Valuation Part 3 Presented by: Wee Yang Yale-NUS Investment Masterminds Discounted Cash Flow Model

Earnings Approach  PE Ratio  Price per share / Earnings Per Share  Earnings Yield  Earnings per share / Price per share x 100%

Earnings Approach Notes on PE Ratio:  Shows how long it will take (in years) for you to earn back your initial investment, provided that the earnings per share do not change  The lower the PE when you invest, the better  High PE suggest that investors/market are expecting higher growth for the company in the future  Beware of companies with extremely high PE (>20) and companies with extremely low PE (<5)  Avoid making decisions just based on this number as PE is highly susceptible to manipulation

Earnings Approach Notes on PE Ratio:  Use PE Ratios to compare within industry peers, NOT across industries  Earnings Yield can be used to compare with other types of investment such as bonds or property  Can consider Price to Cash Flow ratio instead, which is less prone to manipulation (but not as popular a metric)

Earnings Approach Price to Cash Flow ratio Calculated by:

Earnings Approach Notes to PCF Ratio:  A measure of the market's expectations of a firm's future financial health.  Because this measure deals with cash flow, the effects of depreciation and other non-cash factors are removed.  Similar to the price-earnings ratio, this measures provides an indication of relative value.  Because accounting laws on depreciation vary across jurisdictions, the price-to-cash-flow ratio can allow investors to assess foreign companies from the same industry

Earnings Approach Compound Annual Growth Rate - CAGR  The year-over-year growth rate of an investment over a specified period of time.  The compound annual growth rate is calculated by taking the nth root of the total percentage growth rate, where n is the number of years in the period being considered.

Earnings Approach Notes to CAGR:  CAGR isn't the actual return in reality. It's an imaginary number that describes the rate at which an investment would have grown if it grew at a steady rate.

Earnings Approach

Notes to PEG Ratio:  Used to compare between industry peers  The lower the ratio, the more the stock is undervalued in relation to its growth (Similar to PE Ratio)  You need to take into account the sources of the company’s growth  High Quality Growth – Increased sales or entering new markets (increasing volume)  Low Quality Growth – Cost-cutting measures, accounting tricks, (any growth that is unsustainable)  Growth projections are highly inaccurate even among experts  We usually limit CAGR in calculations to less than 20% to remain safe

Earnings Approach Notes to PEG Ratio:  You can use growth rate in revenue instead of earnings, or the lower of the two, to calculate CAGR and PEG  Sales Growth mainly come in 4 areas: 1. Selling More Goods/Services 2. Raising Prices 3. Selling New Goods/Services 4. Buying Another Company

Asset Approach Price to Book Ratio (PB Ratio)  A ratio used to compare a stock's market value to its book value.  Calculated as:

Earnings Approach Notes to PB Ratio:  For value investors, P/B remains a tried and tested method for finding low price stocks that the market has neglected.  If a company is trading for less than its book value (or has a P/B less than one), it normally tells investors one of three things:  The market believes the asset value is overstated, OR  the company is earning a very poor (even negative) return on its assets, or  The company is undervalued

Earnings Approach Notes to PB Ratio:  The ratio is really only useful when you are looking at capital-intensive businesses or financial businesses with plenty of assets on the books.  Book value completely ignores intangible assets like brand name, goodwill, patents and other intellectual property created by a company. In only takes into account how much the company is worth if it liquidates  Book value doesn't carry much meaning for service-based firms with few tangible assets.

Earnings Approach Notes to PB Ratio:  P/B provides a valuable reality check for investors seeking growth at a reasonable price. Large discrepancies between P/B and ROE, a key growth indicator, can sometimes send up a red flag on companies.  Overvalued growth stocks frequently show a combination of low ROE and high P/B ratios. If a company's ROE is growing, its P/B ratio should be doing the same.

Concept of Intrinsic Value It is the discounted value of the cash that can be taken out of a business during its remaining life. “Price is what you pay. Value is what you get.” - Warren E. Buffett “The stock market is filed with individuals who know the price of everything, but the value of nothing.” - Philip Fisher

Discounted Rate The Fed’s Discount Rate is an administered rate set by the Federal Reserve Banks, rather than a market rate of interest. The discount rate in DCF analysis takes into account not just the time value of money, but also the risk or uncertainty of future cash flows; the greater the uncertainty of future cash flows, the higher the discount rate.

Discounted Rate A simple explanation of the discount rate used in DCF analysis is as follows. Let's say you expect $1,000 in one year. To determine the present value of this $1,000 (what it is worth to you today), you would need to discount it by a particular interest rate. Assuming a discount rate of 10%, the $1,000 in a year's time would be equivalent to $ to you today (1,000 / [ ]). If you expect to receive the $1,000 in two years, its present value would be $

Intrinsic Value Value Investors that follow fundamental analysis look at both qualitative (business model, governance, target market factors etc.) and quantitative (ratios, financial statement analysis, etc.) aspects of a business to see if the business is currently out of favor with the market and is really worth much more than its current valuation **A reminder: look at qualitative and quantitative aspects before you do this final step of valuation.

Valuation Ratios Intrinsic Value “It is the discounted value of the cash that can be taken out of a business during its remaining life.” -Warren Buffett Discounted Cash Flow Model (DCF) Assumptions of Model used: Number of Years Growth Rate Interest (Discount) Rate Projected Earnings or Cash Flow

CALCULATE YOUR INTRINSIC VALUE! Exercise

Valuating Businesses

Any Questions? Valuation Part 3 Presented by: Wee Yang