Financial Statement Analysis & Valuation Third Edition

1. Financial Statement Analysis & Valuation Third Edition Peter D. Mary Lea Gregory A. Xiao-Jun Easton McAnally Sommers Zhang

2. Module 15: Market-BasedValuation

3. Valuation Model Using Market Multiples • Used as a shortcut valuation method • Popular due to simplicity • Does not rely on subjective forecasts of future performance • Also referred to as the method of comparables

4. Company or Equity Value? Depends on whether the output is company or equity value If an equity performance measure is selected Output will be an equity value Examples: earnings, book value Most Common If a company performance measure is selected Output will be a company value Examples: NOPAT, NOA

5. Using the Valuation Model Step 1 Select a relevant summary performance measure from financial statements Identify companies that are comparable to the target company on relevant dimensions Step 2 Compute the market multiple using the average of the market value ratio to the performance measure for each company compared Step 3 Multiply the summary measure by the market multiple to get the target company’s value Step 4 If equity performance, divide by outstanding shares. If company performance, subtract net nonoperating obligations before dividing by outstanding shares Step 5

6. Weaknesses of the Market Multiple Model • No ‘right’ measure to use • Because company value depends on future performance • No ‘right’ companies to use for comparison • Could be over or undervalued • No ‘right’ way to combine comparable company data to produce a multiple • Median, equal-weighted average, value-weighted average, or other average

7. Valuation Using Balance Sheet Multiples This data will be used to estimate the intrinsic value of Family Dollar’s equity.

8. Valuation Using a Net Operating Asset (NOA) Multiple Determine the market multiple for each company: Dollar General = $12,499 ÷ $6,854 = 1.82 NOA market multiple = [1.82 + 2.84] ÷ 2 = 2.33 Company intrinsic value = Net operating assets × NOA market multiple

9. Valuation Using a Net Operating Asset Multiple Family Dollar’s intrinsic value = Net operating assets × NOA market multiple = $1,021 × 2.33 = $2,379 Family Dollar’s Equity intrinsic value = Company intrinsic value – Net nonoperating obligations = $2,379 – $(401) = $2,780 Family Dollar’s Equity intrinsic value per share Equity intrinsic value = = = $21.30 Common shares outstanding $2,780 130.5 shares

10. Valuation Using a Book Value (BV) Multiple • Yields the intrinsic value for equity, not for the entire company This data will be used to estimate the intrinsic value of Family Dollar’s equity.

11. Valuation Using a Book Value Multiple Family Dollar’s Equity intrinsic value = Book value of equity x BV Market multiple = $1,422 x 2.44 = $3,470 Family Dollar’s Equity intrinsic value per share Equity intrinsic value = = = $26.59 Common shares outstanding Because Family Dollar’s actual stock price at year end was $43.34, its stock is markedly overvalued. $3,470 130.5 shares

12. Assessing Quality of Value Estimates • Careful selection of companies • Such as similar capital structures • Operating in the same industry • Must control for • Profitability • Growth • Risk

13. Valuation Using Earnings • Most commonly used performance measure for estimating company value with market multiples • Intuition • Dividends are paid out of earnings, and potential dividend payouts are the basis for company value • Higher earnings should warrant higher payment for stock

14. Valuation Using NOPAT Multiple NOPAT intrinsic value for Family Dollar: Company intrinsic value Net operating profit after tax NOPAT market multiple = x Family Dollar’s intrinsic value = $366 × 12.50 = $4,575 million

15. Valuation Using NOPAT Multiple Equity intrinsic value for Family Dollar: Equity intrinsic value Company intrinsic value Net nonoperating obligations = – Family Dollar’s equity intrinsic value per share $4,575 – $(401) 130.5 shares = $38.13 =

16. Valuation Using Net Income (NI) Multiple Net income intrinsic value for Family Dollar: Equity intrinsic value NI market multiple Net income = – Family Dollar’s equity intrinsic value per share = $35.63 = $358 x 12.99 130.5 shares

17. Selecting Comparables for Market Multiples • Companies should be selected based on similar profitability, growth, and risk • Common multiples • Price-to-Book • Price-to-Earnings

18. Residual Operating Income Model Includes parameters for • Residual operating income • Expected growth rate in residual operating income • Weighted average cost of capital • Leverage Present value of expected ROPI, discounted using rw Price-to-Book = 1 + OE ROPI = NOPAT – (NOAbeg × rw)

19. PB Ratios in Relation to Profitability Model assumes that residual operating income grows at a constant rate, g, in perpetuity Present value of expected ROPI Expected ROPI Rw - g = PV of $150 $100 = 2.5 Company A Price-to-Book = 1 + PV of $50 $100 = 1.5 Company B Price-to-Book = 1 +

20. PB Ratios in Relation to Growth Model assumes that residual operating income grows at a constant rate, g, in perpetuity Present value of expected ROPI Expected ROPI Rw - g = PV of $200 $100 = 3.0 Company C Price-to-Book = 1 + PV of $120 $100 = 2.2 Company D Price-to-Book = 1 +

21. PB Ratios in Relation to Company Operating Risk Model assumes that residual operating income grows at a constant rate, g, in perpetuity Present value of expected ROPI Expected ROPI Rw - g = PV of $46.7 $100 = 1.47 Company E Price-to-Book = 1 + PV of $120 $100 = 2.2 Company F Price-to-Book = 1 +

22. PB Ratios in Relation to Company Leverage PV of $120 $100 = 2.2 Company G Price-to-NOA = 1 + PV of $120 $100 = 2.2 Company H Price-to-NOA = 1 + PV of $120 $100 = 2.2 Company G Price-to-Book = 1 + PV of $120 $40 = 4.0 Company H Price-to-Book = 1 +

23. Residual Operating Income Model PE ratio equals the total of • The capitalized value of current income • Normal income and residual income • Capitalized present value of changes in future residual income Present value of expected changes in RI Earnings 1 + re re x 1 + PE ≈

24. PE Ratios in Relation to Profitability, Growth, and Risk • Growth and risk affect PE • Profitability has no effect on PE • Unaffected by RNOA • Expected growth in residual income leads to higher PE ratios • Higher cost of equity capital leads to lower PE ratios Consider expected earnings, growth, and risk when selecting comparables to use for valuing a firm based on earnings multiples.

25. Reverse Engineering • Process of observing market price metrics such as the PB and PE ratio, and • Assessing the quality of the underlying expectations supporting the observed stock price Expected ROE – re re - g PB = 1 + $11,396 million $625 million = 18.2 1 + Limited Brand’s PB =

26. Reverse Engineering of PB Ratio for Limited Brands Case 1 Assumes we know the market’s expectation for ROE and the discount rate To support an 18.2 PB ratio, a high implied growth rate (6.7% to 11.2%) is required.

27. Reverse Engineering of PB Ratio for Limited Brands Case 2 Assumes we know the market’s expectation for ROE and the discount rate To support an 18.2 PB ratio, a discount rate between 5.2% and 8.4% is required.

28. Reverse Engineering of PB Ratio for Limited Brands Case 3 Assumes we know the market’s expectation for ROE and the discount rate To justify the 18.2 PB ratio, profitability in perpetuity from 43.4% to 78.8% is required.

29. Present value of expected changes in RI Earnings 1 + re re 1 + Interpreting the PE Ratio • PE approximates the capitalization factor of [1 + re] ÷ re x PE ≈ • Example: A company has a 10% equity cost of capital, which implies a capitalization factor of 11. • If investors think residual income will change, PE ratio ≈ 11 • If investors think residual income will increase more than 10% times the change in book value, PE ratio > 11

30. Process of Fundamental Analysis • Models requiring explicit modeling of a company’s future performance using forecast for valuation • Discounted dividends • Discounted cash flows • Residual operating income model • Lack of assurance using market multiples • Valuation by market multiples

31. Implementing Valuation Multiples Step 1: Use forward-looking performance measures to compute the market multiples for comparable companies Step 2: Select comparable companies with care so as to match them on profitability, growth, and risk Step 3: Use both income-statement-based and balance-sheet-based valuation multiples

32. End Module 15