Relative Valuations FINAL.ppt

7/29/2019 Relative Valuations FINAL.ppt

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A beggar to another beggar: I had a grand dinner at Tajyesterday.

How? The other beggar asked.

First beggar: Some one gave me a Rs 100/- note yesterday.

I went to Taj and ordered dinner worth Rs 1,000/-,

And enjoyed the dinner. When the bill came, I said, I had nomoney.

The Taj manager called the policeman, and handed me overto him.

I gave the Rs 100/- note to the police fellow, and he set mefree.

A wonderful example of financial management indeed :)


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Relative Valuations

Represent valuations based on some comparablevariables.

In the absence of audited data, such relativevaluations often provide a thumb rule for valuations.

Often due to role of intangibles in the valuation ofthe firm the traditional models of valuation like DDM,DCF model etc. do not work.

Here the Relative valuations provide useful tipsCare to be exercised in its application.


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Relative valuation ispervasive

Most valuations on Wall Street are relative valuations.

Almost 85% of equity research reports are based upon a multiple andcomparables.

More than 50% of all acquisition valuations are based upon multiples

Rules of thumb based on multiples are not only common but are oftenthe basis for final valuation judgments.

While there are more discounted cashflow valuations in consulting andcorporate finance, they are often relative valuations masquerading asdiscounted cash flow valuations.

The objective in many discounted cashflow valuations is to back into a

number that has been obtained by using a multiple. The terminal value in a significant number of discounted cashflow

valuations is estimated using a multiple.


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So, you believe only in intrinsic value? Here is whyyou should still care about relative value

Even if you are a true believer in discounted cashflowvaluation, presenting your findings on a relative valuationbasis will make it more likely that yourfindings/recommendations will reach a receptive

audience.

In some cases, relative valuation can help find weakspots in discounted cash flow valuations and fix them.

The problem with multiples is not in their use but in their

abuse. If we can find ways to frame multiples right, weshould be able to use them better.


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Standardizing Value

You can standardize either the equity value of an asset or the value

of the asset itself, which goes in the numerator. You can standardize by dividing by the

Earnings of the asset

Price/Earnings Ratio (PE) and variants (PEG and RelativePE)

Value/EBIT Value/EBITDA

Value/Cash Flow

Book value of the asset

Price/Book Value(of Equity) (PBV)

Value/ Book Value of Assets

Value/Replacement Cost (Tobins Q)

Revenues generated by the asset

Price/Sales per Share (PS)

Value/Sales Asset or Industry Specific Variable (Price/kwh, Price per ton of


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The Four Steps toUnderstanding Multiples

Define the multiple

Describe the multiple

Analyze the multiple

Apply the multiple


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Definitional Tests

Is the multiple consistently defined?

Proposition 1: Both the value (the numerator) and thestandardizing variable ( the denominator) should be to the same

claimholders in the firm. In other words, the value of equity should

be divided by equity earnings or equity book value, and firm value

should be divided by firm earnings or book value. Is the multiple uniformly estimated?

The variables used in defining the multiple should be estimateduniformly across assets in the comparable firm list.

If earnings-based multiples are used, the accounting rules to measure

earnings should be applied consistently across assets. The same ruleapplies with book-value based multiples.


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Relative Valuations

Price-Earning Ratio/Multiple ( P/E):-

Market price per share / EPS

Most widely used ratio reflecting customerconfidence on the shares of the company.


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Price Earnings Ratio: Definition

PE = Market Price per Share / Earnings per Share

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

Price: is usually the current price

is sometimes the average price for the year

EPS: earnings per share in most recent financialyear

earnings per share in trailing 12 months (Trailing PE)

forecasted earnings per share next year (Forward PE)

forecasted earnings per share in future year

NOTE: SENSITIVE NUMERATOR AND INSENSITIVEDENOMINATOR

High future growth potential- high P/E

Established cos. With stable profits- Low P/E

P/E High in bullish market and Low in Bearish market


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PE Ratio and Fundamentals

Proposition: Other things held equal, highergrowth firms will have higher PE ratios than

lower growth firms.

Proposition: Other things held equal, higherrisk firms will have lower PE ratios than

lower risk firms

Proposition: Other things held equal, firmswith lower reinvestment needs will have

higher PE ratios than firms with higher

reinvestment rates.


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Relative Valuations

P/E to Growth Ratio:-

Market Price / Growth rate of EPS

Used in valuation of Technologycompanies to avoid astronomical P/Eratios.

Suitable for growth oriented cos.Finds the reason for real growth in Price.


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PEG as a Valuation Tool

Security-1- Let Price be-Rs. 30 and EPS- Rs.5P/E ratio= 6.

Security-2- Let Price be Rs. 40 and EPS- Rs.8

P/E ratio= 5. DECISION TO BUY=SECY-2

Suppose the Growth rate isSecy-1-30% and Secy-2- 15%

PEG- Secy-1 = 6/30= 0.2 and Secy-2 =0.33

Lower the PEG better it is . SO SECY-1 IS BETTER

IF PEG < 1- BETTER AND CHEAPER STOCKIF PEG > 1- STOCK COSTLY

CARE: IBM-based on 5 yr.avg. growth rate-1.26 (YahooFinance)

and 1 yr. growth rate-1.14(Nasdaq)


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Relative Valuations

Relative P/E Ratio:-

P/E of firm / P/E of Market index*

* P/E of market index can be calculated by dividing

Market capitalisation of index companies by thetotal EPS of the index companies.

To consider whether the stock is more valuablefor the same earnings compared to the market.


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Relative Valuations

Value /EBITDA :-

= Market cap of the company +Market Value ofdebt /

EBITDA

Used extensively for valuation of technologystocks . The ratio compares the value of the

company to earnings before reducing financecharges.

Used to avoid valuation of companies showinglosses.


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Reasons for Increased Use ofValue/EBITDA

1. The multiple can be computed even for firms that are reporting netlosses, since earnings before interest, taxes and depreciation areusually 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/earningsratio.

3. In leveraged buyouts, where the key factor is cash generated by thefirm prior to all discretionary expenditures, the EBITDA is the

measure of cash flows from operations that can be used to supportdebt payment at least in the short term.


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Value/Earnings andValue/Cashflow Ratios

While Price earnings ratios look at the market value of equity relative toearnings to equity investors, Value earnings ratios look at the market valueof the firm relative to operating earnings. Value to cash flow ratios modifythe 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

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 longterm interest should be added back.


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Relative Valuations

EV / EBITDA:-

Enterprise Value* / EBITDA

Used in takeovers/acquisitions


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Value/EBITDA Multiple

The Classic Definition

The No-Cash Version

When cash and marketable securities are nettedout of value, none of the income from the cashand securities should be reflected in thedenominator.

Value

EBITDA

Market Value of Equity + Market Value of Debt

Earnings before Interest,Taxes and Depreciation

Enterprise Value

EBITDA

Market Value of Equity + Market Value of Debt - Cash

Earnings before Interest,Taxes and Depreciation


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Relative Valuations

Price/ Book Value:-

Market price of the share / Book value*

* Book value = Net worth / No. of sharesoutstanding

Widely used for valuation of financecompanies/ Banks etc. whose assets areMarked to Market.


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Price-Book Value Ratio:Definition

The price/book value ratio is the ratio of the market value of equity to thebook value of equity, i.e., the measure of shareholders equity in thebalance 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 ofcommon stock outstanding, the book value of common equity should beused 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 factoredin.


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Relative Valuations

Price to Sales:-

Value of the company (marketcap)/ Sales

Widely used in FMCG and consumer durablesmanufacturing companies where sales/market share are more important than

Earnings.


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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 Equity

Total Revenues


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TOBINs Q

Q = market value of assets / estimatedreplacement cost

Thus when Q is >1,there is incentive to

invest and visa-versa. When Q is < 1, it is wiser to acquire assets

through merger than purchase of new

assets. Q is higher for firms with a strongcompetitive advantage/brand image.


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In Practice

As a general rule of thumb, the following table provides a way of picking amultiple for a sector

Sector 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 P/S, V /Sales Assume future marginswill be good

Heavy Infrastructure EV/EBITDA Firms in sector have losses inearly years and reported earningscan vary depending ondepreciation method

REITs P/CF Generally no cap ex investments

from equity earningsFinancial Services PBV Book value often marked to

market

Retailing,FMCG,Pharma PS If leverage is similar across firms

VS If leverage is different


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Reviewing: The Four Steps toUnderstanding Multiples

Define the multiple

Check for consistency

Make sure that they are estimated uniformly

Describe the multiple

Multiples have skewed distributions: The averages are seldomgood indicators of typical multiples

Check for bias, if the multiple cannot be estimated

Analyze the multiple

Identify the companion variable that drives the multiple

Examine the nature of the relationship

Apply the multiple


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Primer on Relative

Valuation MethodologySimple applications


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Applying Market-Based (RelativeValuation) Methods

MVT = (MVC / IC) x IT

Where

MVC = Market value of the comparable company C

IC = Measure of value for comparable company C

IT = Measure of value for company T

(MVC/IC) = Market value multiple for the comparable

company


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Market based valuation

T- Target company

Ic Measure of Value(P/E) of comp.co.(10)

It - Measure of value of Target co. say-8C- Comparable company

MVt = MVc(1000 lacs)/Ic * It

1000/10 * 8= Rs. 800 lacs.


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Market-Based Methods:Same or Comparable Industry Method

Multiply targets earnings or revenues bymarket value to earnings or revenue ratiosfor the average firm in targets industry or

a comparable industry. Primary advantage is the ease of use and

availability of data.

Disadvantages include presumptionindustry multiples are actually comparableand analysts projections are unbiased.


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Valuation for cos. In sameIndustry

Target co. earnings- say Rs.1000 lacs

Comparable co. ( MV/Earnings)-

20( Industry avg.)Market value of Target co.

1000 x 20 = Rs. 20000 lacs.

Asset Based Methods:


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Asset-Based Methods:Tangible Book Value

Tangible book value (TBV) = (total assets -goodwill) Targets estimated value = Targets TBV x

[(industry average or comparable firm market

value) / (industry or comparable firm TBV)]. Often used for valuing Financial services firms where tangible book

value is primarily cash or liquid assets

Distribution firms where current assetsconstitute a large percentage of total assets


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Asset Based MethodTangible book value

Tangible Book Value of Target co. = Total assets-goodwill say Rs. 1000- 200 =800 lacs.

Avg. market value of comp. firm- Rs. 2000 lacs

Avg. Tangible Book value of com. Firm-1200 lacsMarket Value of Target co.= 800 *2000/1200

Rs. 1333 lacs.


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Asset-Based Methods: Liquidation Method

Value assets as if sold in an orderly fashion (e.g., 9-12

months) and deduct value of liabilities and expensesassociated with asset disposition.

While varies with industry,

Receivables often sold for 80-90% of book value

Inventories might realize 80-90% of book book valuedepending on degree of obsolescence and condition

Equipment values vary widely depending on age andcondition and purpose (e.g., special purpose)

Book value of land may understate market value

Prepaid assets such as insurance can be liquidatedwith a portion of the premium recovered.


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Replacement Cost Method

All target operating assets are assigned a

value based on what it would cost to replacethem.

Each asset is treated as if no additional valueis created by operating the assets as part of agoing concern.

Each assets value is summed to determinethe aggregate value of the business.

This approach is limited if the firm is highlyprofitable (suggesting a high going concernvalue) or if many of the firms assets areintangible.


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Weighted Average ValuationMethod

An analyst has estimated the value ofa company using multiplevaluation methodologies. Thediscounted cash flow value is$220 million, comparabletransactions value is $234 million,

the P/E-based value is $224million and the liquidation value is$150 million. The analyst hasgreater confidence in certainmethodologies than others.Estimate the weighted averagevalue of the firm using all valuationmethodologies and the weights orrelative importance the analystgives to each methodology.

Estimated

Value ($M)

Relative

Weight

Weighted

Avg. ($M)

220-DCF .30 66.0

234-comp. .40 93.6

224-P/E .20 44.8

150-Liq.value .10 15.0

1.00 219.4


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Adjusting Firm Value

Generally, the value of the firms equity isthe Enterprise Value less market value offirms long-term debt.

However, value may be under oroverstated if not adjusted for non-operating assets or liabilities assumed by

the acquirer.


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Adjusting Firm Value Example

A target firm has the following characteristics: An estimated enterprise value of $104 million

Long-term debt whose market value is $15 million

$3 million in excess cash balances

Estimated PV of currently unused licenses of $4million

Estimated PV of future litigation costs of $2.5 million

2 million common shares outstanding

What is the value of the target firm per common share?

Adjusting Firm Value Example


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Adjusting Firm Value ExampleContd.

Enterprise Value $104

Plus: Non-Operating Assets

Excess Cash Balances

PV of Licenses

$3

$4

Less: Non-Operating Liabilities

PV of Potential Litigation $2.5

Less: Long-Term Debt $15

Equals: Equity Value $93.5

Equity Value Per Share $46.75


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Things to Remember

Alternatives to discounted cash flow analysis include the

following: Market based methods

Comparable companies

Recent transactions

Same or comparable industries

Asset based methods

Tangible book value

Liquidation value

Replacement cost method

Weighted average method Firm value must be adjusted for both non-operating assets and

liabilities.


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Relative Valuations

The three choices:-

Since there can be only one final valuation Use simple average of valuations obtained using

various multiples.OR

Use weighted average depending on the weights thatfits properly

OR

Choose one of the multiples that best fits.


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Relative Valuations

In conclusion- None of the relative valuations are perfect.

A view needs to be taken after calculating the

relative valuations and comparing the samewith Traditional Valuations like DDM, FCFFModel, FCFE Model etc.

Non-financial factors needs carefulexamination

Indirect benefits / drawbacks need to be also

inputted before deciding valuation.


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Relative Valuation

For after all,

The True Value is what you

perceive to be true !!The methodologies only help

in beginning thenegotiations


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Financial Data of an FMCGCompany:-

Current share price (P) $ 68.24

No. shares of common stockoutstanding 641,387,165Growth rate (g) 13.50%

Earnings per share (EPS) $ 4.68

Operating profit per share $ 8.37Sales per share $ 114.29Book value per share (BVPS) $ 25.82

Industry Benchmark ratio is given


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Industry Benchmark ratio is givenFind the following ratios for the co. and

comment on relative valuation

To Find for the Co.Industry

Benchmark

Price to earnings (P/E) 18.54

Price to next year expected

earnings16.87

Price-earnings-growth (PEG) 1.87

Price to operating profit (P/OP) 10.95

Price to sales (P/S) 0.91

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