Valuation: Principles and Practice: Part 1 – Relative Valuation 03/03/08 Ch. 12

Valuation techniques Relative valuation the value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable such as earnings, book value or revenues. Discounted cash flow valuation The value of an asset is the discounted expected cash flows on that asset at a rate that reflects its riskiness. Residual Income valuation The value of an asset is based on the discounted expected difference between net income and its associated cost of equity.

Relative valuation The value of the firm is determined as: Comparable multiple * Firm-specific denominator value where the denominator value can be earnings, book value, sales, etc. A firm is considered over-valued (under-valued) if the calculated price (or multiple) is greater (less) than the current market price (comparable firm multiple) Assumptions: Comparable firms, on average, are fairly valued Comparable firms have similar fundamental characteristics to the firm being valued.

Relative valuation Examples of relative valuation multiples Price/Earnings (P/E) Earnings calculations should exclude all transitory components Price/Book (P/BV) Book value of equity is total shareholders equity – preferred stock Price/Sales (P/S) Enterprise Value/EBITDA Enterprise Value = Mkt Cap + Debt – Cash EBITDA = Earnings before Interest Taxes Depreciation and Amortization

Advantages and drawbacks of P/E Advantages: Earnings power is the chief driver of investment value Main focus of security analysts The P/E is widely recognized and used by investors Drawbacks If earnings are negative, P/E does not make economic sense Reported P/Es may include earnings that are transitory Earnings can be distorted by management Assumption: Required rate of return, retention ratio and growth rates are similar among comparable firms

Advantages and drawbacks of P/BV Advantages Since book value is a cumulative balance sheet amount, it is generally positive BV is more stable than EPS, therefore P/BV may be more meaningful when EPS is abnormally low or high P/BV is particularly appropriate for companies with primarily liquid assets (financial institutions) Disadvantages Differences in asset age among companies may make comparing companies difficult Assumption: Required rate of return, return on equity, retention ratio and growth rates are similar among comparable firms

Advantages and drawbacks of P/S Advantages Sales are generally less subject to distortion or manipulation Sales are positive even when EPS is negative Sales are more stable than EPS, therefore P/S may be more meaningful when EPS is abnormally low or high Disadvantages High growth in sales may not translate to operating profitability P/S does not reflect differences in cost structure Assumption: Required rate of return, profit margin, retention ratio and growth rates are similar among comparable firms

Advantages and drawbacks of EV/EBITDA Advantages This represents a valuation indicator for the overall company and not just equity. It is more appropriate for comparing companies that have different capital structures since EBITDA is a pre-interest measure of earnings. Appropriate for valuing companies with large debt burden: while earnings might be negative, EBIT is likely to be positive. Disadvantages Differences in capital investment is not considered. Assumption: Required rate of return, growth rates, working capital needs, capital expenditures and depreciation are similar among comparable firms

Benchmarks for comparison Peer companies Constituent companies are typically similar in their business mix Industry or sector Usually provides a larger group of comparables therefore estimates are not as effected by outliers Overall market Own historical This benchmark assumes that the firm will regress to historical average levels Considerations: market efficiency, historical trends, comparable assumptions

Leading and trailing P/E Trailing (or current) P/Es is calculated using the firm’s current market price and the four most recent quarters’ EPS. Leading P/Es is calculated using the firm’s current market price and next year’s expected earnings.

PEG Ratio “I don’t buy stocks with P/E’s over 30. To our Foolish ear, that sounds identical to: I don't buy hydrogenated milk; I am born in May.” Motley Fool When comparable firm P/Es are used to calculate the value of a firm, the assumption is that the firm has characteristics that are similar to that of the average comparable firm. However, differences may exist. For example, a higher P/E for a particular firm may be justified because the firm has higher growth.

PEG Ratio The Price/Earnings-to-Growth (PEG) accounts for differences in the growth in earnings between companies. PEG is calculated as: P/E divided by expected earnings growth (%). "The P/E ratio of any company that's fairly priced will equal its growth rate." Peter Lynch