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. 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, book value or revenues.

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### Valuation: Principles and Practice: Part 1 – Relative Valuation

03/03/08

Ch. 12

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