EQUITY VALUATION

MODELS

CONTINUED…..

Relative Valuation

The value of any asset can be estimated by looking at how the market prices “similar” or „comparable” assets.

Why use it?

It is the opinion of some that

The intrinsic value of an asset is impossible (or close to impossible) to estimate. The value of an asset is whatever the market is willing to pay for it (based upon its characteristics)

Advantages of Relative Valuation

Relative valuation is much more likely to reflect market perceptions and moods than discounted cash flow valuation.

Relative valuation generally requires less informationthan discounted cash flow valuation

Disadvantages of Relative Valuation

Stocks which are under valued on a relative basis may still be overvalued

It is just less overvalued than other securities in the market.

Relative valuation may require less information maybe because of implicit assumptions made about other variables

To the extent that these implicit assumptions are wrong the relative valuation will also be wrong.

Even within an industry, companies are rarely perfectly comparable.

There is no way to know for sure what the “correct” price multiple is.

When relative valuation works best..

This approach is easiest to use when

there are a large number of assets comparable to the

one being valued

these assets are priced in a market

there exists some common variable that can be used to

standardize the price

When relative valuation works best..

This approach tends to work best for investors

who have relatively short time horizons

can take actions that can take advantage of the

relative mispricing; for instance, a hedge fund can

buy the under valued and sell the over valued

assets

How to conduct Relative Valuation

To do a relative valuation, you need an identical asset, or a group of comparable or

similar assets

a standardized measure of value (in equity, this is obtained by dividing the price by a common variable, such as earnings or book value) if the assets are not perfectly comparable, variables to

control for the differences

Examine Fundamentals

Is there a reason your company should have lower/higher ratios than the comparable companies

Application Tests

Given the firm that we are valuing, what is a “comparable” firm?

Firms in the same sector are comparable firms

A comparable firm is one which is similar to the one being analyzed in terms of fundamentals.

A firm may be compared with another firm in a very different business, if the two firms have the same risk, growth and cash flow characteristics.

Given the comparable firms, how do we adjust for differences across firms on the fundamentals?

It is impossible to find an exactly identical firm to the one you are valuing.

Standardizing Value

Prices can be standardized using a common variable such as earnings, cash flows, book value or revenues. Some of them are:

Earnings Multiples

Price/Earnings Ratio (PE) and PEG ratio

Enterprise Value/EBITDA

Book Value Multiples

Price/Book Value(of Equity) (PBV)

Revenues

Price/Sales per Share (PS)

Multiples

Relative valuation relies on the use of multiples and a little algebra.

For example: house prices.

House Price Sq ft Price per sq ft

A Rs 1,10,00,000 1,700 Rs 6471

B Rs 1,20,00,000 1,725 Rs 6957

C Rs 96,00,000 1,500 Rs 6400

D Rs 99,00,000 1,550 Rs 6387

E Rs 1,05,00,000 1,605 Rs 6542

Average Rs 6551

What is the price of a 1,650 sq ft house?

Answer: 1650 × 65.51 = Rs 1,08,09,200

Using P/E ratio

P/E Ratio: This values the stock based on expected

annual earnings

The value of an equity share, using P/E ratio, is estimated as follows:

P0 = E1 x (P0 / E1 )

(P0 / E1 ) is the „justified P/E ratio‟

E1 is the EPS for the next year

We are using leading PE multiple here

Leading PE (also called the forward P/E) uses next four quarters‟ earnings per share

The trailing P/E (sometimes referred to as current P/E) uses the most recent four quarters’ earnings per share

http://www.investopedia.com/articles/investing/04

1013/differences-between-forward-pe-and-

trailing-pe.asp

Justified P/E multiple

Select the benchmark The P/E of the most closely matched individual stock.

The average or median value of the P/E for the company‟s peer group of companies within an industry.

The average or median value of the P/E for the company‟s industry or sector.

The P/E for a representative equity index

An average past value of the P/E for the stock.

Compare the benchmark with the firm you are valuing on the basis of

Growth, risk or cash flows

If differences cannot be explained by fundamentals, analysts make subjective judgments

Estimate the justified P/E ratio

Example: Valuing a firm using P/E ratios

In an industry we identify 4 stocks which are similar to the stock we want to evaluate.

The average PE = (14+18+24+21)/4=19.25

Our firm has expected EPS of Rs 2.10.

Price=19.25*2.1=Rs 40.425

Note – do not include the stock to be valued in the average

Also do not include firm with negative P/E ratios

Stock A PE=14

Stock B PE=18

Stock C PE=24

Stock D PE=21

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P/E Ratio from Gordon DDM

RR is the retention ratio; 1- RR is the dividend payout ratio

This formula indicates the factors that affect the estimated P/E

ratio

Illustration

Assume the following information for ABC Ltd:

Dividend payout = 50%

Required return = 12%

Expected growth = 9% . What is the stock’s P/E ratio?

7.1603./50..09-.12

.50P/E

In the previous example, assume the current earnings of Rs 2.00 and the growth rate

of 9%. What would be the estimated stock price?

You would expect E1 to be (2.00*1.09) = Rs 2.18

Estimated Price = 16.7 x Rs 2.18 = Rs 36.41

You estimate the long-run retention rate of firm ABC will be 55

percent and the ROE will be about 14 percent. The current

dividend per share is Rs 20.00; the cost of equity is 11.7%.

Compute the value of the equity share.

k = 0.117

g = RR × ROE = 0.55 × 0.14 = 0.077

D1 = 20.00(1+g) = 20.00(1.077) = Rs 21.54

Value = 21.54/(0.117-0.077) = Rs 538.5

PE of Sensex

http://www.bseindia.com/indices/indiceswatch.asp

x?index_Code=16&iname=BSE30

3 Aug 2015

Sensex P/E 22.50

Sensex P/B 3.07

High valuations fail to deter equity investorsFeb 21 2015

http://www.livemint.com/Money/fkfcYLCKDhAg343

WeZGVAK/High-valuations-fail-to-deter-equity-

investors.html

http://www.indiainfoline.com/marketstatistics/pe-

ratios/banks-sector

http://www.moneycontrol.com/stocks/marketinfo/p

e/bse/homebody.php?indcode=0&sortcode=0

Rationales for the use of P/E ratios

Earning power is a chief driver of investment value. Earnings per share (EPS) is perhaps the chief focus of security analysts‟ attention.

The price–earnings ratio is widely recognized and used by investors.

Drawbacks to P/E ratios

EPS can be negative. The P/E ratio does not make economic sense with a negative denominator.

Earnings often have volatile, transient components, non recurring items making the analyst‟s task difficult.

PEG ratios

An analyst might say that XYZ is undervalued relative to ABC (which is in the same industry) because it has a lower P/E ratio, but a higher earnings growth rate.

The PEG ratio:

P/E ÷ Expected earnings growth rate.

Stocks with lower PEGs are more attractive than stocks with higher PEGs, all else equal.

Applying the PEG Ratio

An analyst is asked to determine whether BAS or CPX is more attractive as an

acquisition target. Both firms provide engineering, construction, and specialty

services to the oil, gas, refinery, and petrochemical industries.

BES and CPX have projected annual earnings per share growth rates of 15

percent and 9 percent, respectively.

BES‟ and CPX‟ current earnings per share are Rs 2.05 and Rs 3.15, respectively.

The current share prices as of June 25, 2008 for BAS is Rs 31.48 and for CPX is

Rs 26.

The industry average price-to-earnings ratio and growth rate are 12.4 and 11

percent, respectively.

Based on this information, which firm is a more attractive takeover target as of the

point in time the firms are being compared?

BES

PE = 31.48/2.05

= 15.36

PEG = 15.35/15

= 1.02

CPX

PE = 26/3.15

= 8.25

PEG = 8.25/9

=0.92

Industry PEG = 12.4/11 = 1.13

Both have PEG lesser than industry average.

Relatively, CPX is more undervalued than BES

Book Value

Book value (BV) is equal to the shareholder's equity

(share capital plus reserves and surplus).

Book value per share-BV divided by the number of

outstanding shares

The Price-Book Value Ratio

Book value can be a reasonable measure of value for firms

that have consistent accounting practice (for example, firms in

the same industry).

It can apply to firms with negative earnings or negative cash

flows.

Not to be used to compare firms with different levels of hard

assets: a heavy industrial firm to a service firm.

Fama and French (1992) study indicated inverse relationship

between P/BV ratios and excess return for a cross section of

stocks

Value or Price = P/B ratio x Book Value

To get the right P/B ratio,

Median of comparable companies (one of the ways)

Or

DDM Model (based on fundamentals)

Justified P/B based on Gordon Model

D1=EPS1* (1-RR)

Return on Equity (ROE)=EPS1/BV0

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Price Book Value Ratio for a Stable

Growth Firm: Example

J Pharm, a pharmaceutical manufacturer, was expected to have

revenues of 230 million and earnings before interest and taxes of 30

million in the next year.

The firm had a book value of assets of 110 million, and a book value

of equity of 58 million. The interest expenses next year is expected to

be 15 million. The corporate tax rate is 40%.

The firm was expected to maintain sales in its niche product, a

contraceptive pill, and grow at 5% a year in the long term, primarily

by expanding into the generic drug market.

The average beta of pharmaceutical firms traded on the stock

exchange was 1.05. The ten-year G-sec rate in the country at the time

of this valuation was 7%; the risk premium for stocks over G-Sec is

assumed to be 5.5%.

Calculate the value of equity per share if the number of shares is 1

million.

Expected Net Income = (EBIT - Interest Expense)*(1-t) = (30 -

15) * (1-0.4) = 9 mn

Return on Equity = Expected Net Income / Book Value of

Equity = 9/58 = 15.52%

Cost on Equity = 7% + 1.05 (5.5%) = 12.775%

Price/Book Value Ratio = (ROE - g) / (k - g)

= (.1552 - .05) / (.12775 - .05) = 1.35

Estimated MV of equity = BV of Equity * Price/BV ratio = 58

* 1.35

= 78.3 mil

Value per share = 78.3/1 = 78.3

Usually, P/BV figures for companies in the services industries

like software and FMCG are high as compared to those of

companies in the sectors like auto, engineering, steel and

banking.

Sectors such as software and FMCG have low amount of

tangible assets (fixed assets etc.) on their books and therefore,

the P/BV may not be a correct indicator of valuation.

Capital intensive businesses such as auto and engineering have

a large amount of fixed assets and investments. P/BV is a

good indicator of measuring value of stocks from such capital

intensive sectors.

If P/B less than 1, we have 2

possibilities.

The stock is being unfairly or incorrectly undervalued by investors because of some transitory circumstance and represents an attractive buying opportunity at a bargain price.

That's the way value investors think.

It is assumed that the company's positive fundamentals are still in place and will eventually lift it to a much higher price level.

Or

If the market's low opinion and valuation of the company are correct (the way growth investors think)

it will be perceived at its worst as a losing proposition and at its best as being a stagnant investment.

http://www.investopedia.com/university/ratios/investment-valuation/ratio2.asp#ixzz3htLn8hcb

The Price-Sales Ratio

Sales growth drives all subsequent earnings and

cash flow

If you are concerned with accounting manipulation,

sales is one of the purest numbers available.

Sales is subject to LESS manipulation than other financial

data

Relative comparisons using P/S ratio should be

between firms in similar industries

P/S

The price to sales ratio

= Market price (of the stock) ÷ Current sales per share.

Or

= Market capitalization of the company ÷ annual sales.

Let's assume Company XYZ reports net sales of Rs 5,000,000 and it currently has 500,000 shares outstanding. The stock is currently trading at Rs 20.

Sales per Share = (5,000,000/500,000) = 10

Price-to-Sales Ratio = 20/10 = 2

Now we want to compare XYZ to one of its competitors, Company ABC.

ABC also reports net sales of Rs 5,000,000 and it also has 500,000 shares outstanding. The stock is trading at Rs100.

Sales per Share = (5,000,000/500,000) = 10

Price-to-Sales Ratio = 100/10 = 10

Investors in ABC are willing to pay Rs 10 for Re1 in sales, while investors in XYZ are willing to only pay Rs 2 for Re1 in sales.

Any number of scenarios could explain this discrepancy, so it's important to know what makes ABC stock so much more appealing.

If you can't find a good reason, perhaps stock XYZ is undervalued, and represents a good bargain.

Thumb rule

P/S lower than 1 may be a bargain

Formula

Price = P/S ratio x Sales

When comparing P/S ratios, make sure the firms are within the same industry.

Retail companies typically display a much higher P/S ratio than companies highly involved in research and development.

Even though sales are difficult to manipulate, it's not impossible.

One of Enron's accounting tricks was to recognize revenue earlier than it should have, enabling it to report inflated sales figures.

P/S is appropriate to use when valuing most types of stock. But note that P/S should never be the sole metric used when valuing a company.

A business may have higher sales but a lower profit margin than a competitor, indicating that it's not operating efficiently.