Reading 22: Market Based Valuation Price & EV Multiple

I0SDix RatioMarketof year valuePage No. 5Date//3rd Nov'2022in entier equityReading 22 : . Market basedValuation Price & EV MultipleM221 : PLE mutipleApproches to using price multiple in valuationMethod of Comparables- Valuation of Stock based on multiples of similar (os orbenchmark.-Ecconomic relatiote : The law of One price ( two similarassets should sell at the same price)- Vatuation Most widely Used- Price scaled by a measure of value such assale MBV or CF- Compore relative to bechmark multiple- Choices of the benchmark value of a multiple includethemultiple of the benthmark value of amultiple include the multiple of 8 closely matchedindividual stock or avg (or median value) for thestock peer group of company of industry Page No S2Date/Method of forecasted fundamentalsRelatesBased onmultiples DCF to Company fundanantel - growth Risk & payoutPermitsanalysttoexplicitlyexaminehow viluationsdiffer across Stock andagainstabechmarkdifferent across expectationgivenValue is absoluteforgrowthandriskPricemultipleFundamentals-Justified price multiple :What pricemultiple shouldbeif Stockisvaluedfairly-AslowarrantedandIntrinsicpricemultipleActual = Justified=Actual=Properly ValueJustifiedUndervaluedActual > Justified=OvervaluedWhatwe needtoKnowlFor relativevaluationmeasuressuchasPLEP/BP/CF&+div+Plsmyield+Knowthefollowingfor each ratios- Rational- Possible drawback- Fundamental influences- Calculate justified ratio- Calculation- Evaluate a stock with the ratiomm Page No. 53Date / /PIE*Rationale- Primary determinant ofve or low earninginvestment valueVolatile or transitory earnings- Popular in investmentmake interple tation difficultComunityInterpret of PIE is difficult- PLE diff are related toMgm A/c pratices Canlong run average Stockdistort earningsreturn- Proxy for Risk & growthSolely using PLE avoid useingfun Lamentals*Market PIEnot useful when firms biz has changedTrailing PIE:UsesEPSfrom last yrPo =Market price per shareEoEPS last 12 monthLeading PLE : Uses EPS of Coming yr (forward)not useful Po=MPSif earnings E1EPS next 12 monthare volatile PIE is the decreasing function of RiskRiskPESPage No. 54RiskPIEDate//Problem with trailing PLEWhen Calculating a PLE ratio using trailing earningsCare must be taken in determining the EPS numbThe issues includea- Transitory nonrecurring Components of earnings that arecompany- specific- CyclicalityComponents of earnings due to biz or trends- Diffin- Potentialaccounting pt methoddilutionofEPSUnderlying EarningsGoal :Analysts want to remove non recurring item fromearnings for forecastingpurpose- Gains (losses onNonrecurring items to removeInclude :asset class Sale- Asset write down(impaiment)- Loss provisions- Changes in accounting estResult : Persistent f countinuing and core earingsDiluted P/E =PriceNIadditional Shore Page No. 55Date / /Normalized EarningsAdjustEPS to remove cyclical Component of earningsandcapture mid-cycle or an avg of earningsundernormalmarketconditionsTwonormalizationmethods- Method- Methodofhistorical avgEPSAvy BV isofavg ROEMore usefulalso usefulEx :2005200620072008EPS43.85.254.5BVPS25262628ROE15%15% 21%16%SolnAvg EPS=4+3.8+5.25+4.5=4.39High4Avg ROE=0.15 + 0.15 t 0.21 +0.16 = 0.16754AvyRUEXBUPS=0.1675X28=4.69lowPitfall :ELP : Earnings Yieldlook-ahead biosProblem: Negative Earnings make PLE ratios meaninglessPotential Solution : Substitute E/P / simply the is inverse ofthe PIE Page No. ofS6Date / /Price is never -veHigh E/PcheapLow ElpExpEx :CMPTrailing EPSTraliling PIEE/P RatioABC260.4953.061.9%GHI19.2(0.11)-- 0.6%PQR8.59(0.40)- 4.7%Tuv8.07(3.15)-- 34.0%Justified P/ELeadingTrailingPo= D1P. = Do(1tg)5-gr-gPo =DilE,Po =DolE.) (1+g)E5-gEor-g= (1-b) (ltg)Po =(1-b),r-yE,5-y-Justified leading PIE) X (Ity)=Div Payoutr-g PE is Ting function of rItPEPage No. 57rvPEDate / /Fundamental factor affecting justified PIE :PLE positively related to growth rate and payout,all else equal- Assume no interaction bet" g + payout t & RDE- Recall : g = ROE X (1 - Div )EPSPLE inversely related to leg return, + ( real rate inflation,and equity risk prem) all else equalPredicted P/E from RegressionThe PIE and Company characteristicsaremeasuredcross - sectionallyThe PIEs are regressed against the stock & CompanycharacteristicsThe est equation exibits therelationshipbet"thePLE and the stocks characteristics- +ve coeffient with growth and payout--VecoeffientwithBExample:Predicted PLE regression :Div payout ratio = 0.50Beta = 0.95Expected earnings growth rate = 6%A regression on related public utility firms produces thefollowing eq" : Page No. 58Date//Predict PLE := 6.75 + (4 X div payout) + (10 12.35 x growth) - (0.5x beta)Calculate the predicated PIESol= 6.75 + (4) 0.5) t (12 35 X 0.06) - (o 0.95)= 9.02 XUseful for large data setsInfrequently used due to theselimitations:- Changing relationships- Multipolinearithy- UnknownpredictivepowerValuationUsingComparablesSelectandCalculatetheComparativepricemultiplefor the security.Selectthebenchmarkassetand Calculatethe mean or median PLECompare the stock PLE with the benchmark's PLEAre observed diff bet" asset & bechmarkPLEx plained by underlying determinats of PLE ! Ifnot asset maybemispriced. Page No. 59Date / /thePEGRatiobetterPEG ratio is a PIE div by the expected longterm earnings growthrate (g) :PE/G=PIEgWhole no. not decimalCalculate a stock's PLE per unit of expected growthlow PEG - More attractiveHigh PEG - less attractiveProblemPEGratio does not account forDiff in firm Risk attributesDiff in the duration of growthNon linear relationship bet growth & the PLE ratioin Real world but it assume H hasTerminal Value EstTerminal value : Value projected at end of est horizonTerminal value = (trailing PIE) X ( earnings forecast)Two methods1. Fundamentals : Req est of g, 4 payout2. Comparables : Uses market data to calculate benchmark Page No. 60Date/Price - to - Book Ratio P/B.Book value per share (BVPS) attempts to representthe invest" that Common shareholders have madein the CompanyBVPS is Calculated as Common equity div by no.of share outstandingThere is only a Current PolBe t not leading P/BRationale & DrawbackRationaleDrawbackUsually +ve (even if EPS <0 0)More stable than EPS Less voliatileDoes not reflect value ofintangible assets, off-BIS assetsAppropriate for firms holdingliquid assets ( Banks eg)Misleading when Comparing fireUseful for distressed firm,with significant diff in asset SizCan be distortion due to diffliquidationAlling conventions (International)Diff in P/B ratios explainInflation and tech change candiff in loong - lun avg return Cause big diff bet" BV & MPIB =MVPBVPSBV (Asset - Liability ) - Prefe stock= ROE ? By BoPage No. 61Date / /Justified PolB. RatioBy usingthe Gordon growth model and using theexpression g = b X ROE for the sustainable growthrate, the expression for the justified P/B catio basedonthemost recentBV (Bo) is:Po = ROE - gleading PIEXBegROEPor-gCROEFundamental -r) factor affecting P/B :Larger Spread = Value creation = Higher MVCompara to residual income modelIntuition :Firms that earn ROE = r will have a PIB ofPositive RelationshipP/B increaseas ROE increaseP/B increases as g increaseInverse relationship.P/B increaseasr(ROE)decrease ( falling risk, Int rates inflation,-r& beta) Leading P/S = (Profit Margin X Payout)60-forPage No. 62(r-g)normalDate /Not*P/S RatioforLeadingRationalDraw BackUseful for distressed firmsSales are always +veHigh Sale growth does notNot volatile , stable & lesstranslate to operating profitsdistortion than EPS overtimePls ratio does not captureUsefal for mature, cyclical &diff cost structers bet" firmszero -income stocksRev recognition methodsDiff in PIS ratios may becan distort reported salesrelated to diff in long-iunand forecasts.avg returnMay not refleat suddon charyin Key indicator308Market Pls. RatioMiss problems associated withCost control.P/S=Market Value of equityTotal sale=MVPSSale =EarningSale PSNet MarginJustified Profit Pols.Basedon(MarginPayoutfundamentalfactorsPo =E./S.X(1-b) X (1+g)Sor-gPo = (Net margin ) X (Trailing PIE)S.Lea Saleg = RR X Profit marginXBV EquityPage No. 63Date//Relationship of fundamentals to the Pols, Ratio8 Pols. increase as :(E.ls.)Pols.decrease as :Current profit margin improveThe profit margin decreasesRisk increaseSustainable growth (g) increaseInflation increases3757Growth decreasesRisk fallsValuation Using Comparable P./S.Same method asPIE & P/BLow PIS undervaluedUse trailingSalestocalculateIn choosingcomparablescontrol+for:- Profit molgin- Expectedgrowth- Risk*- Quality of accounting data*P/CF. RatioRationalesMore difficulttomanipulate CFthanEPSCash flowisMore stable than earningsAddresses qualityofearningsproblemDiff in P/CF,avg returnsmayexplaindiffinlong-run - Page No. 64Date/DrawbackNI t depEarnings +noncashchargesapprochignoresSomeCFsuch netas fixedinvestment , workingCapitalinvestment &netborrowingFCFE is preferabletoCFO 7 but FCFE more volatileandmoredifficultto computeFCFECanbenegtivewithlargerCapExMarket PICF Ratiodustified trailing PICFPICF =My of EquityTotal CF1 - (1+g)CF (r-g)CMPCF per shareWhat is CF?ITraditional CFCF = N + NCC2CFOC CF statement )3Adjust CFOAdj CFO = CFO + [ Int (1 1-t) PageNo. G5Date / /4EBITDA Also used for EV/EBITDA:5FCFE:Theoretically superior (from this study st)CF definitionsFCFE CF concept with the closest relationship tothalthough Can be more volatile due to CopeyEBITDA is a pre-tax pre-Int, pre - investment inWC and pre- invest in fixedasset- -Appropriate for firm value, not equityJustified P/CFTwo - Step ProcessStep \ : Calculate Stock Value using suitable DCF mVo = FCFE. (1tg)r-gStep 2: Div result by CFjustified P/CF = VoCF Page No. 66Date /Fundamental Factors Affecting justified P/CFJustified P/CF will increase all else equal t if:CFgrSame relationship as all other ratioValuation Using Comparable PICFSame method as PIE PIB & P/SLow P/CF undervaluedControl for :- Return and Risk- Cash flow- Growth rateEV MultiplesMV of Common Stock + MV of prof Stock tMV of debt - Cash+MinoritylatAEBITDA is an earnings flow to both debt & equity holdmultiple using total company value : Enterprise value(EV) in the numerator is logically more appropriatethan equity market price (P)Because the numerator is enterprise value . Ev / EBITDAis a valuation indicator for the overall Companyrather than Common stock Page No. 67Date / /EV= MV of Stock + MUqf debt t MV pref - Cash & InvestEV.RatioEBITDARatio provides an indication of Company /firm value /not equity valueExampleRecent Share price Sf 22.5 ; 40 million share outstandingMV of debt sf 137 million Cash & marketable securities,sf 62.3 million ; Invest Sf 327 million;ENet Income If 137. 5 million ; Int exp sf 6.9 million ; DepandmillionEBITamort sf 10.4 million Taxes of 95.9DASolEV = (22.5 X 40) + 137 - 62.3 - 327 = of 647.7 millionEBITDA = 137.5 + 6.9 + 95.9 of 10.4 = of 250 ,7 millionEV / EBITDA =647.7=2.6times250.7RationalComparing firms with diff financial levelagesinceEBITI OA is pre-int Page No. 69Date /Controlsfordep/amortdiffEBITDAusually+vewhenEPS is -veDrawbacksIgnoreschangesinWCinvestFCFF (whichControlsforCapEx)ismoretied to valuecloselyEV / EBITDA < Benchmark = UndervaluedEV / EBITDA > Benchmark = OvervaluedArguments forDiv yieldUsingD. / P.isaComponenttotalreturnDiv are a lessComponentofriskyoftotalreturnthan capital appriationfor Semiannuat field(Recent)MarketDivYield(DIP)AnnaldivMPSTrailing D/P =4XmostrecentquartelyDIVMP per shareLeading D/P =next 4 quatorforecasted DIVsMP price per shareFore practical purpose , div yield DIP ispreferred over PlD 1 zero div are a problem) Page No. 69Date / /Justified div yield in Gordon model isDo = r-yPo 1+gFundamental Factors affecting D. P.Div yield Increase as :Req return increase (price falls)High growth rate decreases the firms payout andtherefore the firm is less able to pay divwhich results in a lower DIP ratioHigh DIP strategy = Value strategyCross Border Valuation DiffComparing Companies across borders freq involves accountmethod diff + cultural diff eco diff + & resultingdiff in risk & growth opportunityFor example, PIE ratios for individual Companies in thesame industry across borders have been found tovary widely.E.V / EBIDA is the most seriously affected by itbecause it is most closely tied to accounting convent A given size factor forecaste error is more (less) meaningful thesmaller ( larger) the historical sise forecast errorPage No. 70Date/Momentum IndicatorsMovmentum indicators based on price, such as therelative strength indicator , have also been referred toas technical indicatorsUnexpected earnings Calso called earnings suprise) is thediff beth reported earnings and expectedearningsUE, = EPSt - E CEPS+)Anotherearning suprise Reported EPS - Expected EPSmomentumindicatorsbasedontherelativechange in earnings pershareiscalledStandardizUnexpected EarningSUE t =EPS+ - ECEPSt)Mose meaningful the a [ EPSt - ECEPS E)]Earning SupriseSDlarger the historical size of forecost error*Measuring Central Tendencyin multipleArithmetic mean-Most affects by outliersHarmonic mean- LessaffectsbylargefmorebysmallallHier,Weighted harmonic mean- Effect of outlier depends on MV weight Page No. 71Date / /Median- Least affected by outliersSimple Harmonic MeanOutliers- Reduces impact of large outlier- May worsen impact ofsmalloutliersSmall outliers bounded by zero , so less problematicWeighting: :N- Less weight on higher ratiosHarmonic =I- More weight on lower ratios1=1XiLowervaluethanarithmeticmean (urlessallobservations are the same value)Used when marketvalueweightinfounavailableWeightedHarmonic MeanSimilar to simple harmonic mean except in weight:- Uses market value weights- Major advantage : Corresponds to portfolio value (e.gtotal priceTotal earning Page No. 72Date //ExABCTotalMPS4006001001100EPS205050120PIE201229.16AM :34=11.33X3HM :3=473 XI+20+I122Weighted HM :I=06 9.164001100(1)201100 600 ) tz+(1001100)(1)Note : :Using medianmitigatestheriskofoutliersUsing HM mitigatestheimpact(i.eoflargeoutlierbutnot smalloutliersthoseclosetozeto)Note 2 :Other EV multiples :RentEV / FCFFEV / EBITDAREV I salesValuation metriccouldalsobetotalinvested(TIC)insteadCapitalofEV+Justified P :EYardeni model(except E) the historical size of forcastA given size of fore cast ellor errors is more (less) meaningful 73 the smallerPage (larger)No.Date / /Terminal ValueBased on ComparablesBased on fundamentalsTrailingTradiliny :Benchmark PLE X EarningsJustified P/E EarningsLeading :LeadingBenchmark PIE x EarningsJustified PLE X EarningsEvaluation of StockFed ModelStock marketis overvalued when earnings yield (EIP)onS&P 500 is less than 10-yr T-bond yieldVice versaCriticism assumes earnings yield will be equal to10-yr T-bond yield .Yardeni ModelCurrent Moody's A-ratedCorporate bond yieldError terrCEY =CBY - K X LTEG + Wcurrent earningweighted given(on Sensus five -yr eairyield of theby marketgrowth ratemarketCo.2 recent yr)Yardeni model includes the consensus live year earningsgrowth sate forecast bur the market 0 index Page No. 74Date //Taking reciprocalP =E(By - K X LTEGPLERatioisve relatedtoint rates&positivelyrelatedtogrowthPrice multiple affectedby IASleast AffectedMost affectedPl FLFEPIE , + P/B y PLEBITDAEVIEBITDAgaines