1. Lecture 15 Market Based Valuation Investment Analysis

2. ASSIGNMENT (Question 1) Based on the information in the following figure, calculate the current P/B rate for ABC Inc. and XYZ Inc. Investment Analysis CompanyBook Value of Equity 2008 (millions of $) Sales 2008 (millions of $) Shares Outstanding 2008 (millions) Price per Share 2008 ($) ABC Inc.28,03918,8787,00117.83 XYZ Inc.6,3209,4755,23312.15

3. P/S Ratio The advantages of using the price-to-sales (P/S) ratio include: P/S is meaningful even for distressed firms, since sales revenue is always positive. Sales revenues is not as easy to manipulate or distort as EPS and book value, which are significantly affected by accounting conventions. P/S ratios are not as volatile as P/E multiples. This may make P/S ratios more reliable in valuation analysis when earnings for a particular year are vary high or very low relative to the long-rum average. P/S ratios are particularly appropriate for valuing stocks in mature or cyclical industries and start-up companies with no record of earnings. It is also often used to value investment management companies and partnerships. Like P/E and P/B ratios, empirical research finds that differences in P/S are significantly related to differences in long-run average stock returns. Investment Analysis

4. P/S Ratio (cont’d …) The disadvantages of using P/S ratios include: High growth in sales does not necessarily indicate high operating profits as measured by earnings and cash flow. P/S ratios do not capture differences in cost structures across companies. While less subject to distortion, revenue recognition practices can still distort sales forecasts. For example, analysts should look for company practices that speed up revenue recognition. An example is sales on a bill and hold basis, which involves selling products and delivering them at a later date. This practice accelerates sales into an earlier reporting period and distorts the P/S ratio. Investment Analysis

5. ASSIGNMENT (Question 2) P/S multiple is computed by dividing stock’s price per share by sales or revenue per share or by dividing the market value of the firm’s equity by its total sales: P/S ratio=market value of equity / total assets P/S ratio =market price per share / sales per share Based on the information provided in Question 1, calculate the current P/S for ABC Inc. and XYZ Inc. Investment Analysis

6. P/CF Ratio Advantages of using the price-to-cash flow ratio (P/CF) include: Cash flow is harder for manager to manipulate than earnings. Price to cash flow is more stable than price to earnings. Reliance on cash flow rather than earnings handles the problem of differences in quality of reported earnings, which is a problem of P/E. Empirical evidence indicates that differences in price to cash flow are significantly related to differences in long-run average stock returns. Investment Analysis

7. P/CF Ratio (cont’d …) There are two drawbacks to the price to cash flow, both of which are related to the definition of cash flow. Items affecting actual cash flow from operations are ignored when the EPS plus noncash charges estimate is used. For example, noncash revenue and net changes in working capital are ignored. From a theoretical perspective, free cash flow to equity (FCFE) is preferable to operating cash flow. However, FCFE is more volatile than operating cash flow so it’s not necessarily more informative. Investment Analysis

8. P/CF Ratio (cont’d …) There are at least four definitions of cash flow available for use in calculating the P/CF ratio: (1) earnings plus noncash charges (CF), (2) adjusted cash flow (adjusted CFO), (3) free cash flow to equity (FCFE) and (4) earnings before interest, taxes, depreciation and amortization (EBITDA) (1) One commonly used proxy for cash flow is earnings plus noncash charges (CF): CF=net income + depreciation + amortization The limitation to this definition, as we mentioned previously is that it ignores some items that affect cash flow, such as noncash revenue and changes in net working capital. (2) Another proxy for cash flow is cash flow from operations (CFO) from the cash flow statement. The limitation of CFO, however, is that it includes items related to financing and investing activities. Therefore, analysts often adjust CFO by adding back the after-tax interest cost and call it adjusted CFO: Adjusted CFO=CFO + [(net cash interest outflow) x (1 – tax rate)] Investment Analysis

9. P/CF Ratio (cont’d …) (3) Analysts also often use free cash flow to equity (FCFE) and earnings before interest, taxes, depreciation and amortization (EBITDA) as proxies for cash flow. As we mentioned above, theory suggests that FCFE is the preferred way to define cash flow but it is more volatile than straight cash flow: FCFE=CFO – FC Inv + net borrowing Where: FC Inv=Fixed Capital Investment Net Borrowing = (long and short-term debt issues) – (long and short-term debt repayments) (4) EBITDA is a pretax, pre-interest measure that represents a flow to both equity and debt. Thus, it is better suited as an indicator of total company value than just equity value. P/CF ratio=market value of equity / cash flow P/CF ratio=market price per share / cash flow per share Where: Cash flow=CF, adjusted CFO, FCFE or EBITDA Investment Analysis

10. ASSIGNMENT (Question 1) Pal Co. reported net income of $32 million, depreciation and amortization of $41 million, net interest expense of $12 million and cash flow from operations of $44 million. The tax rate is 30%. Calculate the P/CF ratio using CF and adjusted CFO as proxies for cash flow. Pak Co. has 25 million shares outstanding, trading at $47 per share. Investment Analysis

11. EV/EBITDA Ratio Because EBITDA is a flow to both equity and debt, it should be related to a numerator that measures total company value. Enterprise Value (EV) is total company value: EV = market value of common stock + market value of preferred equity + market value of debt + minority interest – cash and investments The rationale for subtracting cash and investments is that an acquirer’s net price paid for an acquisition target would be lowered by the amount of the target’s liquid assets. Thus, EV/EBITDA indicates the value of the overall company, no equity. EV/EBITDA is the ratio of enterprise value to EBITDA: EV/EBITDA=Enterprise Value/EBITDA Where: Enterprise Value = market value of common stock + market value of debt – cash and investments EBITDA = net income + interest + taxes + depreciation + amortization Investment Analysis

12. EV / EBITDA Ratio (cont’d …) EV/EBITDA is useful in a number of situations: The ratio may be more useful than P/E when comparing firms with different degrees of financial leverage. EBITDA is useful for valuing capital intensive business with high levels of depreciation and amortization. EBITDA us usually positive even when EPS is not. EV/EBITDA has a number of drawbacks, however: If working capital is growing, EBITDA will overstate CFO. Further, the measure ignores how different revenue recognition policies affect CFO. Because FCFF captures the amount of capital expenditures, it is more strongly linked with valuation theory than EBITDA. EBITDA will be an adequate measure if capital expenses equal depreciation expenses. Investment Analysis

13. ASSIGNMENT (Question 2) An analyst gathered the following data for ABC industries, based on the information, calculate the EV/EBITDA ratio for ABC Inc: Investment Analysis Recent share price$22.50 Shares outstanding40 million Market value of debt$137 million Cash & Marketable Securities$62.3 million Investments$327 million Net income$137.5 million Interest expense$6.9 million Depreciation & Amortization$10.4 million Taxes$95.9 million