Valuation: Principles and Practice: Part 1 – Relative Valuation

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Valuation: Principles and Practice: Part 1 – Relative Valuation

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Valuation: Principles and Practice: Part 1 – Relative Valuation

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Valuation: Principles and Practice: Part 1 – Relative Valuation

03/03/08

Ch. 12

- Relative valuation
- the value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable such as earnings, 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.

- Residual Income valuation
- The value of an asset is based on the discounted expected difference between net income and its associated cost of equity.

- 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)
- Assumptions:
- Comparable firms, on average, are fairly valued
- Comparable firms have similar fundamental characteristics to the firm being valued.

- Examples of relative valuation multiples
- Price/Earnings (P/E)
- Earnings calculations should exclude all transitory components

- Price/Book (P/BV)
- Book value of equity is total shareholders equity – preferred stock

- Price/Sales (P/S)
- Enterprise Value/EBITDA
- Enterprise Value = Mkt Cap + Debt – Cash
- EBITDA = Earnings before Interest Taxes Depreciation and Amortization

- Price/Earnings (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

- 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
- 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 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
- 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

- Advantages
- This represents a valuation indicator for the overall company and not just equity.
- It is more appropriate for comparing companies that have different capital structures since EBITDA is a pre-interest measure of earnings.
- Appropriate for valuing companies with large debt burden: while earnings might be negative, EBIT is likely to be positive.

- Disadvantages
- Differences in capital investment is not considered.

- Assumption:
- Required rate of return, growth rates, working capital needs, capital expenditures and depreciation are similar among comparable firms

- 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

- 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.

- “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.

- 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