McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2 VALUATION Behavioral Corporate Finance by Hersh Shefrin

1 Valuation Heuristics  P/E heuristic P 0 = P 0 /E 1 x E 1 Target price P 1 = P 1 /E 2 x E 2  PEG Heuristic P 0 = PEG x E 1 x G, where G is 100 x growth rate  Price-to-sales Heuristic P 0 = P 0 /S 1 x S 1, where S stands for sales

2 Behavioral Pitfalls: Judging the Value of eBay  On May 20, 2003 eBay’s P/E ratio was 66.2, while Wal-Mart’s P/E was eBay appeared to be over twice as expensive as War-Mart.  Analysts were expecting eBay to grow by 42.5%, while they were only expecting Wal-Mart to grow by 14%. eBay’s PEG was 1.56, which was actually lower than Wal-Mart’s PEG of 1.62.

3 Behavioral Pitfalls: Wall-Marting of the Web  Mary Meeker, “Queen of the Internet.”  Just as the traditional retailer Wal-Mart came to dominate the retail sector, web- based counterparts would emerge and dominate Internet commerce. Mary Meeker described the phenomenon as the “Wal-Marting of the Web.”

4 Mary Meeker’s Target Prices for eBay Exhibit 2.1

5 Methodology Exhibit 2.2

6 Free Cash Flow Computation Meeker forecasted that free cash flows in 2011 will be $3,266,096 = 1.07 x $3,052,426. She then applied the perpetuity formula PV = $3,266,096 / ( ) = $65,321,907 Exhibit 2.3

7 Biases  Discount rate, 12%, fair expected return.  Target price of $106 implies expected return exceeds 12%.  PEG and P/E target prices imply returns below 12%, even negative.  FCF and price-to-sales target prices imply returns above 12%.

8 Biased Free Cash Flows Differences?  EBITDA  working capital  investment Exhibit 2.4

9 Textbook Style Valuation  $23,742 = E 2011 /r = $2,849/0.12  Because eBay pays no dividends before 2010, the $23,742 would be worth $21,199 at the end of 2009, $21,199= $23,742/1.12.  Discounting back to mid-2004 would lead to a value of $11,366 (=$12,029/ ) at that time. Exhibit 2.5

10 Mistaking Growth for Growth Opportunities  Mary Meeker titled her April 2003 report on eBay “Tales of a Growth Machine.”  Analysts are inclined to mistake growth in EPS for growth opportunities Growth opportunity features ROE > r.  From the time that eBay went public, through June 2004, eBay's ROE < its r of 12%.

11 Intrinsic PEG?  PEG heuristic effectively assumes P/E is proportional to g.  When the plowback ratio is 0, g = 0.  When the plowback ratio is 1, g = ROE.  Regardless of whether g is equal to 0 or equal to the ROE, P/E is 1/r for a firm with zero growth opportunities.  Therefore, P/E does not vary in proportion to g.

12 1/n Heuristic  The 1/n heuristic is a rule of thumb that assigns the same weight to each technique, as if they are all equally valid.  Very wide dispersion in values associated with P/E, PEG, price-to-sales, and DCF.  Meeker averaged the numbers, which in her words, “combine to an average fair value of about $106.”

13 Excessive Optimism  On April 23, 2003 The Wall Street Journal suggested that analysts' revenue forecasts were excessively optimistic. The article singled out Mary Meeker and Safa Rashtchy from U.S. Bancorp Piper Jaffray.  On January 20, 2005 Safa Rashtchy downgraded his recommendation on eBay from “outperform” to “market perform,” stating that the stock was priced for perfection.

14 Agency Conflicts  Managers of firms prefer favorable coverage from analysts to unfavorable coverage.  Analysts whose firms seek to do business with companies have an incentive to generate favorable (optimistic) reports.  Agency conflict might induce analysts to view valuation heuristics as instruments to provide numbers they want to deliver.