Behavioral Corporate Finance Chapter 2 VALUATION Behavioral Corporate Finance by Hersh Shefrin

TRADITIONAL APPROACH TO VALUATION Valuation centers on the constant-growth present-value perpetuity formula PV=C/(r-g), where C is the first payment, future payment grow at the rate g, and discount rate is r.

Cont… An alternative approach to equity valuation focuses on a firm’s growth opportunities. Valuation through growth opportunities involves decomposing equity value into two components : The value of the firm when it pays out 100 percent of its earnings as cash dividend The net present value associated with plowing back a potion future earnings into firm’s future projects.

VALUATION HEURISTICS The valuation techniques taught in traditional finance textbooks are based on the computation of intrinsic or fundamental value. Three common heuristics, named for ratios upon which they rely: P/E, PEG, and price-to-sales.

Cont.. P/E heuristic PEG Heuristic Price-to-sales Heuristic P0 = P0/E1 x E1 Target price P1 = P1/E2 x E2 PEG Heuristic P0 = PEG x E1 x G, where G is 100 x growth rate Price-to-sales Heuristic P0 = P0/S1 x S1, where S stands for sales

P/E HEURISTIC P/E Heuristic:An approach to valuation based on multiplying a P/E ratio and an earnings forecast. Security analysts rely on the P/E Heuristic more than any other technique. The valuation identity is given by Pₒ =Pₒ/E2 E1.However this relationship is also used to forecast price in future.

PEG HEURISTIC A firm's PEG ratio is defined as its P/E ratio divided by its expected earnings growth rate per year (actually 100 x expected earnings growth rate) Valuation based on the PEG ratio involves the product of three terms, the PEG ratio, an estimate of future earnings per share, and an estimate of expected earnings growth.

Cont… The valuation identity is given by Po=PEG x E1x G,where G is 100 x growth rate.

Price-to-Sales Heuristic Price-to-sales heuristic:An approach to valuation based on multiplying a price-to-sales ratio and a sales forecast. The valuation identity is given by Po=Po/S1 xS2, where S stands for sales.

A CFO’S RELIANCE ON VALUATION HEURISTICS Heuristics are simpler to :P/E,PEG, and price-to-sales require very few variables and involve simple formulas. The DCF-based analyses taught in textbooks require far more detail than the heuristic techniques, involves more complex formulas, and are far less intuitive.

HOW ANALYSTS VALUE FIRMS :AN ILLUSTRATIVE EXAMPLE ANALYST MARY MEEKER Financial executives at eBay relied on the PEG heuristic to assess whether or not their stock price seemed to be fairly priced. However, they did little analysis beyond that. What about security analysts?One of their tasks is to assess value .Do they rely on DCF?Do they use heuristics, and if so which ones?

Cont… Mary Meeker from the firm Morgan Stanley .Mary Meeker’s analysis of eBay used a series of valuation techniques, each of which gave a different target price for eBay.

Mary Meeker’s Target Prices for eBay At the time Mary Meeker released her April 2003 report, eBay’s price was $89.22.Meeker’s task was to develop a target price for eBay over the subsequent 12 months . In undertaking this task, she used all three valuation heuristics described earlier ,as well as discounted cash flow (DCF) computation.

Mary Meeker’s Target Prices for eBay Exhibit 2.1

Mary Meeker’s Target Prices for eBay Exhibit 2.1

Free Cash Flow Computation Exhibit 2.3 Meeker forecasted that free cash flows in 2011 will be $3,266,096 = 1.07 x $3,052,426. She then applied the perpetuity formula PV = $3,266,096 / (0.12-0.07) = $65,321,907

Methodology Exhibit 2.2

Cont… For each of the first three heuristics, Meeker computed a low, high, and intermediate guess, which she calls downside, upside, and base respectively. She then averaged these together with her DCF valuation to arrive at a target price of $106 per share.

Cont… A firm generates positive free cash flows when its after-tax cash flows from operations are positive and it does not spend all those after-tax acquiring working capital and fixed assets. The difference between after-tax cash flow from operations and investment in working capital and fixed assets is paid out to the firm’s owners.

BIASES Biases and Heuristics Was Mary Meeker’s valuation analysis of eBay biased? At the end of June 2004,eBay’s stock price reached $180(on a presplit basis), well above Meeker’s target price of $106. At the year-end 2004 its stock price closed 2004(pre-split) at $232, and its forward P/E for eBay was 70,well above Meeker’s forecast of 47.

Cont…. The rate of return associated with a target price of $106 lies above Meeker’s discount rate of 12 percent. In this respect , $106 would be upwardly biased, if in April 2003 Meeker judged eBay’s stock to have been fairly priced.

Cont… The target priced range of $97 to $210 based on the price-to-sales ratio might well be biased upward. The average of this range produces are turn of 63 percent above the required return 12 percent

Cont.. Discount rate, 12%, fair expected return. Target price of $106 implies expected return exceeds 12%. PEG and P/E target prices imply returns below 12%, even negative. FCF and price-to-sales target prices imply returns above 12%.

Biases and Framing Effects The DCF based free cash flow computation is the only technique that purports to measure intrinsic value. There are multiple ways to define free cash flows. One definition, called sources of free cash flows, is cash flows from operations less the sum of new short term debt, investment in working capital and fixed assets.

Cont.. Another definition, called the uses of cash flows, is the sum of interest payments, dividends, and share repurchases, less the sum of new debt and new share issues. Sources of free cash flows must equal the uses of free cash flows.

Biased Free Cash Flows Exhibit 2.4 Differences? EBITDA working capital investment Exhibit 2.4

Textbook Style Valuation Exhibit 2.5 $23,742 = E2011/r = $2,849/0.12 Because eBay pays no dividends before 2010, the $23,742 would be worth $21,199 at the end of 2009, $21,199= $23,742/1.12. Discounting back to mid-2004 would lead to a value of $11,366 (=$12,029/1.120.5) at that time.

Other Sources of Bias Growth Opportunities PEG and DCF 1/N Heuristic Excessive Optimism

Mistaking Growth for Growth Opportunities Mary Meeker titled her April 2003 report on eBay “Tales of a Growth Machine.” Analysts are inclined to mistake growth in EPS for growth opportunities Growth opportunity features ROE > r. From the time that eBay went public, through June 2004, eBay's ROE < its r of 12%.

Intrinsic PEG? PEG heuristic effectively assumes P/E is proportional to g. When the plowback ratio is 0, g = 0. When the plowback ratio is 1, g = ROE. Regardless of whether g is equal to 0 or equal to the ROE, P/E is 1/r for a firm with zero growth opportunities. Therefore, P/E does not vary in proportion to g.

1/n Heuristic The 1/n heuristic is a rule of thumb that assigns the same weight to each technique, as if they are all equally valid. Very wide dispersion in values associated with P/E, PEG, price-to-sales, and DCF. Meeker averaged the numbers, which in her words, “combine to an average fair value of about $106.”

Excessive Optimism On April 23, 2003 The Wall Street Journal suggested that analysts' revenue forecasts were excessively optimistic. The article singled out Mary Meeker and Safa Rashtchy from U.S. Bancorp Piper Jaffray. On January 20, 2005 Safa Rashtchy downgraded his recommendation on eBay from “outperform” to “market perform,” stating that the stock was priced for perfection.

Agency Conflicts Managers of firms prefer favorable coverage from analysts to unfavorable coverage. Analysts whose firms seek to do business with companies have an incentive to generate favorable (optimistic) reports. Agency conflict might induce analysts to view valuation heuristics as instruments to provide numbers they want to deliver.

The End