Relative Valuations FINAL.ppt

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  • 7/29/2019 Relative Valuations FINAL.ppt


    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 :)

  • 7/29/2019 Relative Valuations FINAL.ppt


    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


    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


    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


    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 /


    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.



    Market Value of Equity + Market Value of Debt

    Earnings before Interest,Taxes and Depreciation

    Enterprise Value


    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


  • 7/29/2019 Relative Valuations FINAL.ppt


    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


    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


    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


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    Market based valuation

    T- Target company

    Ic Measure of Value(P/E) of

    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.


    Value ($M)




    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



    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


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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


    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


    Price to earnings (P/E) 18.54

    Price to next year expected


    Price-earnings-growth (PEG) 1.87

    Price to operating profit (P/OP) 10.95

    Price to sales (P/S) 0.91