MARKET-BASEDVALUATION:

PRICE AND ENTERPRISE VALUE MULTIPLES

VALUATION INDICATORS

Price Multiples

Enterprise Value

Multiples

Momentum Indicators

METHODS FOR PRICE & ENTERPRISE VALUE MULTIPLES

1) Method of Comparables• Economic rationale is the law of one price

2) Method Based on Forecasted Fundamentals• Reflects firm fundamentals and future cash flows

Justified Price Multiples• Can be determined using either method

PRICE-TO-EARNINGS MULTIPLERATIONALES & DRAWBACKS

RationalesEPS is driver of value

Widely used

Related to stock returns

DrawbacksZero, negative, or very

small earnings

Permanent vs. transitory earnings

Management discretion for earnings

PRICE-TO-EARNINGS MULTIPLEDEFINITIONS

Trailing P/E

Uses last year’s

earnings

Preferred when

forecasted earnings are not available

Forward P/E

Uses next year’s

earnings

Preferred when trailing earnings are not reflective

of future

EXAMPLE: FORWARD P/E

Stock price $20 .002011:Q1 EPS $0 .182011:Q2 EPS $0 .252011:Q3 EPS $0 .322011:Q4 EPS $0 .352011 Fiscal year forecast $1 .10

2012:Q1 EPS $0 .432012:Q2 EPS $0 .482012:Q3 EPS $0 .502012:Q4 EPS $0 .592012 Fiscal year forecast $2 .00

EXAMPLE: FORWARD P/E EXAMPLE: FORWARD P/E

ISSUES IN CALCULATING EPS

EPS Dilution Underlying Earnings

Normalized Earnings

Differences in Accounting

Methods

EXAMPLE: UNDERLYING EARNINGS

Reported EPS from previous four quarters $4.00

Restructuring charges $0.10

Amortization of intangibles $0.15

Impairment charge $0.20

Stock price $50.00

EXAMPLE: UNDERLYING EARNINGSEXAMPLE: NORMALIZED EARNINGS

Year EPS BVPS ROE

2010 $0.66 $4.11 16.1%

2009 $0.55 $3.67 15.0%

2008 $0.81 $2.98 27.2%

2007 $0.73 $2.12 34.4%

2006 $0.34 $1.61 21.1%

2011 stock price $24.00 

EXAMPLE: NORMALIZED EARNINGSEXAMPLE: NORMALIZED EARNINGS

JUSTIFIED FORWARD P/E FROM FUNDAMENTALS

JUSTIFIED TRAILING P/E FROM FUNDAMENTALS

EXAMPLE: JUSTIFIED FORWARD P/E FROM FUNDAMENTALS

Retention ratio 0 .36

Dividend growth rate 4.0%

Required return on stock 10.0%

EXAMPLE: JUSTIFIED FORWARD P/E FROM FUNDAMENTALS

EXAMPLE: JUSTIFIED P/E FROM REGRESSION ON FUNDAMENTALS

Values for subject firm

Dividend payout ratio 0.40Beta 1 .20 Earnings growth rate 6.00%Actual P/E 15 .0

EXAMPLE: JUSTIFIED P/E FROM REGRESSION ON FUNDAMENTALS

METHOD OF COMPARABLES

Benchmark Value of the Multiple Choices

Industry peers

Industry or sector

index

Broad market index

Firm’s historical values

METHOD OF COMPARABLESUSING PEER COMPANY MULTIPLES

Law of one priceRisk and earnings growth adjustmentsPEG limitations:Assumes linear relationship Does not account for risk Does not account for growth duration

EXAMPLE: METHOD OF COMPARABLESUSING P/E AND PEG

Values for subject firmFive-year EPS growth rate 8.0%Consensus EPS forecast $4.50Current stock price $28.00

Values for peer groupMedian P/E 9 .00Median PEG 1 .60

EXAMPLE: METHOD OF COMPARABLESUSING P/E AND PEG

METHOD OF COMPARABLESUSING INDUSTRY AND MARKET MULTIPLES

Industry or Sector Index Mean vs. median Check industry valuation against market

Broad Market Index Adjust for differences in fundamentals & size Use relative values on a historical basis

METHOD OF COMPARABLESVALUING THE MARKET

Fed Model: Earnings Yield vs. T-Bond Yield Does not account for inflation correctly Relationship between earnings yield &

interest rates is nonlinear Small rate s → large s in P/E

Yardeni Model

METHOD OF COMPARABLESUSING OWN HISTORICAL MULTIPLES

Rationale: Regression to the MeanApproaches:Average of four middle values over past 10 yearsFive-year average trailing P/E

Potential Problems from Changes inFirm businessFirm financial leverageInterest rate environmentEconomic fundamentalsInflationary environment

USING P/ES FOR TERMINAL VALUE

Justified P/E

P/E =(D/E)/(r – g)

Sensitive to required inputs

P/E Based on Comparables

Grounded in market data

If comp is mispriced, terminal value will

be mispriced

EXAMPLE: USING P/ES FOR TERMINAL VALUE

Values for subject firmRequired rate of return 11.0%EPS forecast for year 3 $2.50

Values for peer groupMean dividend payout ratio 0 .40Mean ROE 8.0%Median P/E 9 .00

EXAMPLE: USING P/ES FOR TERMINAL VALUEUSING GORDON GROWTH MODEL

EXAMPLE: USING P/ES FOR TERMINAL VALUEUSING COMPARABLES

PRICE-TO-BOOK VALUE MULTIPLERATIONALES

Book Value Is Usually Positive

More Stable than EPS

Appropriate for Financial Firms

Appropriate for Firms that Will Terminate

Can explain stock returns

PRICE-TO-BOOK VALUE MULTIPLEDRAWBACKS

Does Not Recognize Nonphysical Assets

Misleading when Asset Levels Vary

Can Be Misleading Due to Accounting Practices

Less Useful when Asset Age Differs

Can Be Distorted Historically by Repurchases

ADJUSTMENTS TO BOOK VALUE

Intangible Assets

Inventory Accounting

Off-Balance-Sheet Items Fair Value

JUSTIFIED P/BPRICE-TO-SALES

MULTIPLE RATIONALES

Sales Less Easily Manipulated

Sales Are Always Positive

P/S Appropriate For Mature, Cyclical, & Distressed Firms

P/S More Stable Than P/E

Can Explain Stock Returns

PRICE-TO-SALES MULTIPLE DRAWBACKS

Sales ≠ Earnings & Cash Flow

Numerator & Denominator Not Consistent

P/S Does Not Reflect Cost Differences

P/S Can Be Misleading Due to Accounting Practices

JUSTIFIED P/S

EXAMPLE: CALCULATING THE ACTUAL & JUSTIFIED P/E, P/B, & P/S

Stock price $50 .00EPS $2 .00Dividends per share $1 .20Book value of equity per share $6 .25Sales per share $15 .00ROE 22.5%Required return on stock 12.0%

EXAMPLE: CALCULATING THE ACTUALP/E, P/B, & P/S

EXAMPLE: CALCULATING THE INPUTS FOR THE JUSTIFIEDP/E, P/B, & P/S

EXAMPLE: CALCULATING THE JUSTIFIEDP/E, P/B, & P/S

PRICE-TO-CASH-FLOW MULTIPLE RATIONALES

Cash Flow Less Easily Manipulated

Ratio More Stable Than P/E

Ratio Addresses Quality of Earnings Issue with P/E

Ratio Can Explain Stock Returns

PRICE-TO-CASH-FLOW MULTIPLE DRAWBACKS

Cash Flow Can Be Distorted

FCFE More Volatile and More Frequently

Negative

Cash Flow Increasingly Managed by Firms

DEFINITIONS OF CASH FLOW

• Earnings + Depreciation + Amortization + DepletionCF

• From statement of cash flowsCFO

• Most valid but volatileFCFE• Best used with enterprise

valueEBITDA

JUSTIFIED PRICE-TO-CASH-FLOW RATIO

DIVIDEND YIELDRATIONALES & DRAWBACKS

RationalesComponent of return

Dividends less risky than future capital

gains

DrawbacksOnly one component of

return

Dividends may displace future earnings

Market may not favor dividends

JUSTIFIED DIVIDEND YIELD

INVERSE PRICE RATIOS

Price Ratio Inverse Price Ratio

Price-to-earnings (P/E) Earnings yield (E/P)

Price-to-book (P/B) Book-to-market (B/P)

Price-to-sales (P/S) Sales-to-price (S/P)

Price-to-cash-flow (P/CF) Cash flow yield (C/P)

Price-to-dividends (P/D) Dividend yield (D/P)

ENTERPRISE VALUE/EBITDA MULTIPLERATIONALES & DRAWBACKS

RationalesUseful for comparing firms

of different leverage

Useful for comparing firms of different capital utilization

Usually positive

DrawbacksExaggerates cash flow

FCFF more strongly grounded

ISSUES IN USING ENTERPRISE VALUE MULTIPLES

EV = Market Value of Stock + Debt – Cash – Investments

Justified EV/EBITDA• Positively related to FCFF growth• Positively related to ROIC• Negatively related to WACC

Comparables May Utilize TIC

Other EV Multiples• EV/FCFF• EV/EBITA• EV/EBIT• EV/S

CROSS-COUNTRY COMPARISONS

• Net income higher under IFRS• Shareholder's equity lower under IFRS• ROE higher under IFRS

US GAAP vs. IFRS

• P/CFO & P/FCFE most comparable• P/B, P/E, & EBITDA multiples least

comparable

Valuation Multiples

• Higher inflation Lower justified price multiples

• Higher pass-through rates Higher justified price multiples

Inflation

MOMENTUM INDICATORS:EARNINGS SURPRISES

MOMENTUM INDICATORS:RELATIVE STRENGTH

Past Performance

Relative to an Index

Inherently Self-Destructing

VALUATION INDICATORS IN PRACTICE: AVERAGING MULTIPLES

• Overestimate of index P/EArithmetic Mean &

Weighted Mean

• Closer to index P/E but is influenced by small outliersHarmonic Mean

• Equal to index P/EWeighted Harmonic Mean

VALUATION INDICATORS IN PRACTICE: STOCK SCREENS

Database Limitations• Variables are predetermined• Does not contain qualitative data

Look-Ahead Bias• Assumes investor has info not yet available

Sector Rotation

SUMMARY

• Method of comparables• Method based on forecasted fundamentals

Price & Enterprise Value Multiples

• Rationales: EPS Driver of value; widely used; related to stock returns

• Drawbacks: Zero, negative, or very small earnings; transitory components; management discretion for earnings

• Trailing and forward P/Es

Price-to-Earnings Rationales & Drawbacks

SUMMARY

• EPS dilution• Underlying earnings• Normalized earnings• Differences in accounting methods

Issues in Calculating EPS

• Industry peers• Industry or sector index• Broad market index• Own historical values

Method of Comparables

SUMMARY

• Rationales: Book value usually > 0, more stable than EPS, appropriate for financial firms & firms that will terminate, explains stock returns

• Drawbacks: Doesn’t recognize nonphysical assets, misleading if asset levels vary or differ from accounting practices, less useful when asset age differs, can be distorted by repurchases

Price-to-Book Rationales & Drawbacks

• Intangible assets• Inventory accounting• Off-balance-sheet items• Fair value

Issues in Calculating Book Value

SUMMARY

• Rationales: Sales less easily distorted, sales always positive, P/S more stable than P/E, appropriate for many firms, explains stock returns

• Drawbacks: Sales ≠ Earnings & Cash flow, numerator & denominator not consistent, does not reflect cost differences, can be distorted

Price-to-Sales Rationales & Drawbacks

• Rationales: CF less easily manipulated, more stable than P/E, addresses quality of earnings issue, explains stock returns

• Drawbacks: can be distorted, FCFE more volatile and more frequently negative, increasingly managed by firms

Price-to-Cash-Flow Rationales & Drawbacks

SUMMARY

• CF: Earnings + Depreciation + Amortization + Depletion• CFO: From statement of cash flows • FCFE: Most valid but volatile• EBITDA: Best used with enterprise value

Measures of Cash Flow

• Rationales: A component of return, dividends less risky than future capital gains

• Drawbacks: Only one component of return, dividends may displace future earnings, market may not favor dividends

Dividend Yield Rationales & Drawbacks

SUMMARY

• Useful when denominators are small, low, or negative (e.g., earnings)

• Earnings yield, book-to-market, sales-to-price, cash flow yield, and dividend yield

Inverse Price Ratios

• EV = Market value of stock + Debt – Cash –Investments

• Rationales: Useful for comparing firms of different leverage & capital utilization, usually positive

• Drawbacks: Exaggerates cash flow, FCFF more strongly grounded

Enterprise Value Multiples

SUMMARY

• P/E: + related to g, – related to r• P/B: + related to ROE, – related to r• P/S: + related to g & PM, – related to r• P/CF: + related to g, – related to r• D/P: - related to g, + related to r• EV/EBITDA: + related to g and PM, –

related to WACC

Justified Multiples

SUMMARY

• IFRS ROE higher than GAAP ROE• P/CFO & P/FCFE most comparable• P/B, P/E, & EBITDA multiples least

comparable• Higher inflation Lower justified price

multiples• Higher pass-through rates Higher

justified price multiples

Cross-Country Comparisons

SUMMARY

• Unexpected earnings (UE)• Standardized unexpected earnings (SUE)• Relative strength

Momentum Indicators

• Database limitations• Potential look-ahead bias• Used in sector rotation

Stock Screens