MARKET-BASED VALUATION: PRICE AND ENTERPRISE VALUE MULTIPLES Dr. David Krause AIM Program Marquette University

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 MULTIPLE RATIONALES & DRAWBACKS Rationales EPS is driver of valueWidely used Related to stock returns Drawbacks Zero, negative, or very small earnings Permanent vs. transitory earnings Management discretion for earnings

PRICE-TO-EARNINGS MULTIPLE DEFINITIONS 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$ :Q1 EPS$ :Q2 EPS$ :Q3 EPS$ :Q4 EPS$ Fiscal year forecast$ :Q1 EPS$ :Q2 EPS$ :Q3 EPS$ :Q4 EPS$ Fiscal year forecast$2.00

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 EARNINGS

EXAMPLE: NORMALIZED EARNINGS YearEPSBVPSROE 2010$0.66$ % 2009$0.55$ % 2008$0.81$ % 2007$0.73$ % 2006$0.34$ % 2011 stock price$24.00

EXAMPLE: 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 rate4.0% Required return on stock10.0%

EXAMPLE: JUSTIFIED FORWARD P/E FROM FUNDAMENTALS

EXAMPLE: JUSTIFIED P/E FROM REGRESSION ON FUNDAMENTALS Values for subject firm Dividend payout ratio 0.40 Beta 1.20 Earnings growth rate6.00% 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 COMPARABLES USING PEER COMPANY MULTIPLES  Law of one price  Risk and earnings growth adjustments  PEG limitations:  Assumes linear relationship  Does not account for risk  Does not account for growth duration

EXAMPLE: METHOD OF COMPARABLES USING P/E AND PEG Values for subject firm Five-year EPS growth rate8.0% Consensus EPS forecast$4.50 Current stock price$28.00 Values for peer group Median P/E 9.00 Median PEG 1.60

EXAMPLE: METHOD OF COMPARABLES USING P/E AND PEG

METHOD OF COMPARABLES USING 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 COMPARABLES VALUING 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 COMPARABLES USING OWN HISTORICAL MULTIPLES  Rationale: Regression to the Mean  Approaches:  Average of four middle values over past 10 years  Five-year average trailing P/E  Potential Problems from Changes in  Firm business  Firm financial leverage  Interest rate environment  Economic fundamentals  Inflationary 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 firm Required rate of return11.0% EPS forecast for year 3$2.50 Values for peer group Mean dividend payout ratio 0.40 Mean ROE8.0% Median P/E 9.00

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

EXAMPLE: USING P/ES FOR TERMINAL VALUE USING COMPARABLES

PRICE-TO-BOOK VALUE MULTIPLE RATIONALES Book Value Is Usually PositiveMore Stable than EPSAppropriate for Financial FirmsAppropriate for Firms that Will TerminateCan explain stock returns

PRICE-TO-BOOK VALUE MULTIPLE DRAWBACKS Does Not Recognize Nonphysical AssetsMisleading when Asset Levels VaryCan Be Misleading Due to Accounting PracticesLess Useful when Asset Age DiffersCan Be Distorted Historically by Repurchases

ADJUSTMENTS TO BOOK VALUE Intangible Assets Inventory Accounting Off-Balance- Sheet Items Fair Value

JUSTIFIED P/B

PRICE-TO-SALES MULTIPLE RATIONALES Sales Less Easily ManipulatedSales Are Always PositiveP/S Appropriate For Mature, Cyclical, & Distressed FirmsP/S More Stable Than P/ECan Explain Stock Returns

PRICE-TO-SALES MULTIPLE DRAWBACKS Sales ≠ Earnings & Cash FlowNumerator & Denominator Not ConsistentP/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$50.00 EPS$2.00 Dividends per share$1.20 Book value of equity per share$6.25 Sales per share$15.00 ROE22.5% Required return on stock12.0%

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

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

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

PRICE-TO-CASH-FLOW MULTIPLE RATIONALES Cash Flow Less Easily ManipulatedRatio More Stable Than P/E Ratio Addresses Quality of Earnings Issue with P/ERatio 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 + Depletion CF From statement of cash flows CFO Most valid but volatile FCFE Best used with enterprise value EBITDA

JUSTIFIED PRICE-TO-CASH-FLOW RATIO

DIVIDEND YIELD RATIONALES & DRAWBACKS Rationales 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

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 MULTIPLE RATIONALES & DRAWBACKS Rationales Useful for comparing firms of different leverage Useful for comparing firms of different capital utilization Usually positive Drawbacks Exaggerates cash flow FCFF more strongly grounded

ISSUES IN USING ENTERPRISE VALUE MULTIPLES EV = Market Value of Stock + Debt – Cash – InvestmentsJustified EV/EBITDA Positively related to FCFF growth Positively related to ROIC Negatively related to WACC Comparables May Utilize TICOther 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/E Arithmetic Mean & Weighted Mean Closer to index P/E but is influenced by small outliers Harmonic Mean Equal to index P/E Weighted 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

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