1 Relative Valuation

8/10/2019 1 Relative Valuation

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Why relative valuation?

A little inaccuracy sometimes saves tonsof explanation

Hector Hugh Munro


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Standardizing Value Prices can be standardized using a common variable

such as earnings, cashflows, book value or revenues. Earnings Multiples Price/Earnings Ratio (PE) and variants (PEG and Relative PE) Value/EBIT Value/EBITDA Value/Cash Flow

Book Value / Replacement Value Multiples Price/Book Value(of Equity) (PBV) Value/ Book Value of Assets

Value/Replacement Cost (Tobin

s Q) Revenues Price/Sales per Share (PS) Value/Sales

Industry Specific Variable (Price/kwh, Price per tonof steel ....)


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The Four Steps to Understanding Multiples Define the multiple

In use, the same multiple can be defined in different ways bydifferent users. When comparing and using multiples, estimatedby someone else, it is critical that we understand how themultiples have been estimated

Describe the multiple Too many people who use a multiple have no idea what its

cross sectional distribution is. If you do not know what thecross sectional distribution of a multiple is, it is difficult to look at anumber and pass judgment on whether it is too high or low .

Analyze the multiple It is critical that we understand the fundamentals that drive each

multiple, and the nature of the relationship between the multipleand each variable.

Apply the multiple Defining the comparable universe and controlling for differences is

far more difficult in practice than it is in theory.


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Descriptive Tests What is the mean and standard deviation for this multiple,

across the universe (market)? What is the median for this multiple?

The median for this multiple is often a more reliablecomparison point.

How large are the outliers to the distribution, and how do wedeal with the outliers? Throwing out the outliers may seem like an obvious solution,

but if the outliers all lie on one side of the distribution (they

usually are large positive numbers), this can lead to a biasedestimate. Are there cases where the multiple cannot be estimated? Will

ignoring these cases lead to a biased estimate of the multiple?

How has this multiple changed over time?


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Application Tests what is a comparable

firm?

While traditional analysis is built on the premise thatfirms in the same sector are comparable firms,valuation theory would suggest that a comparablefirm is one which is similar to the one beinganalyzed in terms of fundamentals.

Proposition 4: There is no reason why a firmcannot be compared with another firm in a verydifferent business, if the two firms have thesame risk, growth and cash flow characteristics.

Given the comparable firms, how do we adjust fordifferences across firms on the fundamentals? Proposition 5: It is impossible to find an exactly

identical firm to the one you are valuing.


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Price Earnings Ratio: DefinitionPE = Market Price per Share / Earnings per Share

There are a number of variants on the basic PE ratio in use.They are based upon how the price and the earnings aredefined.

Price: is usually the current price

is sometimes the average price for the year EPS: Consensus earnings per share in the current (most

recent) Financial yearearnings per share in trailing 12 months (most

recent four quarters) (Trailing PE)forecasted earnings per share next year ( ForwardPE ) forecasted earnings per share in future yearRolling P/E


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PE Ratio: Descriptive StatisticsDistribution of PE Ratios - September 2001

0

200

400

600

800

1000

1200

0-4 4 - 6 6 - 8 8 - 10 10 - 15 15-20 20-25 25-30 30-35 35-40 40 - 45 45- 50 50 -75 75 -100

> 100

PE ratio

Current PE

Trailing PE

Forward PE


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PE: Deciphering the DistributionCurrent PE Trailing PE Forward PE

Mean 30.93 30.33 21.13Standard Error 2.70 2.74 0.73

Median 15.27 15.20 13.71Mode 10 10 14Standard Deviation 157.30 150.65 38.22Kurtosis 795.82 1615.73 224.85

Skewness 26.28 36.04 12.97Range 5370.00 7090.50 864.91Maximum 5370.00 7090.50 865.00Count 3387 3021 2737


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PE Ratio and Fundamentals Proposition: Other things held equal, higher growth

firms will have higher PE ratios than lower growthfirms.

Proposition: Other things held equal, higher riskfirms will have lower PE ratios than lower risk firms

Proposition: Other things held equal, firms withlower reinvestment needs will have higher PE ratiosthan firms with higher reinvestment rates.

Of course, other things are difficult to hold equal sincehigh growth firms, tend to have risk and highreinvestment rates.


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Using the Fundamental Model to EstimatePE For a High Growth Firm

The price-earnings ratio for a high growth firm can also berelated to fundamentals. In the special case of the two-stagedividend discount model, this relationship can be made explicitfairly simply:

For a firm that does not pay what it can afford to individends, substitute FCFE/Earnings for the payout ratio.

Dividing both sides by the earnings per share:

P 0 =

EPS 0 * Payout Ratio*(1+g)* 1 (1+ g) n

(1+r) n

r - g+

EPS 0 * Payout Ratio n *(1+g)n *(1+g n )

(r-g n )(1+ r)n

P0EPS 0

=

Payout Ratio * (1 + g) * 1 (1 + g)n

(1+ r) n

r - g+

Payout Ratio n *(1+g)n *(1+ g n )

(r - g n )(1+ r)n


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Expanding the Model In this model, the PE ratio for a high growth firm

is a function of growth, risk and payout ,exactly the same variables that it was a functionof for the stable growth firm.

The only difference is that these inputs have tobe estimated for two phases - the high growthphase and the stable growth phase.

Expanding to more than two phases, say thethree stage model , will mean that risk, growthand cash flow patterns in each stage.


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A Simple Example Assume that you have been asked to estimate the PE ratio for

a firm which has the following characteristics:Variable High Growth Phase Stable Growth Phase

Exp. Growth Rate 25% 8%Payout Ratio 20% 50%Beta 1.00 1.00 Riskfree rate = T.Bond Rate = 6% Required rate of return = 6% + 1(5.5%)= 11.5%

PE =

0.2 * (1.25) * 1 (1.25) 5

(1.115) 5

(.115 - .25)+

0.5 * (1.25) 5 * (1.08)(.115-.08) (1.115) 5

= 28.75


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Comparisons across countries

In July 2000, a market strategist is makingthe argument that Infosys and TCS arecheap relative to Moser Baer, becausethey have much lower PE ratios. Wouldyou agree?YesNo

What are some of the factors that maycause one market

s PE ratios to be lowerthan another market s PE?


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Comparing PE ratios acrossfirms

C1 29.18 9.50% 20.58%C2 43.65 15.50% 21.88%c3 24.31 11.00% 22.92%c4 16.24 7.50% 23.66%c5 21.76 14.00% 24.08%c6 8.96 3.50% 24.70%c7 8.94 3.00% 25.74%c8 10.07 11.50% 29.43%c9 23.02 10.00% 29.52%c10 33 10.50% 31.35% c11 44.33 19.00% 35.51%c12 10.59 17.13% 39.58%c14 25.19 11.50% 44.26%c15 16.47 14.00% 45.84%c16 37.14 27.00% 51.34%

c17 9.7 17.00% 62.45%


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A Question

You are reading an equity research reporton this sector, and the analyst claims thatONGC and Welspun Gujarat are undervalued because they have low PE ratios.Would you agree?YesNo

Why or why not?


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Investment Strategies that comparePE to the expected growth rate

If we assume that all firms within a sector have similar growthrates and risk, a strategy of picking the lowest PE ratiostock in each sector will yield undervalued stocks.

Portfolio managers and analysts sometimes compare PE ratiosto the expected growth rate to identify under and overvaluedstocks. In the simplest form of this approach, firms with PE ratios

less than their expected growth rate are viewed asundervalued.

In its more general form, the ratio of PE ratio to growth isused as a measure of relative value.

P bl i h i PE i


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Problems with comparing PE ratios toexpected growth

In its simple form, there is no basis forbelieving that a firm is undervalued justbecause it has a PE ratio less than expectedgrowth.

This relationship may be consistent with afairly valued or even an overvalued firm, ifinterest rates are high, or if a firm is highrisk.

As interest rate decrease (increase), fewer(more) stocks will emerge as undervaluedusing this approach.


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PEG Ratio: Definition The PEG ratio is the ratio of price earnings to expected growth in earnings

per share.

PEG = PE / Expected Growth Rate in Earnings Definitional tests:

Is the growth rate used to compute the PEG ratio on the same base? (base year EPS)

over the same period?(2 years, 5 years) from the same source? (analyst projections, consensus estimates..)

Is the earnings used to compute the PE ratio consistent with the growthrate estimate?

No double counting: If the estimate of growth in earnings per share isfrom the current year, it would be a mistake to use forward EPS incomputing PE


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PEG Ratio: Distribution


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PEG Ratios: Select Companies

Company Name

Trailin

g PE

Expect ed

Growth

Standa

rd Dev

P E

GDLF 29.18 9.5 20.58 3.071579Essar 43.65 15.5 21.88 2.816129JK Cements 24.31 11 22.92 2.21Tata Steel 16.24 7.5 23.66 2.165333

ACC 21.76 14 24.08 1.554286

ONGC 8.96 3.5 24.7 2.56Reliance Capt 8.94 3 25.74 2.98

Axis Bank 10.07 11.5 29.43 0.875652Divis Lab 23.02 10 29.52 2.302Edu Comp 33 10.5 31.35 3.142857Financial technologies 44.33 19 35.51 2.333158Cairn India 10.59 17.13 39.58 0.618214JSW Steel 25.19 11.5 44.26 2.190435Reliance Power 16.47 14 45.84 1.176429Sesa Goa 37.14 27 51.34 1.375556

Wel Spun Gujarat 9.7 17 62.45 0.570588

Average 22.659375 12.601875 33.3025 1.996388


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PEG Ratio: Reading theNumbers

The average PEG ratio for select companiesis 2.00. The lowest PEG ratio in the groupbelongs to Welspun, which has a PEG ratioof 0.57. Using this measure of value,Welspun isthe most under valued stock in the groupthe most over valued stock in the group

What other explanation could there be forWelspun

s low PEG ratio?


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PE, Growth and RiskDependent variable is: PE

R squared = 51.1% R squared (adjusted) = 43.65%

Variable Coefficient SE t-ratio prob

Constant 20.87 6.935 3.009 0.01Growth rate 183.24 50.1 3.65 0.001 Std Dev -63.98 24.32 -2.63 0.02


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Is ONGC OR WELSPUN undervalued?

DLF -4.06442Essar -8.3717JK Cements 2.057019Tata Steel 3.240095

ACC 9.362074ONGC 2.525017Reliance Capt 0.963395

Axis Bank 13.04799Divis Lab -2.70822Edu Comp -12.9429

Financial technologies -11.359Cairn India 16.35031JSW Steel -11.5606Reliance Power 0.729569Sesa Goa 0.361962

Wel Spun Gujarat 2.369391


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Using comparable firms- Pros and Cons The most common approach to estimating the PE ratio for a firm is

to choose a group of comparable firms , to calculate the average PE ratio for this group and to subjectively adjust this average for differences between the firm

being valued and the comparable firms.

Problems with this approach. The definition of a 'comparable ' firm is essentially a subjective

one. The use of other firms in the industry as the control group is often

not a solution because firms within the same industry can havevery different business mixes and risk and growth profiles.

Even when a legitimate group of comparable firms can beconstructed, differences will continue to persist in fundamentalsbetween the firm being valued and this group.

P bl ith th i


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Problems with the regressionmethodology

The basic regression assumes a linear relationship between PE ratios and the financial proxies, and thatmight not be appropriate.

The basic relationship between PE ratios and financial

variables itself might not be stable , and if it shifts fromyear to year, the predictions from the model may not bereliable.

The independent variables are correlated with each other.

For example, high growth firms tend to have high risk. Thismulti-collinearity makes the coefficients of theregressions unreliable and may explain the large changesin these coefficients from period to period.

l


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PEG Ratio: Analysis To understand the fundamentals that determine

PEG ratios, let us return again to a 2-stageequity discounted cash flow model

Dividing both sides of the equation by theearnings gives us the equation for the PE ratio.

Dividing it again by the expected growth

g

No respite from g still

P 0 =

EPS 0 * Payout Ratio*(1+ g)* 1 (1+g) n

(1+r) n

r - g+


(r-g n )(1+ r)n

n

n nn n

nn

(1+g)Payout Ratio*(1+g)* 1

(1+r) Payout Ratio *(1+g) *(1+g )PEG= +

g(r-g) g(r-g )(1+r)


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PEG Ratios and Fundamentals

Risk and payout, which affect PE ratios,continue to affect PEG ratios as well. Implication: When comparing PEG ratios

across companies, we are making implicit orexplicit assumptions about these variables.

Dividing PE by expected growth does not

neutralize the effects of expected growth,since the relationship between growth andvalue is not linear and fairly complex (even

in a 2-stage model)


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PEG Ratios and Fundamentals: Propositions Proposition 1: High risk companies will trade at much lower PEG

ratios than low risk companies with the same expected growthrate. Corollary 1: The company that looks most under valued on a

PEG ratio basis in a sector may be the riskiest firm in the sector Proposition 2: Companies that can attain growth more efficiently

by investing less in better return projects will have higher PEGratios than companies that grow at the same rate less efficiently. Corollary 2: Companies that look cheap on a PEG ratio basis

may be companies with high reinvestment rates and poor

project returns.


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Estimating the PEG Ratio for


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Estimating the PEG Ratio forWelspun

Applying this regression to Welspun, the predictedPEG ratio for the firm can be estimated usingWelspun

s measures for the independent variables: Expected Growth Rate = 17.00% Standard Deviation in Stock Prices = 62.45%

Plugging in,Expected PEG Ratio for Welspun = 3.61 - 2.86 (.17) -

3.75 (.6245) = 0.78 With its actual PEG ratio of 0.57, welspun looks

undervalued, notwithstanding its high risk. (Still Cheap!!!!)


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Relative PE: Definition

The relative PE ratio of a firm is the ratio of the PE of the firm tothe PE of the market.

Relative PE = PE of Firm / PE of Market While the PE can be defined in terms of current earnings,

trailing earnings or forward earnings, consistency requires thatit be estimated using the same measure of earnings for boththe firm and the market.

Relative PE ratios are usually compared over time. Thus, a firmor sector which has historically traded at half the market PE(Relative PE = 0.5) is considered over valued if it is trading at arelative PE of 0.7.


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Relative PE: DistributionalStatistics

The average relative PE is always one. The median relative PE is much lower,

since PE ratios are skewed towards highervalues. Thus, more companies trade at PEratios less than the market PE and haverelative PE ratios less than one.


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Relative PE: Determinants To analyze the determinants of the relative PE ratios, let us

revisit the discounted cash flow model we developed for the PEratio. Using the 2-stage DDM model as our basis (replacing thepayout ratio with the FCFE/Earnings Ratio, if necessary), weget

where Payout j, g j, r j = Payout, growth and risk of the firm

Payout m, g m, r m = Payout, growth and risk of the market

Relative PE j =

Payout Ratio j *(1+g j ) * 1 (1+g j )

n

(1 + r j )n

r j - g j+

Payout Ratio j,n *(1+g j )n *(1+g j,n )

(r j - g j,n )(1+r j )n

Payout Ratio m *(1+g m )* 1 (1+g m)

n

(1 + r m )n

r m - gm+ Payout Ratio m,n *(1+g m )

n

*(1+g m,n )(r m - gm,n )(1+ r m )

n


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Relative PE: A Simple Example Consider the following example of a firm growing at twice the

rate as the market, while having the same growth and riskcharacteristics of the market:

Firm MarketExpected growth rate 20% 10%Length of Growth Period 5 years 5 yearsPayout Ratio: first 5 yrs 30% 30%Growth Rate after yr 5 6% 6%Payout Ratio after yr 5 50% 50%Beta 1.00 1.00Riskfree Rate = 6%Market risk premium=5.5%


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Estimating Relative PE The relative PE ratio for this firm can be

estimated in two steps. First, we computethe PE ratio for the firm and the market

separately:

Relative PE Ratio = 15.79/10.45 = 1.51

PE firm =

0.3 * (1.20) * 1 (1.20)5

(1.115)5

(.115 - .20)+ 0.5 * (1.20)

5 * (1.06)(.115 -.06) (1.115) 5

= 15.79

PE market =0.3 * (1.10) * 1 (1.10)

5

(1.115) 5

(.115 - .10)+

0.5 * (1.10) 5 *(1.06)(.115 - .06) (1.115) 5

= 10.45


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Value/Earnings and Value/Cashflow


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Value/Earnings and Value/CashflowRatios

While Price earnings ratios look at the market value of equity relative to

earnings to equity investors, Value earnings ratios look at the market valueof the firm relative to operating earnings. Value to cash flow ratios modify theearnings number to make it a cash flow number.

The form of value to cash flow ratios that has the closest parallels in DCF

valuation is the value to Free Cash Flow to the Firm, which is defined as:

Value/FCFF = (Market Value of Equity + Market Value of Debt-Cash)EBIT (1-t) - (Cap Ex - Deprecn) - Chg in WC

Consistency Tests: If the numerator is net of cash (or if net debt is used, then the interest

income from the cash should not be in denominator The interest expenses added back to get to EBIT should correspond to

the debt in the numerator. If only long term debt is considered, only long

term interest should be added back.


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Value/FCFF Distribution

l f i / C i


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Value of Firm/FCFF: Determinants Reverting back to a two-stage FCFF DCF model, we get:

V0 = Value of the firm (today) FCFF 0 = Free Cashflow to the firm in current year g = Expected growth rate in FCFF in extraordinary

growth period (first n years) WACC = Weighted average cost of capital gn = Expected growth rate in FCFF in stable growth

period (after n years)

V0 =

FCFF 0 (1 + g) 1- (1+g)n

(1+ WACC) n

WACC-g +

FCFF 0 (1+ g)n (1+g n)

(WACC-gn

)(1 + WACC) n


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Value Multiples

Dividing both sides by the FCFF yields,

The value/FCFF multiples is a function of the cost of capital the expected growth

V0FCFF 0

=(1 + g) 1-

(1+g) n

(1+ WACC) n

WACC-g +

(1+ g) n (1+ g n )(WACC - g n )(1 + WACC)

n


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Value/FCFF Multiples and the


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Value/FCFF Multiples and the Alternatives

Assume that you have computed the value of a firm, usingdiscounted cash flow models. Rank the following multiples inthe order of magnitude from lowest to highest?Value/EBIT

Value/EBIT(1-t)Value/FCFFValue/EBITDA

What assumption(s) would you need to make for the

Value/EBIT(1-t) ratio to be equal to the Value/FCFF multiple?


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Multiple Magic


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Multiple Magic In this case of MCI there is a big difference between the FCFF

and short cut measures. For instance the following tableillustrates the appropriate multiple using short cut measures,and the amount you would overpay by if you used the FCFFmultiple.Free Cash Flow to the Firm= EBIT (1-t) - Net Cap Ex - Change in Working Capital= 3356 (1 - 0.36) + 1100 - 2500 - 250 = $ 498 million

$ Value Correct MultipleFCFF $498 31.28382355EBIT (1-t) $2,148 7.251163362EBIT $ 3,356 4.640744552EBITDA $4,456 3.49513885 (Now Doesn t That

look really CHEAP!!!!!)

Reasons for Increased Use of Val e/EBITDA


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Reasons for Increased Use of Value/EBITDA1. The multiple can be computed even for firms that are reporting net

losses, since earnings before interest, taxes and depreciation areusually positive.

2. For firms in certain industries, such as Telecom, Power etc. whichrequire a substantial investment in infrastructure and long gestationperiods, this multiple seems to be more appropriate than the

price/earnings ratio.3. In leveraged buyouts, where the key factor is cash generated by the

firm prior to all discretionary expenditures, the EBITDA is themeasure of cash flows from operations that can be used to supportdebt payment at least in the short term.

Value/EBITDA Multiple


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Value/EBITDA Multiple The Classic Definition (problem is that cash is reflected in numerator

but not in the denominator)

The No-Cash Version

When cash and marketable securities are netted out of

value, none of the income from the cash and securitiesshould be reflected in the denominator. Be careful if you have a X% equity holding, then adjust both

the numerator and denominator!!

ValueEBITDA

= Market Value of Equity + Market Value of DebtEarnings before Interest, Taxes and Depreciation

Enterprise ValueEBITDA

=Market Value of Equity + Market Value of Debt - Cash

Earnings before Interest, Taxes and Depreciation


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Value/EBITDA Distribution

The Determinants of Value/EBITDA Multiples:


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The Determinants of Value/EBITDA Multiples:Linkage to DCF Valuation

Firm value can be written as:

The numerator can be written as follows:

FCFF = EBIT (1-t) - (Cex - Depr) - Working Capital

= (EBITDA - Depr) (1-t) - (Cex - Depr) - WorkingCapital= EBITDA (1-t) + Depr (t) - Cex - Working Capital

V0 =FCFF1

WACC-g

F Fi V l t EBITDA


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From Firm Value to EBITDAMultiples

Now the Value of the firm can be rewrittenas,

Dividing both sides of the equation byEBITDA,

Value =EBITDA (1- t) + Depr (t) - Cex - Working Capital

WACC-g

ValueEBITDA

=(1- t)

WACC- g +

Depr (t)/EBITDAWACC -g

-CEx/EBITDA

WACC-g -

Working Capital/EBITDAWACC-g


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A Simple Example

Consider a firm with the followingcharacteristics: Tax Rate = 36% Capital Expenditures/EBITDA = 30% Depreciation/EBITDA = 20% Cost of Capital = 10% The firm has no working capital requirements The firm is in stable growth and is expected to

grow 5% a year forever.

C l l ti g V l /EBITDA


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Calculating Value/EBITDAMultiple

In this case, the Value/EBITDA multiple forthis firm can be estimated as follows:

Effect of (i) Taxes (ii) Net Capex and (iii)ROCE on Value/EBITDA ratio.

ValueEBITDA

=(1- .36).10 -.05

+(0.2)(.36).10 -.05

-0.3

.10 - .05 -

0.10 - .05

= 8.24


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Price Book Value Ratio:


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Price-Book Value Ratio:Definition

The price/book value ratio is the ratio of the market value ofequity to the book value of equity, i.e., the measure ofshareholders

equity in the balance sheet. Price/Book Value = Market Value of Equity

Book Value of Equity Consistency Tests:

If the market value of equity refers to the market value ofequity of common stock outstanding, the book value ofcommon equity should be used in the denominator.

If there is more that one class of common stockoutstanding, the market values of all classes (even thenon-traded classes) needs to be factored in.


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Price to Book Value: Distribution

Price Book Value Ratio: Stable


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Price Book Value Ratio: StableGrowth Firm

Going back to a simple dividend discountmodel,

Defining the (expected) return on equity (ROE)= EPS 1 / Book Value of Equity, the value ofequity can be written as:

P 0 =DPS1r g n

P 0 = BV 0 * ROE * Payout Ratio * (1 + gn )

r-gn

P 0BV 0

= PBV =ROE* Payout Ratio * (1 + g n )

r-g n

P 0BV 0

= PBV =ROE * Payout Ratio

r-g n

Price Book Value Ratio: Stable Growth Firm


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Another Presentation This formulation can be simplified even further by relating

growth to the return on equity:g = (1 - Payout ratio) * ROE

Substituting back into the P/BV equation,

The price-book value ratio of a stable firm is determined by the

differential between the return on equity and the required rateof return on its projects.

P 0BV 0

= PBV = ROE - g nr-g n

Price Book Value Ratio for High


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Price Book Value Ratio for HighGrowth Firm

The Price-book ratio for a high-growth firmcan be estimated beginning with a 2-stagediscounted cash flow model:

Dividing both sides of the equation by thebook value of equity:

P 0 =

EPS 0 * Payout Ratio * (1 + g) * 1 (1+ g) n

(1+ r) n

r - g+


( r - g n )(1+ r)n

P0BV0

=

ROE* Payout Ratio *(1+ g)* 1 (1+g) n

(1+ r) n

r - g+

ROE n * Payout Ratio n *(1+g)n *(1+g n )

( r -g n )(1+ r)n

PBV R ti f High G th Fi E l


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PBV Ratio for High Growth Firm: Example Assume that you have been asked to estimate the PBV ratio for a

firm which has the following characteristics:High Growth Phase Stable Growth Phase

Length of Period 5 years Forever after year 5Return on Equity 25% 15%Payout Ratio 20% 60%Growth Rate .80*.25=.20 .4*.15=.06Beta 1.25 1.00Cost of Equity 12.875% 11.50%

The riskfree rate is 6% and the risk premium used is 5.5%.

Estimating Price/Book Value


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Estimating Price/Book ValueRatio

The price/book value ratio for this firm is:

PBV =

0.25 * 0.2 * (1.20) * 1 (1.20) 5

(1.12875) 5

(.12875 - .20)+

0.15 * 0.6 * (1.20) 5 * (1.06)(.115 - .06) (1.12875) 5

= 2.66

PBV/ROE: Oil & Power Companies


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PBV/ROE: Oil & Power Companies

UR looking out formismatches

Company Name PBV ROE

Aban Offshore 0.29 -14.60%

BPCL 0.54 7.47%

Essar Oil 0.64 -5.83%

GAIL India 0.95 6.26%

HPCL 0.95 3.99%

IOC 1.13 10.27%

ONGC 1.45 13.41%

RIL 1.59 13.42%

RNRL 1.72 13.28%

RPL 1.77 16.69%Cairn 1.95 15.44%Lanco Infratech 2.15 16.68%

Rel Power 2.33 13.41%

NTPC 2.4 14.49%

NEYVELLI 2.44 13.77%

Siemens 2.64 17.92%

TATA Power 3.03 15.69%GVK Power 3.24 13.43%

Torrent Power 3.53 10.67%

GMR 3.59 28.88%

ABB 4.22 11.20%

Rel Infra 4.66 14.34%

Suzlon 5.57 31.02%

Average 2.294782609 12.23%


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Value/Book Ratio: Description

Determinants of Value/Book


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Determinants of Value/BookRatios

To see the determinants of the value/book ratio, consider the simplefree cash flow to the firm model:

Dividing both sides by the book value, we get:

If we replace, FCFF = EBIT(1-t) - (g/ROC) EBIT(1-t),we get

V0

=FCFF1

WACC-g

V0BV

=FCFF 1/BVWACC-g

V0BV

=ROC - gWACC-g

Value/Book Ratio: An Example


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Value/Book Ratio: An Example Consider a stable growth firm with the following

characteristics: Return on Capital = 12% Cost of Capital = 10%

Expected Growth = 5% The value/BV ratio for this firm can be

estimated as follows:

Value/BV = (.12 - .05)/(.10 - .05) = 1.40 The effects of ROC on growth will increase if

the firm has a high growth phase, but the basic

determinants will remain unchanged.


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Price Sales Ratio: Definition

The price/sales ratio is the ratio of themarket value of equity to the sales.

Price/ Sales= Market Value of EquityTotal Revenues

Consistency Tests The price/sales ratio is internally inconsistent,

since the market value of equity is divided bythe total revenues of the firm.

Price/Sales Ratio: Cross


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Price/Sales Ratio: CrossSectional Distribution


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Price/Sales Ratio: Determinants

The price/sales ratio of a stable growthfirm can be estimated beginning with a 2-stage equity valuation model:

Dividing both sides by the sales per share:

P 0 =DPS1r g n

P0Sales 0

= PS = Net Profit Margin* Payout Ratio*(1 + g n )

r-g n

Price/Sales Ratio for High Growth Firm


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Price/Sales Ratio for High Growth Firm When the growth rate is assumed to be high for

a future period, the dividend discount modelcan be written as follows:

Dividing both sides by the sales per share:

where Net Margin n = Net Margin in stable growthphase

P 0 =

EPS 0 * Payout Ratio * (1 + g) * 1 (1+ g) n

(1+ r) n

r - g+


( r - gn

)(1+ r) n

P0

Sales 0=

Net Margin * Payout Ratio* (1+ g)* 1 (1+ g) n

(1+ r) n

r - g

+ Net Margin n * Payout Ratio n *(1+g)

n *(1+g n )

( r - g n )(1 + r)n

Price Sales Ratios and Profit Margins


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Price Sales Ratios and Profit Margins The key determinant of price-sales ratios is the profit margin.

A decline in profit margins has a two-fold effect. First, the reduction in profit margins reduces the price-salesratio directly.

Second, the lower profit margin can lead to lower growth and

hence lower price-sales ratios.Expected growth rate = Retention ratio * Return on Equity= Retention Ratio *(Net Profit / Sales) * ( Sales / BV of

Equity)

= Retention Ratio * Profit Margin * Sales/BV of Equity

Price/Sales Ratio: An Example


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p

High Growth Phase Stable GrowthLength of Period 5 years Forever after year 5Net Margin 10% 6%Sales/BV of Equity 2.5 2.5

Beta 1.25 1.00Payout Ratio 20% 60%Expected Growth (.1)(2.5)(.8)=20% (.06)(2.5)(.4)=.06Riskless Rate =6%

PS =

0.10 * 0.2 * (1.20) * 1 (1.20) 5

(1.12875) 5

(.12875 - .20)+

0.06 * 0.60 * (1.20) 5 * (1.06)(.115 -.06) (1.12875) 5

= 1.06


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Value/Sales Ratio: Cross


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Value/Sales Ratio: CrossSectional Distribution

Value/Sales Ratios: Analysis ofD i


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Determinants If operating margins are used, the appropriate value estimate is that

of the firm. In particular, if one makes the assumption that Free Cash Flow to the Firm = EBIT (1 - tax rate) (1 -

Reinvestment Rate) Then the Value of the Firm can be written as a function of the after-

tax operating margin= (EBIT (1-t)/Sales

g = Growth rate in after-tax operating income for the first n years

gn = Growth rate in after-tax operating income after n years forever(Stable growth rate)RIRGrowth, Stable = Reinvestment rate in high growth and stable

periodsWACC = Weighted average cost of capital

ValueSales 0

= After - tax Oper. Margin *

(1 - RIR growth )(1 + g) * 1 (1 +g) n

(1+ WACC) n

WACC - g+

(1- RIR stable )(1 + g)n *(1+ g n )

(WACC - g n )(1 + WACC)n

Value/Sales Ratio: An Example


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p Consider, for example, the Value/Sales ratio of Coca Cola. The

company had the following characteristics:

After-tax Operating Margin =18.56% Sales/BV of Capital = 1.67Return on Capital = 1.67* 18.56% = 31.02% Reinvestment Rate= 65.00% in high growth; 20% in stable growth;Expected Growth = 31.02% * 0.65 =20.16% (Stable Growth

Rate=6%)Length of High Growth Period = 10 yearsCost of Equity =12.33% E/(D+E) = 97.65%

After-tax Cost of Debt = 4.16% D/(D+E) 2.35%

Cost of Capital= 12.33% (.9765)+4.16% (.0235) = 12.13%

Value of Firm 0Sales 0

=.1856*

(1- .65)(1.2016)* 1 (1.2016) 1 0

(1.1213) 1 0

.1213- .2016+

(1- .20)(1.2016) 1 0 * (1.06)(.1213- .06)(1.1213) 1 0

= 6.10

Brand Name Premiums in Valuation


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You have been hired to value Coca Cola for an

analyst report and you have valued the firm at6.10 times revenues, using the model describedin the last few slides (Value to Sales Ratio).

Another analyst is arguing that there should bea premium added on to reflect the value of thebrand name. Do you agree?YesNo

Explain.


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Illustration: Valuing a brand name: Coca Cola


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Coca Cola Generic Cola Company

AT Operating Margin 18.56% 7.50% Sales/BV of Capital 1.67 1.67ROC 31.02% 12.53%Reinvestment Rate 65.00% (19.35%) 65.00% (47.90%)

Expected Growth 20.16% 8.15%Length 10 years 10 yeaCost of Equity 12.33% 12.33%E/(D+E) 97.65% 97.65%

AT Cost of Debt 4.16% 4.16%D/(D+E) 2.35% 2.35%Cost of Capital 12.13% 12.13%Value/Sales Ratio 6.10 0.69

Value of Coca Cola

s Brand


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Value of Coca Cola s BrandName

Value of Coke s Brand Name = ( 6.10 -0.69) ($18,868 million) = $102 billion

Value of Coke as a company = 6.10($18,868) million) = $ 115 Billion

Approximately 88.69% of the value of thecompany can be traced to brand namevalue

Choosing Between the Multiples


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Choosing Between the Multiples As presented in this section, there are dozens of multiples that can

be potentially used to value an individual firm. In addition, relative valuation can be relative to a sector (or

comparable firms) or to the entire market (using the regressions, forinstance)

Since there can be only one final estimate of value, there are threechoices at this stage: Use a simple average of the valuations obtained using a number

of different multiples Use a weighted average of the valuations obtained using a

number of different multiples Choose one of the multiples (that best suites your purpose) and

base your valuation on that multiple

Averaging Across Multiples


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Averaging Across Multiples This procedure involves valuing a firm using

five or six or more multiples and then taking anaverage of the valuations across thesemultiples.

This is completely inappropriate since itaverages good estimates with poor onesequally.

If some of the multiples are

sector based

andsome are

market based

, this will alsoaverage across two different ways of thinkingabout relative valuation.


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Picking one Multiple


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This is usually the best way to approach this issue. While a range ofvalues can be obtained from a number of multiples, the

bestestimate value is obtained using one multiple.

The multiple that is used can be chosen in one of two ways: Use the multiple that best fits your objective. Thus, if you want the

company to be undervalued, you pick the multiple that yields the

highest value. Use the multiple that has the highest R-squared in the sector

when regressed against fundamentals. Thus, if you have tried PE,PBV, PS, etc. and run regressions of these multiples againstfundamentals, use the multiple that works best at explainingdifferences across firms in that sector.

Use the multiple that seems to make the most sense for thatsector, given how value is measured and created.

A More Intuitive Approach


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As a general rule of thumb, the following table provides a way of picking a multiple for a sectorSector Multiple Used RationaleCyclical Manufacturing PE, Relative PE Often with normalized earnings

High Tech, High Growth PEG Big differences in growth acrossfirms

High Growth/No Earnings PS, VS Assume future margins will be good

Heavy Infrastructure V/EBITDA Firms in sector have losses in earlyyears and reported earnings can varydepending on depreciation method

REITa P/CF Generally no cap ex investments

from equity earnings

Financial Services PBV Book value often marked to market

Documents

1 Relative Valuation