Valuation Methods

Methods of Corporate Valuation Asset-Based Methods Using Comparables Free Cash Flow Methods Option-Based Valuation

Asset-Based Methods Balance sheet approach: Cash and working capital (book value close to its realizable value) Property, Equipment, and Land (appraisal value) Intangibles. Book value of equity vs market value of equity

Relative Valuation What is relative valuation? What is the logic underlying relative valuation? Using comparables

What is relative valuation? Relative to revenues or cash flows Relative to Earnings Relative to the Book Value of Equity

Relative to Revenue Price/Sales (PS) Value/Sales (VS) Usually used in valuing retailing firms

Relative to Earnings Price/Earnings Ratio (PE) Trailing Price/Earnings Ratio (trailing PE) A trailing PE is a price-earnings ratio based on the most recent 12 months' results. U.S. companies report quarterly, so a trailing PE is computed based on the most recent four quarters. Forward Price/Earnings Ratio (forward PE) Also called estimated PE. Forward PE divides a stock's current price by its estimated future earnings per share. Forward PE is often used to compare a company's current earnings to its estimated future earnings.

Relative to the Book Value of Equity Price/Book Value (PBV) Market to book Value (MB)

Advantages to using multiples in valuation analysis Require fewer explicit assumptions than DCF Easy to compute and don’t require forecasting Commonly quoted and used by management and press

Disadvantages to using multiples in valuation analysis Require more implicit assumptions than DCF Logic behind valuation analysis is often misunderstood Identification of comparable firms is subjective

What is logic underlying relative valuation? P/E ratio Think about a basic DCF model (Gordon’s Growth Model) Divide both sides by earnings per share

Comparing two PE ratios across firms assumes … Identical payout ratio Identical cost or equity Identical expected stable-growth rate

What is logic underlying relative valuation? Price to book value Divide both sides by book value of equity

Comparing two PE ratios across firms assumes … Identical payout ratio Identical cost or equity Identical expected stable-growth rate Identical

What is logic underlying relative valuation? Price to sales Divide both sides by sales

Comparing two PE ratios across firms assumes … Identical payout ratio Identical cost or equity Identical expected stable-growth rate Identical Gross profit margin

Using comparables Construct the multiple for the set of comparable firms Average the multiple across the set of comparable firms Compare individual firm to this average Differences may be attributed to differences in underlying logic of multiple Differences may be attributed to inefficient markets (price)

Remember to control for differences between firms Growth Payout Risk ROE Profit Margin

Ways to control for differences between firms Sample firms and sort according to attributes (Growth, Payout, Risk, ROE, Profit) Requires a large number of potential comparables Compare your firm to subset of comparables with similar attributes Modify the multiples to make them more comparable Divide the PE ratio by the expected growth rate in EPS (PEG Ratio) Divide PBV ratio by the ROE (Value Ratio) This assumes firms are comparable on all other attributes Run regression of multiples on attributes Use coefficient values from regression and attributes for the firm to predict the correct multiple for the firm.

Regression-based multiple analysis Damodaran ran regressions on 2,475 firms using data from 1998 PE=291.27*Growth+37.74*Payout+21.62*Beta PBV=3.99*Payout-0.79*Beta+60.65*growth+31.56*ROE PS=11.56*Growth+1.41*Payout-1.42*Beta+11.93*Margin

Free cash flow method Free cash flows to equity Free cash flows to firm Basic case Firms with insufficient valuation data Acquisition valuation

Option base valuation Real option approach in valuing firm