Relative Valuation Dr. Himanshu Joshi

Market Based Valuation: Price and Enterprise Value Multiples• Price multiples are ratios of a stock’s market price to some measure of

fundamental value per share.• Enterprise value multiples, by contrast, relate the total market value

of all sources of a company’s capital to a measure of fundamental value for the entire company.

Intuition behind price multiples..• Investors evaluates the price of a share of stock- judge whether it is

fairly valued, overvalued, or undervalued- by considering what a share buys in terms of per share earnings, net assets, cash flows or some other measure of a value (stated on per share basis).• A multiple summarizes in a single number the relationship between

the market value of a company’s stock (or its total capital) and some fundamental quantity, such as earnings, sales, or book value.

Correct Use of Multiples..• What accounting issues affect particular price and enterprise value

multiples, and how can analysts address them?• How do price multiples relates to fundamentals, such as earnings

growth rates, and how can analysts use this information when making valuation comparison among stocks?• For which types of valuation problems is a particular price or

enterprise value multiple appropriate or inappropriate?• What challenges arise in applying price and enterprise value multiples

internationally?

Momentum Indicators..• Momentum indicators typically relate either price or a fundamental

(such as earnings) to the time series of its own past values, or in some cases, to its expected value. • The logic behind the use of momentum indicator is that such

indicators may provide information on future patterns of returns over some time horizon.

The Methods of Comparable• The idea behind price multiples is that a stock’s price cannot be

evaluated in isolation. Rather, it needs to be evaluated in relation to what it buys in terms of earnings, net sales, net assets. • Obtained by dividing price by a measure of value per share, a price

multiple gives the price to purchase one unit of value. • EX.. Price/EPS = 20, means that it takes 20 units of currency (say, Rs.

20) to buy one unit of earnings (say Rs. 1 of earnings).• This scaling of price per share by value per share makes possible

comparison among various stocks.

Methods of Comparable..Stocks P/E Analysis

A 20 If they have similar risk, profit margins, and growth prospects, the security with the P/E Of 20 is undervalued relative to the one with P/E of 25.B 25

Example..• Company A’s EPS is $1.50. its closest competitor, Company B, is

trading at a P/E of 22. Assume that companies have similar operating and financial profits.

Q1. if company A’s stock is trading at $37.50, what does that indicate about its value relative to Company B?Q2. if we assume that Company A’ stock should trade at about the same P/E as Company B’s stock, what will we estimate as an appropriate price for company A’s stock?

The Method based on Forecasted Fundamentals..• If the DCF value of a stock is $10.20 and its forecasted EPS is $1.2, the forward P/E

multiple consistent with the DCF value is• $10.20/$1.2 = 8.5• The term forward P/E refers to a P/E calculated on the basis of a forecast of EPS.• Thus, we can approach valuation by using multiples from two perspectives:• First, we can use the method of comparable, which involves comparing an asset’s

multiple to a standard of comparison. Similar assets should sell at similar prices.• Second, we can use the method based on forecasted fundamentals, which

involves forecasting the company’s fundamentals rather than making comparisons with other companies. (The Price Multiple of an asset should be related to its expected future cash flows.)

Justified Price Multiples..• The justified Price multiple is the estimated fair value of that multiple,

which can be justified on the basis of the method of comparable or the method of forecasted fundamentals.• Example.. Suppose we use price-to-book ratio (P/B) in a valuation and

find that median P/B for the company’s peer group, which would be the standard of comparison, is 2.2. The stock’s justified P/B based on the method of comparable is 2.2. • If the current book value per share is $23 then, Price = 2.2*$23 =

$50.60, which can be compared with its market price.

Justified Price Multiples.. (Fundamental)• Suppose that we are using a residual income model and estimate that

the value of stock is $46 (DCF estimate).• Then the justified P/B based on the fundamental is $46/$23 = 2.0• This we can again compare with the actual value of stock’s P/B.

• We can incorporate the insights from the method based on fundamentals to explain differences from results based on comparable.

Price Multiples1. Price to Earnings = Market Price per Share/Earning Per ShareRationales supporting the use of P/E Multiple..a. Earning power is chief driver of investment value, and EPS, the

denominator in the P/E ratio, is perhaps the chief focus of security analyst’s attention.

b. The differences in stocks’ P/Es may be related to differences in long run average returns on investments in those stocks.

P/E Multiple..• Potential Drawbacks:a. EPS can be zero, negative, or insignificantly small relative to price, and P/E

does not make economic sense with zero, negative, or insignificantly small denominator.

b. The ongoing or recurring components of earnings that are most important in determining intrinsic value, can be particularly difficult to distinguish from transient components.

c. The application of accounting standards requires corporate managers to choose among acceptable alternatives and to use estimates in reporting. Doing so, managers may distort EPS as an accurate reflection of economic performance.

Alternative Definitions of P/E..• Trailing P/E: A stock’s trailing P/E is its current market price divided by

the most recent four quarters’ EPS. • Current P/E: to mean a P/E based on EPS for the most recent six

months plus the projected EPS for the coming six months. This calculation blends historical and forward looking elements. • Forward P/E: (leading P/E or prospective P/E): is a stock’s current price

divided by next year’s expected earnings.

Application.• Use same definition of P/E to all companies and time period under

examinations. • Valuation is a forward looking process, so analysts usually focus on

the forward P/E when earning forecasts are available. • When earnings are not readily predictable, a trailing P/E may be more

appropriate than forward P/E. • When the firm has undergone substantial changes in terms of M&A

activities, financial leverage, divestitures etc., trailing P/E based on the past EPS is not informative about future, thus not relevant for valuation.

Calculating the Trailing P/Es• While using trailing earnings to calculate a P/E, the analyst must take

care in determining the EPS to be used in the denominator:1. Potential dilution of EPS.2. Transitory, non recurring components of earnings that are company

specific. 3. Transitory components of earnings ascribable to cyclicality.

(business or industry cyclicality)4. Differences in accounting methods. (for different company stocks)

Basic vs. Dilutive EPS..

Basic EPS Calculation• Basic EPS is the amount of income available to common shareholders

divided by the weighted average number of shares outstanding over of period of time. • Basic EPS = (Net Income – Preferred Dividends)/Weighted average no.

of Shares Outstanding

Basic EPS Calculation• Revenue – Discounts =Net Revenues- COGS- Cost of sales=Gross Profit- general, marketing, administrative expenses= EBDITA-Depreciation and Amortization=EBIT (Operating Profit)- Int (Net Interest Int Revenue – Int Expenses)= EBT-Taxes = EAT - Preference Dividend= Earnings Available to Equity Shareholders = EPS No. of Outstanding Shares

Basic EPS Calculation• For the year ended December 31, 2009, Angler products had net income of

$25,00,000. The Company declared and paid $2,00,000 of dividends on preferred stock. The company also had the following common stock share information:• Shares outstanding on 1 January 2009 = 10,00,000• Shares issued on 1 April 2009 = 2,00,000• Shares repurchased on October 2009 = 1,00,000• Shares outstanding on 31 December 2009 = 11,00,000.Q. What is the company’s weighted average number of shares outstanding?Q. What is the company’s basic EPS?

Solution• The weighted average number of shares outstanding is determined by

the length of time each quantity of shares was outstanding:• 10,00,000 x (3 Months/12 months) = 2,50,000• 12,00,000 x (6 M/12M) = 6,00,000• 11,00,000 x (3M/12 M) = 2,75,000Weighted average no. of shares = 11,25,000

Solution • Basic EPS = (net Income – preferred dividends)/ weighted average no

of shares• = $25,00,000 - $2,00,000/11,25,000 = $2.04

Question. Basic EPS• Assume the same facts as in example 13 except that on 1 December

2009, a previously declared 2 for 1 split took effect. Each shareholder of record receives two shares in exchange of each current shares that he or she owns. What is company’s basic EPS?

Solution• For basic EPS calculation purpose, a stock split is treated as if it

occurred at the beginning of the period. The weighted average number of shares would, therefore, be double 22,50,000, and the basic EPS = $1.02

Diluted EPS• There are three dilutive securities in the capital structure of a

company:1. Convertible preferred;2. Convertible debt;3. Employee stock options.

Dilutive EPS when company has convertible preferred stock outstanding• If converted method: this method is based on what EPS

would have been if the convertible preferred securities had been converted at the beginning of the period.• If the converted preference shares are converted there

will be two effects:1. Convertible preferred stock will longer be outstanding;

instead additional common stock will be outstanding.2. If such conversion had taken place, the company would

not have paid preference dividends.

Dilutive EPS when company has convertible preferred stock outstanding• Diluted EPS = (Net Income)/(weighted average no. of shares

outstanding + new common shares that would have been issued at conversion)

Example..• For the year ended 31 December 2009, XYZ company had net income

of $17,50,000. the company had an average of 5,00,000 shares of common stock outstanding, 20,000 of preferred stock, and no other potentially dilutive securities. Each shares of preferred pays a dividend of $10 per share, and each is convertible into five shares of the company’s common stock.• Calculate company’s basic and dilutive EPS.

Diluted EPS when company has Convertible Debt Outstanding• If Converted Method: as if converted at the beginning. • Debt securities would no longer be outstanding; instead, additional

shares of common stock would be outstanding.• Also, if such conversion had taken place, the company would not have

paid interest on the convertible debt, so the net income available to common shareholders would increase by the after tax amount of interest expense on debt converted.

Diluted EPS when company has Convertible Debt Outstanding• Diluted EPS = (Net Income + After Tax interest on convertible debt –

Preferred dividends)/ weighted average number of shares outstanding + additional common stock if debt is converted.

Example..• Opponex company reported net income of $7,50,000 for the year

ended 31 December 2009. the company had a weighted average of 6,90,000 shares of common stock outstanding. In addition, the company has only one potentially dilutive security: $50,000 of 6% convertible bonds, convertible into a total of 10,000 shares. Assuming tax rate of 30% calculate Opponex’s Basic and Diluted EPS.

Solution..• If the debt securities had been converted, debt securities will no

longer be outstanding, instead, an additional 10,000 shares of common stock would be outstanding.• Company would not have interest of $3000 on the convertible debt,

so the net income will increase by $3000 (1-0.3) =$2100 (after Tax)

Diluted EPS when a company has Stock Options, warrants or their Equivalents Outstanding• When a company has stock options, warrants, or their

equivalents outstanding, diluted EPS is calculated as if the financial instruments had been exercised and the company had used the proceeds from exercise to repurchase as many shares of common stock as possible at the average market price of common stock during the period.

Diluted EPS when a company has Stock Options, warrants or their Equivalents Outstanding• The number of shares outstanding for diluted EPS is

thus increased by the number of shares that would be issued upon exercise minus the number of shares that would have been purchased with the proceeds. • This method is called treasury stock method under US

GAAP. (Same method is used under IFRS)

Diluted EPS• Assumed exercise of these financial instruments would have the

following effects:1.The company is assumed to receive cash upon exercise and, in

exchange, to issue shares.2. The company is assumed to use the cash proceeds to repurchase

shares at the weighted average market price during the period.

• As result of these two effects, the number of shares outstanding would increase by the incremental number of shares issued. (difference between number of shares issued to the holders of the options and number of shares assumed to be repurchased by the company)• Exercise of these financial instrument would not affect net income.

Diluted EPS• Diluted EPS = (Net Income – Preferred Dividends)/ weighted average

number of shares outstanding + (new shares that would have been issued at option exercise – shares that could have been purchased with the received cash) x (proportion of the year during which the financial instruments were outstanding.)

Calculationof Diluted EPS Using Treasury Stock MethodABC company reported net income of $2.3 million for the year ended

30 June 2009and had a weighted average of 8,00,000 common shares outstanding. At the beginning of the fiscal year, the company has outstanding 30,000 options with an exercise price of $35. no other potentially dilutive financial instruments are outstanding. Over the fiscal year, the company’s MPS has averaged $55 per share.

Calculate the company’s basic and diluted EPS.

Solution• Cash received by the company = 30,000 x $35 = $10,50,000. • Additional shares outstanding = 30,000• Shares repurchased = $10,50,000/ $55 = 19,091• Incremental shares = 30,000 – 19091 = 10,909

Solution..Calculation of Dilutive EPS for Bright-Warm Utility Company using Treasury Stock Method

Particulars Basic EPS Diluted EPS

Net Income $2,300,000 $2,300,000

Less: Preferred Dividends 0 0

Numerator $2,300,000 $2,300,000

Weigthed average number of shars 800000 800000

Additional shares if option is exercised $0 10909

Denominator 800000 810909

EPS $2.88 $2.84

2. Analyst Adjustment to Nonrecurring Items..• You are calculating a trailing P/E for AstraZeneca PLC as of 24 April

2008, when the share price closed at $41.95 in New York. In its first quarter of 2008, ended 31 March, AZN reported EPS according to IFRS of $1.03, which included:• $0.06 of restructuring costs,• $0.07 of amortization of intangibles arising from acquisitions, and • $0.12 of impairment charges taken to reflect the negative impact of a

competing generic product on the value of one of the company’s patented products.

Example..• Adjusting for all of these items, AZN reported core EPS of $1.28 =

$1.03+$0.06+$0.07+$0.12. • Because core EPS differed from the EPS calculated under IFRS, the

company provided a reconciliation of the two EPS figures.• Other data is shown in the table below:

Measure Full Year (2007) a

Less Frist Quarter (2007) b

Three Quarters of 2007 (c= a-b)

Plus First Quarter 2008 (d)

Trailing 12 Months EPSe = c+d

Reported EPS $3.74 $1.02 $2.72 $1.03 $3.75

CORE EPS $4.38 $1.07 $3.31 $1.28 $4.59

EPS excluding first quarter impairment

$3.74 $1.02 $2.72 $1.15 $3.87

Example..1. Based on the company’s reported EPS, determine the trailing P/E of AZN as of 24 April 2008.2. Determine the Trailing P/E of AZN as of 24 April 2008 using core earnings as determined by AZN. 3. Suppose you expect the amortization charges to continue for some years and note that, although AZN excluded restructuring charges from its core earnings calculation, AZN has reported restructuring charges in previous year. After reviewing all relevant data, you conclude that, in this instance, only the asset impairment should be viewed as clearly non recurring.

3. Analyst Adjustments for Business Cycle Influences1. The method of historical average EPS, in which normalized EPS is

calculated as average EPS over the most recent full cycle.2. The method of average return on equity, in which normalized EPS is

calculated as the average return on equity (ROE) from the most recent full cycle, multiplied by current book value per share.

Example.. Normalized EPS for Business Cycle Effects• Taiwan Semiconductor Manufacturing Company (in US $)

Measure 2001 2002 2003 2004 2005 2006 2007

EPS (ADR) $0.08 $0.12 $0.28 $0.58 $0.59 $0.74 $0.63

BVPS (ADR) $1.58 $1.64 $1.94 $2.50 $2.67 $3.03 $3.34

ROE 5.2% 7.3% 14.4% 23.1% 21.0% 24.7% 19.0%

What Influence P/E Ratio..• According to infinite period dividend discount model• P = D1/(k-g) ------------(1)• Dividing eqn. (1) by expected earnings (E1):• P/E1 = D1/E1

(k-g)Dividend Payout

Ratio

Required Rate of Return

Expected growth rate of Dividends for

the Stock

P/E Ratio Depends upon:• Dividend Payout Ratio• Expected Required Rate of Return.• Expected Growth Rate in Dividends.• Example: Expected Payout Ratio of 50%. Required Return = 12%,

growth rate = 8%• If k = 13%• If g = 9%• If k = 11% and g = 9%

P/Es in Cross Country Comparisons..1. The effects on EPS of differences in accounting standards.

2.The effects of market wide benchmarks of differences in their macroeconomic contexts. Differences in macroeconomic contexts may distort comparisons of benchmark P/E levels among companies operating in different markets.• A specific case of the second point is differences in inflation rates and

in the ability of companies to pass through inflation in their costs in the form of higher prices to their customers.

P/Es in the Cross Country Comparisons..• For two companies with same pass through ability, the company

operating in higher inflation environment will have a lower justified P/E.• If inflation rates are equal but pass through rates differ, the justified

P/E should be lower for the company with the lower pass through rate.

Summary of Price and Inverse Price RatioPrice Ratio Inverse Price Ratio Comments

Price to Earnings (P/E) Earning Yield (E/P) Both forms commonly used.

Price to Book (P/B) Book to Market (B/P) Book value is less commonly negative than EPS. B/M is favored in research but not common in practice.

Price to Sales (P/S) Sales to Price (S/P) Rarely used, Sales in not negative or zero for going concerns.

Price to Cash Flow Ratio (P/CF)

Cash Flow Yield (CF/P) Both forms are commonly used.

Price to Dividend (P/D) Dividend Yield (D/P) Used in discussing index valuation, and some regular dividend paying firms.