Download Relative value

How do we value companies?
Intrinsic value
• The value of a company to you is wrong
• We assume it will become right
• Stock vs. other assets
Relative value
• Other companies are valued differently
• If our company is an outlier, it will tend to
change to normal over time
• Stock vs. stock
Discounted Cash Flows
Annual FCF for that year
Estimated future Free Cash Flows
Discounted Cash Flows
𝐶0
𝑉≈
𝑟−𝑔
𝐶0 ≈ Net Income
PE Ratio
Annual FCF for that year
Estimated future Free Cash Flows
PE Ratio
𝑉≈
𝐶0
𝑟−𝑔
𝑉
𝑃/𝐸 =
𝑁𝐼
𝑝
𝑃/𝐸 =
𝐸𝑃𝑆
≈
𝑁𝐼
𝑑
Price-to-Earnings Multiple
Rationales & Drawbacks
Rationales
Drawbacks
EPS is driver of value
Zero, negative, or very
small earnings
Widely used
Permanent vs. transitory
earnings
Related to stock returns
Management discretion
for earnings
Price-to-Earnings Multiple
Definitions
Trailing P/E
Uses last
year’s
earnings
Preferred
when
forecasted
earnings are
not available
Forward P/E
Uses next
year’s
earnings
Preferred
when trailing
earnings are
not reflective
of future
PEG Ratio
𝑃/𝐸
𝑃/𝐸/𝐺 =
𝑔
Issues in Calculating EPS
EPS Dilution
Underlying
Earnings
Normalized
Earnings
Differences in
Accounting
Methods
Method of Comparables
Benchmark Value of the
Multiple Choices
Industry
peers
Industry
or sector
index
Broad
market
index
Firm’s
historical
values
Method of Comparables
Using Peer Company Multiples
Law of one price
Risk and earnings growth adjustments
PEG limitations:
Assumes linear relationship
Does not account for risk
Does not account for growth duration
Using P/Es for Terminal Value
Justified P/E
P/E =
(D/E)/(r – g)
Sensitive to required
inputs
P/E Based on
Comparables
Grounded in market
data
If comp is mispriced,
terminal value will
be mispriced
Enterprise Value
EV =
+ market value of common stock
+ market value of preferred equity
+ market value of debt
+ minority interest
- cash and investments
EBITDA
EV/EBITDA
𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒
𝐸𝐵𝐼𝑇𝐷𝐴
Enterprise Value/EBITDA Multiple
Rationales & Drawbacks
Rationales
Drawbacks
Useful for comparing firms
of different leverage
Exaggerates cash flow
Useful for comparing firms
of different capital utilization
Usually positive
FCFF more strongly
grounded
Issues in Using Enterprise Value
Multiples
EV = Market Value of Stock + Debt – Cash – Investments
Justified EV/EBITDA
• Positively related to FCFF growth
• Positively related to ROIC
• Negatively related to WACC
Comparables May Utilize TIC
Other EV Multiples
•
•
•
•
EV/FCFF
EV/EBITA
EV/EBIT
EV/S
Equity / Book Value
𝐸𝑞𝑢𝑖𝑡𝑦 𝑉𝑎𝑙𝑢𝑒
𝐸/𝐵 =
𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒
Price-to-Book Value Multiple
Rationales
Book Value Is Usually Positive
More Stable than EPS
Appropriate for Financial Firms
Appropriate for Firms that Will Terminate
Can explain stock returns
Price-to-Book Value Multiple
Drawbacks
Does Not Recognize Nonphysical Assets
Misleading when Asset Levels Vary
Can Be Misleading Due to Accounting Practices
Less Useful when Asset Age Differs
Can Be Distorted Historically by Repurchases
Adjustments to Book Value
Intangible
Assets
Inventory
Accounting
Off-BalanceSheet Items
Fair Value
Price-to-Cash-Flow
Multiple Rationales
Cash Flow Less Easily Manipulated
Ratio More Stable Than P/E
Ratio Addresses Quality of Earnings Issue with P/E
Ratio Can Explain Stock Returns
Price-to-Cash-Flow
Multiple Drawbacks
Cash Flow Can Be
Distorted
FCFE More Volatile and
More Frequently Negative
Cash Flow Increasingly
Managed by Firms
Cross-Country Comparisons
US GAAP
vs. IFRS
• Net income higher under IFRS
• Shareholder's equity lower under IFRS
• ROE higher under IFRS
Valuation
Multiples
Inflation
• P/CFO & P/FCFE most comparable
• P/B, P/E, & EBITDA multiples least comparable
• Higher inflation  Lower justified price multiples
• Higher pass-through rates  Higher justified
price multiples