Relative Valuation Dr. Himanshu Joshi

Relative Valuation.. How the market prices similar assets. Thus, when determining what to pay for a house, we look at what similar houses in the neighborhood sold for rather than doing an intrinsic valuation. Extending this analogy to stocks, investors often decide whether a stock is cheap or expensive by comparing its pricing to that of similar stocks (usually in the peer group). P/E Ratio, P/Book Ratio, Price/Sales. Price/ARPU, Price/SQRFT.

The Methods of Comparable The idea behind price multiples is that a stock’s price cannot be evaluated in isolation. Rather, it needs to be evaluated in relation to what it buys in terms of earnings, net sales, net assets. Obtained by dividing price by a measure of value per share, a price multiple gives the price to purchase one unit of value. EX.. Price/EPS = 20, means that it takes 20 units of currency (say, Rs. 20) to buy one unit of earnings (say Rs. 1 of earnings). This scaling of price per share by value per share makes possible comparison among various stocks.

Methods of Comparable.. StocksP/EAnalysis A20If they have similar risk, profit margins, and growth prospects, the security with the P/E Of 20 is undervalued relative to the one with P/E of 25. B25

Example.. Company A’s EPS is $1.50. its closest competitor, Company B, is trading at a P/E of 22. Assume that companies have similar operating and financial profits. Q1. if company A’s stock is trading at $37.50, what does that indicate about its value relative to Company B? Q2. if we assume that Company A’ stock should trade at about the same P/E as Company B’s stock, what will we estimate as an appropriate price for company A’s stock?

The Method based on Forecasted Fundamentals.. If the DCF value of a stock is $10.20 and its forecasted EPS is $1.2, the forward P/E multiple consistent with the DCF value is $10.20/$1.2 = 8.5 The term forward P/E refers to a P/E calculated on the basis of a forecast of EPS. Thus, we can approach valuation by using multiples from two perspectives: First, we can use the method of comparable, which involves comparing an asset’s multiple to a standard of comparison. Similar assets should sell at similar prices. Second, we can use the method based on forecasted fundamentals, which involves forecasting the company’s fundamentals rather than making comparisons with other companies. (The Price Multiple of an asset should be related to its expected future cash flows.)

Justified Price Multiples.. The justified Price multiple is the estimated fair value of that multiple, which can be justified on the basis of the method of comparable or the method of forecasted fundamentals. Example.. Suppose we use price-to-book ratio (P/B) in a valuation and find that median P/B for the company’s peer group, which would be the standard of comparison, is 2.2. The stock’s justified P/B based on the method of comparable is 2.2. If the current book value per share is $23 then, Price = 2.2*$23 = $50.60, which can be compared with its market price.

Justified Price Multiples.. (Fundamental) Suppose that we are using a residual income model and estimate that the value of stock is $46 (DCF estimate). Then the justified P/B based on the fundamental is $46/$23 = 2.0 This we can again compare with the actual value of stock’s P/B. We can incorporate the insights from the method based on fundamentals to explain differences from results based on comparable.

Price Multiples 1.Price to Earnings = Market Price per Share/Earning Per Share Rationales supporting the use of P/E Multiple.. a.Earning power is chief driver of investment value, and EPS, the denominator in the P/E ratio, is perhaps the chief focus of security analyst’s attention. b.The differences in stocks’ P/Es may be related to differences in long run average returns on investments in those stocks.

P/E Multiple.. Potential Drawbacks: a.EPS can be zero, negative, or insignificantly small relative to price, and P/E does not make economic sense with zero, negative, or insignificantly small denominator. b.The ongoing or recurring components of earnings that are most important in determining intrinsic value, can be particularly difficult to distinguish from transient components. c.The application of accounting standards requires corporate managers to choose among acceptable alternatives and to use estimates in reporting. Doing so, managers may distort EPS as an accurate reflection of economic performance.

Alternative Definitions of P/E.. Trailing P/E: A stock’s trailing P/E is its current market price divided by the most recent four quarters’ EPS. Current P/E: to mean a P/E based on EPS for the most recent six months plus the projected EPS for the coming six months. This calculation blends historical and forward looking elements. Forward P/E: (leading P/E or prospective P/E): is a stock’s current price divided by next year’s expected earnings.

Application. Use same definition of P/E to all companies and time period under examinations. Valuation is a forward looking process, so analysts usually focus on the forward P/E when earning forecasts are available. When earnings are not readily predictable, a trailing P/E may be more appropriate than forward P/E. When the firm has undergone substantial changes in terms of M&A activities, financial leverage, divestitures etc., trailing P/E based on the past EPS is not informative about future, thus not relevant for valuation.

Interpretation of the Relative Valuation Techniques.. Step1. compare the valuation ratios (P/E, P/Cash Flow, P/B…) for a company to the comparable ratio for the market or/and the stock’s industry to determine how it compare– that is: Is it similar or Continuously at discount or Premium. Step2. understand and compare what factors determine the specific valuation ratio and compare factors for the stock vs. the same factors for market, industry..

Using Market Multiples in DCF Valuation Market multiples can also be used to estimate the terminal value (and this provide a robustness check of the terminal value obtained through the FCF method). This involves estimating terminal value using market multiples from publicly traded firms comparable to the company being valued. Specifically, instead of computing the terminal value as:

Terminal Value TV t = FCFF t+1 = FCFF t x (1+g) TV t = FCFF t+1 = FCFF t x (1+g) WACC - g WACC – g WACC - g WACC – g Where TV t is the terminal value expressed at time t. it should be discounted to present. FCFF t represents the free cash flow to the firm at time t. WACC is the weighted average cost of capital g is the constant growth rate that is expected in perpetuity.

Terminal Value using Market Multiples Suppose comparable companies have EV/EBDITA multiple of seven (7) times its EBDITA (on average). Thus we can apply this multiple to the company being valued: TV t = 7 x EBDITA t Where EBDITA t is the EBDITA of the company being valued in year t.

Terminal Value using Market Multiples This triangulation of the terminal value using multiples is very often used. Given the substantial importance that the terminal value has in a valuation, one must use different approaches to estimate it. Multiples are also very useful to obtain an estimate of the implied growth rate that the market is using it its valuations. It can then be helpful when judging the merits of different long-term growth rates.

Terminal Value using Market Multiples Selection of Comparable Firms: Multiples are often higher for firms with: 1. Higher Growth 2. Higher Margins 3. Lower Risk Which can be seen from the decomposition of the PER for a stable growth company (where we can value it as perpetuity).

Decomposition of PER

Thus, a high-growth company may have a very high PER, and this justifiable based on its fundamentals. It is therefore common to find, even in the same industry, very different multiples for firms with different business risk, cost and growth.

Determinants of Equity Multiples: Stable Growth Model Multiple AnalyzedStable-Growth DDM Model Value of EquityP 0 = DPS1/k e - g n or FCFE 1 /k e - g n P/E Ratio (using current earnings)P 0 /EPS 0 = Payout Ratio * (1+g n )/ke-gn P/E Ratio (using forward earnings)P 0 /EPS 1 = Payout Ratio /ke-gn PEG Ratio (P/E Ratio/ g)Payout Ratio/g*(ke-g n ) P/FCFE1/k e - g n Market to Book Equity (P 0 /BV 0 )ROE * Payout Ratio * (1+g n )/ke - g n Price to Sales Ratio (P 0 /Sales 0 )Profit Margin*Payout Ratio* (1+g n )/ke - g n

V 0 = Value of Stock D t = Dividend k = required return Dividend Discount Models: General Model

Does DDM ignore Capital Gain? It is tempting, but incorrect, to conclude from previous equation that the DDM focuses on dividends and ignore capital gains, as a motive for investing in stock. Price at which you can sell your stock in future depends upon dividend forecasts at that time. The DDM asserts that stock prices are determined ultimately by the cash flows accruing to stockholders, and those are dividends.

What about non-dividend paying stocks? If investors never expected a dividend to be paid, then this model implies that the stock would have no value. Is it true in real world?

Table 18.2 Financial Ratios in Two Industries

One must assume that investors expect that some day it may pay out some cash, even if only a liquidating dividend.

Stocks that have earnings and dividends that are expected to remain constant Preferred Stock No Growth Model

E 1 = D 1 = $5.00 k =.15 V 0 = $5.00 /.15 = $33.33 No Growth Model: Example

g = constant perpetual growth rate Constant Growth Model

E 1 = $5.00b = 40% k = 15% (1-b) = 60%D 1 = $3.00 g = 8% V 0 = 3.00 / ( ) = $42.86 Constant Growth Model: Example

g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate (1- dividend payout percentage rate) Estimating Dividend Growth Rates

Figure 18.1 Dividend Growth for Two Earnings Reinvestment Policies

Example.. High flyer industries has just paid its annual dividend of $3 per share. The dividend is expected to grow at a constant rate of 8% indefinitely. The beta of High Flyer stock is 1.0, risk free rate prevailing in the market is 6%, and market return is 14%. What is the intrinsic value of this stock? What would be your estimate of intrinsic value if you believed that stock was 1.25 times riskier than the market?

Present Value of Growth Opportunities If the stock price equals its IV, growth rate is sustained, the stock should sell at: If all earnings paid out as dividends, price should be lower (assuming growth opportunities exist)

Present Value of Growth Opportunities Continued Price = No-growth value per share + PVGO (present value of growth opportunities)

ROE = 20% d = 60% b = 40% E 1 = $5.00 D 1 = $3.00 k = 15% g =.20 x.40 =.08 or 8% Partitioning Value: Example

V o = value with growth NGV o = no growth component value PVGO = Present Value of Growth Opportunities Partitioning Value: Example Continued