Embed Size (px)
DESCRIPTION
realtive valuation methods
Citation preview
Relative Valuation
Comparable Firm Approach Also called as the relative approach The value of the firm is derived from type value of
comparable firms , based on a set of common variables like earnings, sales, cash flows, book value etc.
The most common method of valuing equity is by using P/E multiple.
The steps involves• Analysis of the firm• Identification of comparable firms• Comparison & Analysis• Valuation of firm
Determinants of Multiples
Finding comparable assets that are priced by the market
Scaling the market prices to a common variable to generate standardized prices that are comparable
Adjust for differences across assets
PROS AND CONS OF RELATIVE VALUATION Use of multiples and comparables is less time
consuming and resource intensive Easier for analysts to justify Factors market imperatives Useful for stock valuation
Earnings Multiples Price/Earnings Ratio (PE) and variants (PEG and Relative PE) Value/EBIT Value/EBITDA Value/Cash Flow
Book 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
PE = 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 are defined.
Price: is usually the current priceis sometimes the average price for the year
EPS: earnings per share in most recent financial yearearnings per share in trailing 12 months (Trailing PE) forecasted earnings per share next year (Forward PE)forecasted earnings per share in future year
PEG Ratio The PEG ratio is the ratio of price earnings to
expected growth in earnings per share.PEG = PE / Expected Growth Rate in Earnings
The relative PE ratio of a firm is the ratio of the PE of the firm to the PE of the market.
Relative PE = P E of Firm / PE of Market
Value/Earnings and Value/Cash flow RatiosValue/FCFF = (Market Value of Equity + Market Value of Debt-
Cash)EBIT (1-t) - (Cap Ex - Deprecn) - Chg in
WC
Value/EBIT Value/EBIT(1-t) Value/FCFF Value/EBITDA
Value/EBITDA Multiples The multiple of value to EBITDA varies widely across
firms in the market, depending upon: how capital intensive the firm is (high capital intensity
firms will tend to have lower value/EBITDA ratios), how much reinvestment is needed to keep the business
going and create growth how high or low the cost of capital is (higher costs of
capital will lead to lower Value/EBITDA multiples) how high or low expected growth is in the sector (high
growth sectors will tend to have higher Value/EBITDA multiples)
The multiple can be computed even for firms that are reporting net losses, since earnings before interest, taxes and depreciation are usually positive.
2. For firms in certain industries, such as cellular, which require a substantial investment in infrastructure and long gestation periods, 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 the appropriate tool.
4. By looking at measure of cash flows from operations that can be used to support debt payment at least in the short term.
5. By looking at cash flows prior to capital expenditures, it may provide a better estimate of “optimal value”, especially if the capital expenditures he value of the firm and cash flows to the firm it allows for comparisons across firms with different financial leverage.
PRICE/BOOK VALUE The Price/Book value ratio is the ratio of the
market value of equity to the book value of equity, i.e., the measure of shareholders’ equity in the balance sheet.
Price/Book Value = Market Value of Equity
Book Value of Equity
Adjusted book value approachThe steps involved: Valuation of Tangible Assets Valuation of Intangible Assets Valuation of Liabilities
WHEN PRICE/BOOK VALUE IS USED Book value provides a relatively stable,
intuitive measure of value that can be compared to the market price
Given reasonably consistent accounting standards across firms, price-book value ratios can be compared across similar firms for signs of under or over valuation
Firms with negative earnings, which cannot be valued using price-earnings ratios, can be evaluated
Price/Book Value Not Feasible Book values, like earnings, are affected by
accounting decisions on depreciation and other variables.
Book value may not carry much meaning for technology firms which do not have significant tangible assets.
The book value of equity can become negative if a firm has a sustained string of negative earnings reports, leading to a negative price-book value ratio.
How to treat options outstanding to equity value Impact of buybacks and acquisitions
Financial FactorsThe value of the firm depends on the following three factors-
Return on Equity Cost of Equity Growth Rate
The constant dividend discount model says thatP0= d1/k-g
Also,DPS1 = (EPS1)(Payout ratio), P0=EPS *(PAYOUT RATIO)/k-gDefining ROE=EPS/Book value of equitySubstituting d1,
P0=B*roe*b/k-gDividing both sides by B
P0/B=r*b/k-gAlso, g=r(1-b)
ROE*b=r-gReplacing r*b,
P0/B=r-g/k-g
P0/B=r-g/k-g
•Thus, a firm’s market to book value ratio can be derived from its return on equity, its cost on equity and its growth rate.•In order to create value for its shareholders, a firm should have positive spread between the return on equity & cost of equity, and high growth rate
TOBIN’S Q
Tobin’s Q is a practical measure of value for a mature firm with most or all of its assets in place, where replacement cost can be estimated for the assets.
Tobin’s Q is more a measure of the perceived quality of a firm’s management with poorly managed firms trading at market values that are lower than the replacement cost of the assets that they own
Firms with low Tobin's Q are more likely to be taken over for purposes of restructuring and increasing value.
Shareholders of high q bidders gain significantly more from successful tender offers than shareholders of low q
bidders.
PRICE/SALES
Determined by(a) Net Profit Margin: Net Income / Revenues. The price-sales
ratio is an increasing function of the net profit margin. Firms with higher net margins, other things remaining equal, should trade at higher price to sales ratios.
(b) Payout ratio during the high growth period and in the stable period: The PS ratio increases as the payout ratio increases, for any given growth rate.
(c) Riskiness (through the discount rate ke,g in the high growth period and ke,st in the stable period): The PS ratio becomes lower as riskiness increases, since higher risk translates into a higher cost of equity.
(d) Expected growth rate in Earnings, in both the high growth and stable phases: The PS increases as the growth rate increases, in both the high growth and stable growth period.
PRICE SALES RATIOS
P 0 DPS1r gn
The price/sales ratio of a stable growth firm can be estimated beginning with a 2-stage equity valuation model:
Dividing both sides by the sales per share:
P0
Sales 0
PS= Net Profit Margin * Payout Ratio *(1 gn )
r-gn
Compute the value of sigma Ltd. using the comparable approach using the following information:
Sales Rs.100crPAT Rs.15crBook Value Rs.60cr
Weightages 50% to earnings,25% to sales & book value eachInformation of comparable firms:Particulars A Ltd. B Ltd. C Ltd.Sales 80 120 150PAT 12 18 25Book value 40 90 100Market value 120 150 240
Particulars A B CAvg.Price /Sales ratio 1.50 1.25 1.601.45Price/Earning ratio 10.00 8.339.60 9.31Price/book value 3.00 1.66 2.402.35
Applying the above multiples, the value of sigma is as follows:Particulars Multiples ParameterValuePrice /Sales 1.45 100 145.00
Price/Earning 9.31 15 139.65
Price/book value 2.35 60 141.00
Value of the firm:(145.00*1)+(139.65*2)+(141.00*1)/4 =
141.32
ADVANTAGES OF RELATIVE VALUATION Relative valuation is much more likely to reflect market
perceptions and moods than discounted cash flow valuation. This can be an advantage when it is important that the price reflect these perceptions as is the case when the objective is to sell a security at that price today (as in the case of an IPO) investing on “momentum” based strategies
With relative valuation, there will always be a significant proportion of securities that are under valued and over valued.
Since portfolio managers are judged based upon how they perform on a relative basis (to the market and other money managers), relative valuation is more tailored to their needs
Relative valuation generally requires less information than discounted cash flow valuation (especially when multiples are used as screens)
DISADVANTAGES OF RELATIVE VALUATION A portfolio that is composed of stocks which are under valued on arelative basis may still be overvalued, even if the analysts’ judgmentsare right. It is just less overvalued than other securities in the market. Relative valuation is built on the assumption that markets are
correctin the aggregate, but make mistakes on individual securities. To the
degree that markets can be over or under valued in the aggregate, relative valuation will fail
Relative valuation may require less information in the way in whichmost analysts and portfolio managers use it. However, this is becauseimplicit assumptions are made about other variables (that would havebeen required in a discounted cash flow valuation). To the extent thatthese implicit assumptions are wrong the relative valuation will also
be wrong.
PE Ratio: Understanding the Fundamentals
To understand the fundamentals, start with a basic equity discounted cash flow model.
With the dividend discount model,
Dividing both sides by the earnings per share,
If this had been a FCFE Model,
P0 DPS1r gn
P0EPS0
PE = Payout Ratio * (1 gn )
r-gn
P0 FCFE1
r gn
P0
EPS0
PE = (FCFE/Earnings) * (1 gn )
r-gn
PE Ratio and Fundamentals
Proposition: Other things held equal, higher growth firms will have higher PE ratios than lower growth firms.
Proposition: Other things held equal, higher risk firms will have lower PE ratios than lower risk firms
Proposition: Other things held equal, firms with lower reinvestment needs will have higher PE ratios than firms with higher reinvestment rates.
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 PhaseStable Growth Expected 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
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 have very different business mixes and risk and growth profiles.
There is also plenty of potential for bias. Even when a legitimate group of comparable firms can be
constructed, differences will continue to persist in fundamentals between the firm being valued and this group.
Using the entire cross section: A regression approach
In contrast to the 'comparable firm' approach, the information in the entire cross-section of firms can be used to predict PE ratios.
The simplest way of summarizing this information is with a multiple regression, with the PE ratio as the dependent variable, and proxies for risk, growth and payout forming the independent variables.
Problems with the regression methodology
The basic regression assumes a linear relationship between PE ratios and the financial proxies, and that might not be appropriate.
The basic relationship between PE ratios and financial variables itself might not be stable, and if it shifts from year to year, the predictions from the model may not be reliable.
The independent variables are correlated with each other. For example, high growth firms tend to have high risk. This multi-colinearity makes the coefficients of the regressions unreliable and may explain the large changes in these coefficients from period to period.
Investment Strategies that compare PE to the expected growth rate
If we assume that all firms within a sector have similar growth rates and risk, a strategy of picking the lowest PE ratio stock in each sector will yield undervalued stocks.
Portfolio managers and analysts sometimes compare PE ratios to the expected growth rate to identify under and overvalued stocks. In the simplest form of this approach, firms with PE ratios
less than their expected growth rate are viewed as undervalued.
In its more general form, the ratio of PE ratio to growth is used as a measure of relative value.
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
This measure helps in identifying undervalued and overvalued stocks.
Commonly used in technology firms. 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 growth rate estimate?
No double counting: If the estimate of growth in earnings per share is from the current year, it would be a mistake to use forward EPS in computing PE
If looking at foreign stocks or ADRs, is the earnings used for the PE ratio consistent with the growth rate estimate? (US analysts use the ADR EPS)
PEG Ratio: Analysis To understand the fundamentals that determine PEG
ratios, let us return again to a 2-stage equity discounted cash flow model
Dividing both sides of the equation by the earnings gives us the equation for the PE ratio. Dividing it again by the expected growth ‘g’
P0 =EPS0 * Payout Ratio *(1+ g)* 1
(1+ g)n
(1+ r)n
r - g+
EPS0 * Payout Ratio n *(1+ g)n *(1+ gn )(r -gn )(1+ r)n
PEG =Payout Ratio *(1 + g) * 1
(1+ g)n
(1 + r)n
g(r - g)
+ Payout Ratio n * (1+ g)n * (1+ gn )
g(r - gn )(1 + r)n
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 growth rate. 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 PEG ratios 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. Proposition 3: Companies with very low or very high growth rates will tend to
have higher PEG ratios than firms with average growth rates. This bias is worse for low growth stocks. Corollary 3: PEG ratios do not neutralize the growth effect.
Relative PE: Definition
The relative PE ratio of a firm is the ratio of the PE of the firm to the 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 that it be estimated using the same measure of earnings for both the firm and the market.
Relative PE ratios are usually compared over time. Thus, a firm or sector which has historically traded at half the market PE (Relative PE = 0.5) is considered over valued if it is trading at a relative PE of 0.7.
Relative PE: Determinants To analyze the determinants of the relative PE ratios, let
us revisit the discounted cash flow model we developed for the PE ratio. Using the 2-stage DDM model as our basis (replacing the payout ratio with the FCFE/Earnings Ratio, if necessary), we get
where Payoutj, gj, rj = Payout, growth and risk of the firm Payoutm, gm, rm = Payout, growth and risk of the market
Relative PE j =
Payout Ratio j *(1 + g j) * 1 (1+ g j)
n
(1+ rj)n
rj - g j
+ Payout Ratio j,n *(1 + g j)
n *(1 + g j,n )(rj - g j,n )(1 + rj)
n
Payout Ratio m * (1+ gm )* 1 (1+ gm)n
(1+ rm )n
rm - gm
+ Payout Ratio m,n * (1+ gm )n *(1 + gm, n )
(rm - gm, n )(1+ rm )n
Relative PE: Summary of Determinants
The relative PE ratio of a firm is determined by two variables. In particular, it will increase as the firm’s growth rate relative to the market
increases. The rate of change in the relative PE will itself be a function of the market growth rate, with much greater changes when the market growth rate is higher. In other words, a firm or sector with a growth rate twice that of the market will have a much higher relative PE when the market growth rate is 10% than when it is 5%.
decrease as the firm’s risk relative to the market increases. The extent of the decrease depends upon how long the firm is expected to stay at this level of relative risk. If the different is permanent, the effect is much greater.
Relative PE ratios seem to be unaffected by the level of rates, which might give them a decided advantage over PE ratios.
Value/Earnings and Value/Cash flow Ratios While Price earnings ratios look at the market value of equity relative
to earnings to equity investors, Value earnings ratios look at the market value of the firm relative to operating earnings. Value to cash flow ratios modify the earnings 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 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.
Value of Firm/FCFF: Determinants
Reverting back to a two-stage FCFF DCF model, we get:
V0 = Value of the firm (today)
FCFF0 = Free Cash flow 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 =
FCFF0 (1 + g) 1- (1 + g)n
(1+ WACC)n
WACC - g +
FCFF0 (1+ g)n (1+ gn)
(WACC - gn)(1 + WACC)n
Value Multiples
Dividing both sides by the FCFF yields,
The value/FCFF multiples is a function of the cost of capital the expected growth
V0
FCFF0
= (1 + g) 1-
(1 + g)n
(1 + WACC) n
WACC - g
+ (1+ g)n (1+ gn )
(WACC - gn )(1 + WACC) n
Alternatives to FCFF - EBIT and EBITDA
Most analysts find FCFF too complex or messy to use in multiples (partly because capital expenditures and working capital have to be estimated). They use modified versions of the multiple with the following alternative denominator: after-tax operating income or EBIT(1-t) pre-tax operating income or EBIT net operating income (NOI), a slightly modified version of
operating income, where any non-operating expenses and income is removed from the EBIT
EBITDA, which is earnings before interest, taxes, depreciation and amortization.
Reasons for Increased Use of Value/EBITDA
1. The multiple can be computed even for firms that are reporting net losses, since earnings before interest, taxes and depreciation are usually positive.
2. For firms in certain industries, such as cellular, which require a substantial investment in infrastructure and long gestation periods, 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 the are unwise or earn substandard returns.
5. By looking at the measure of cash flows from operations that can be used to support debt payment at least in the short term.
4. By looking at cash flows prior to capital expenditures, it may provide a better estimate of “optimal value”, especially if the capital expenditures he value of the firm and cash flows to the firm it allows for comparisons across firms with different financial leverage.
Value/EBITDA Multiple The Classic Definition
The No-Cash Version
When cash and marketable securities are netted out of value, none of the income from the cash and securities should be reflected in the denominator.
ValueEBITDA
Market Value of Equity + Market Value of Debt Earnings before Interest, Taxes and Depreciation
Enterprise ValueEBITDA
Market Value of Equity + Market Value of Debt - Cash
Earnings before Interest, Taxes and Depreciation
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) - (Capex - Depr) - Working Capital
= (EBITDA - Depr) (1-t) - (Capex - Depr) - Working Capital
= EBITDA (1-t) + Depr (t) - Capex - Working Capital
V0 = FCFF1
WACC - g
Price-Book Value Ratio
The price/book value ratio is the ratio of the market value of equity to the book value of equity, i.e., the measure of shareholders’ 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 of equity of common stock outstanding, the book value of common equity should be used in the denominator.
If there is more that one class of common stock outstanding, the market values of all classes (even the non-traded classes) needs to be factored in.
Price Book Value Ratio: Stable Growth Firm
Going back to a simple dividend discount model,
Defining the return on equity (ROE) = EPS0 / Book Value of Equity, the value of equity can be written as:
If the return on equity is based upon expected earnings in the next time period, this can be simplified to,
P 0 DPS1r gn
P 0 BV0 * ROE * Payout Ratio * (1 gn )
r-gn
P 0BV 0
PBV = ROE * Payout Ratio * (1 gn )
r-gn
P 0BV 0
PBV = ROE * Payout Ratio
r-gn
Price Book Value Ratio: Stable Growth Firm 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 rate of return on its projects.
P 0BV0
PBV = ROE - gn
r-gn
The Valuation MatrixMV/BV
ROE-r
High ROE High MV/BV
Low ROE Low MV/BV
Overvalued Low ROE High MV/BV
Undervalued High ROE Low MV/BV
Determinants of Value/Book Ratios
To see the determinants of the value/book ratio, consider the simple free 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
V0
BV=
FCFF1/BV WACC - g
V0
BV=
ROC - gWACC - g
Price Sales Ratio
The price/sales ratio is the ratio of the market value of equity to the sales.
Price/ Sales= Market Value of Equity
Total Revenues Consistency Tests
The price/sales ratio is internally inconsistent, since the market value of equity is divided by the total revenues of the firm.
Price/Sales Ratio: Determinants The price/sales ratio of a stable growth firm can be estimated beginning
with a 2-stage equity valuation model:
Dividing both sides by the sales per share:
P 0 DPS1r gn
P0
Sales 0
PS= Net Profit Margin * Payout Ratio *(1 gn )
r-gn
Price/Sales Ratio for High Growth Firm When the growth rate is assumed to be high for a future
period, the dividend discount model can be written as follows:
Dividing both sides by the sales per share:
where Net Marginn = Net Margin in stable growth phase
P 0 =EPS0 * Payout Ratio * (1 + g) * 1 (1+ g)n
(1+ r)n
r - g+
EPS0 * Payout Ration * (1+ g)n *(1+ gn )(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 + gn )
(r - gn )(1 + r)n
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-
sales ratio 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
The value of a brand name
One of the critiques of traditional valuation is that is fails to consider the value of brand names and other intangibles.
The approaches used by analysts to value brand names are often ad-hoc and may significantly overstate or understate their value.
One of the benefits of having a well-known and respected brand name is that firms can charge higher prices for the same products, leading to higher profit margins and hence to higher price-sales ratios and firm value. The larger the price premium that a firm can charge, the greater is the value of the brand name.
In general, the value of a brand name can be written as:
Value of brand name ={(V/S)b-(V/S)g }* Sales
(V/S)b = Value of Firm/Sales ratio with the benefit of the brand name
(V/S)g = Value of Firm/Sales ratio of the firm with the generic product
Averaging Across Multiples
This procedure involves valuing a firm using five or six or more multiples and then taking an average of the valuations across these multiples.
This is completely inappropriate since it averages good estimates with poor ones equally.
If some of the multiples are “sector based” and some are “market based”, this will also average across two different ways of thinking about relative valuation.
Picking one Multiple This is usually the best way to approach this issue. While
a range of values can be obtained from a number of multiples, the “best estimate” 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 against fundamentals, use the multiple that works best at explaining differences across firms in that sector.
Use the multiple that seems to make the most sense for that sector, given how value is measured and created.
