Finance Club Thursday, February 2, 2012

Primer on Equity Valuation and Financial Ratios 2

Robert Shiller In 1981 he wrote a paper on market volatility. –He determined if a stock price is the estimate of “something,” (say the discounted cash flows from a corporation), –…then market prices are too volatile in relation to tangible manifestations of that “something.” (he used dividends as proxy). He concluded markets are not as efficient as established by financial theory.

The ability to benefit from identifying a mispriced security depends on the market price converging to the estimated intrinsic value. 4

Categories of Equity Valuation Models 5

Market Multiple Models 6

Major advantage of using price multiples is that they allow fast relative comparisons, both cross-sectional and in time series. Note of caution: Difference in accounting practices can make these ratios less meaningful. Be wary of ratios for companies whose operations are driven by economic cycles. 7

Equity Securities and Company Value What is one goal of a company’s management? Increase book value and maximize market value of its equity. Book value –Shareholders’ equity on balance sheet. –Management can directly affect. Market value 8

A Company’s Market Value Reflects the collective and differing expectations of investors. Rarely will book value and market value be equal. 9

Return on Equity 10

So is an increase in ROE always good? It depends. What if NI decreases slower than BVE? What if a company issues debt and repurchases shares? –This will increase leverage and make company risker. It is important to examine cause of change. (DuPont) 11

Price-to-Book 12

Example PfizerNovartisGlaxoSmithKline Price$21.11$55.66$44.40 BVPS$11.71$27.39$4.67 P/B GSK has the highest P/B. This suggests investors’ expect higher growth opportunities in GSK. But… PfizerNovartisGlaxoSmithKline Gross Margin77.35%67.59%72.28 Debt/Equity ROE11.39%14.11%38.48% Clearly GSK is using higher financial leverage to do so.

Valuation Based on Price Multiple 14 Apple Inc.2012E Sales (billion)$155.4$108.6$65.1$36.3 NI (billion)$39.6$25.9$14.0$5.7 EPS$42.12$27.68$15.15$6.29 P/E Price$505.44$381.98$283.31$128.32