How do we value companies? Intrinsic value The value of a company to you is wrong We assume it will become right Stock vs. other assets Relative value Other companies are valued differently If our company is an outlier, it will tend to change to normal over time Stock vs. stock

Estimated future Free Cash Flows Annual FCF for that year Discounted Cash Flows

PE Ratio Estimated future Free Cash Flows Annual FCF for that year

PE Ratio

Price-to-Earnings Multiple Rationales & Drawbacks Rationales EPS is driver of valueWidely usedRelated to stock returns Drawbacks Zero, negative, or very small earnings Permanent vs. transitory earnings Management discretion for earnings

Price-to-Earnings Multiple Definitions Trailing P/E Uses last year’s earnings Preferred when forecasted earnings are not available Forward P/E Uses next year’s earnings Preferred when trailing earnings are not reflective of future

PEG Ratio

Issues in Calculating EPS EPS Dilution Underlying Earnings Normalized Earnings Differences in Accounting Methods

Method of Comparables Benchmark Value of the Multiple Choices Industry peers Industry or sector index Broad market index Firm’s historical values

Method of Comparables Using Peer Company Multiples  Law of one price  Risk and earnings growth adjustments  PEG limitations:  Assumes linear relationship  Does not account for risk  Does not account for growth duration

Using P/Es for Terminal Value Justified P/E P/E = (D/E)/(r – g) Sensitive to required inputs P/E Based on Comparables Grounded in market data If comp is mispriced, terminal value will be mispriced

Enterprise Value EV = + market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments

EBITDA

EV/EBITDA

Enterprise Value/EBITDA Multiple Rationales & Drawbacks Rationales Useful for comparing firms of different leverage Useful for comparing firms of different capital utilization Usually positive Drawbacks Exaggerates cash flow FCFF more strongly grounded

Issues in Using Enterprise Value Multiples EV = Market Value of Stock + Debt – Cash – InvestmentsJustified EV/EBITDA Positively related to FCFF growth Positively related to ROIC Negatively related to WACC Comparables May Utilize TIC Other EV Multiples EV/FCFF EV/EBITA EV/EBIT EV/S

Equity / Book Value

Price-to-Book Value Multiple Rationales Book Value Is Usually PositiveMore Stable than EPSAppropriate for Financial FirmsAppropriate for Firms that Will TerminateCan explain stock returns

Price-to-Book Value Multiple Drawbacks Does Not Recognize Nonphysical AssetsMisleading when Asset Levels VaryCan Be Misleading Due to Accounting PracticesLess Useful when Asset Age DiffersCan Be Distorted Historically by Repurchases

Adjustments to Book Value Intangible Assets Inventory Accounting Off-Balance- Sheet Items Fair Value

Price-to-Cash-Flow Multiple Rationales Cash Flow Less Easily ManipulatedRatio More Stable Than P/ERatio Addresses Quality of Earnings Issue with P/ERatio Can Explain Stock Returns

Price-to-Cash-Flow Multiple Drawbacks Cash Flow Can Be Distorted FCFE More Volatile and More Frequently Negative Cash Flow Increasingly Managed by Firms

Cross-Country Comparisons Net income higher under IFRS Shareholder's equity lower under IFRS ROE higher under IFRS US GAAP vs. IFRS P/CFO & P/FCFE most comparable P/B, P/E, & EBITDA multiples least comparable Valuation Multiples Higher inflation  Lower justified price multiples Higher pass-through rates  Higher justified price multiples Inflation