions (as outlined) are needed to understand this model.

Relative Valuation Reconciling Different Valuations