1. Relative Valuation Methods

2. Car Example How much are you willing to pay for a new Lexus?

3. Pricing a New Lexus Direct Pricing Measure: Can determine all of the features and add a price for each feature to get the total you are willing to pay. Relative Pricing Measure: Can price a Lexus relative to other luxury cars or relative a Toyota to determine the total you are willing to pay.

4. Pricing a New Lexus Relative Pricing: Are willing to pay 2 times as much for a fully loaded Lexus as for a fully loaded Toyota Corolla. Are willing to pay 1.4 times as much for a fully loaded Toyota Camry as for a fully loaded Toyota Corolla.

5. Pricing a Stock uDirect Measure: Determine the future “cash flows”. Determine the future riskiness of the cash flows and discount them back by the appropriate discount rate. uRelative Measure: Can price a stock relative the stock market, relative its industry, or relative its closest competitor.

6. RELATIVE VALUATION METHODS u P/E Multiplier u P/CF Multiplier u P/S Multiplier u P/BV Multiplier

7. P/E Multiplier Method How much are you willing to pay per dollar of EPS of Firm A?

8. P/E Multiplier Method: A Relative Valuation Model Are you willing to pay more or less per dollar of EPS of Firm A than for an average company in the industry? Are you willing to pay more or less per dollar of EPS of Firm A than for an average stock in the S&P 500?

9. Estimate P/E Multiplier Predict Multiplier: Estimate [P 0 /E 1 ] P 0 is the unknown. Predict the ratio here not the components of the ratio!

10. Drivers of P/E Multiplier 2 Main Drivers of P/E Multiplier: 1. Long Run Growth Rate in EPS: Increases (decreases) lead to increases (decreases) in the P/E ratio 2. Long Run Riskiness of EPS: Increases (decreases) lead to decreases (increases) in the P/E ratio

11. Drivers of P/E Multiplier Time Value of Money: PV = Value = f(future cash flows, riskiness of future cash flows) P/E Multiplier = f(future EPS, riskiness of future EPS)

12. Relative Measure: Done at Various Levels Compare Estimates of Future Growth and Risk: u The Company versus its Closest Competitor u The Company versus its Industry u The Company versus the Stock Market

13. Predicting Growth in EPS  g g = (1 – Predicted DPS/EPS) X (Predicted ROE) g = (Ret.Rate) X (NI/S X S/TA X TA/C.Eq.) DPS/EPS = Dividend Payout Ratio NI/S = Net Profitability S/TA = Total Asset Turnover TA/C.Eq. = Financial Leverage

14. Predicting Growth in EPS = g Each of the ratios break down into finer increments that can be predicted. Example: NI/S = f(GP/S, OP/S, Interest Expense)

15. Predicting Growth in EPS: Company A g = RR X [NI/S X S/TA X TA/C.Eq.] Using Ratio Values Last Year: g 0 = (1-.27) X [.015 X 4.20 X 3.62] = 16.6% Using Our Predicted Avg. Ratio Values for Next Few Yrs: g future = (1-.25) X [.006 X 3.8 X 4.0] = 6.8%

16. Predicting Growth in EPS Estimate of Growth Using Ratios Last Year: Company A: g 0 = (1 -.27) X [.015 X 4.20 X 3.62] = 16.6% Industry: g 0 = (1 -.10) X [.021 X 2.62 X 5.45] = 27.0%

17. Predicting Growth in EPS Prediction for Company A Over Next Several Yrs: g future = (1 -.25) X [.006 X 3.8 X 4.0] = 6.8% Prediction for Industry Over Next Several Yrs: g future = (1 -.10) X [[.026 X 3.2 X 5.2] = 38.9% Growth Analysis: Implies a lower [P 0 /E 1 ] for Company A than the industry.

18. Predicting Future Risk u Business Risk u Financial Risk u Liquidity Risk u Exchange Rate Risk u Political Risk

19. Predicting Future Risk CAPM View: Future Beta = f(future business risk, financial risk, liquidity risk, exchange rate risk, political risk)

20. Predicting Future Risk 1.Historic Risk Assessment: Assess whether the risk has been higher or lower than the industry in the recent past. 2.Future Risk Assessment: Predict what will happen to risk for the company and the industry in the future.

21. Business Risk Business Risk: Variability in annual percentage changes in operating income. Measure: CV in % Change in Op Income  %Chg Op Inc CV in Op Inc = ------------------- Mean %Chg Op Inc

22. Business Risk CV in % Change in Op. Income (past 3 years) Company A = 4.39 CV in % Change in Op. Income (past 3 years) Industry = 1.47 Industry has had lower business risk than Company A. Predict no changes in this relationship in the future.

23. Financial Risk Financial Risk: Increased variability in EPS due to the use of debt. Measures of Financial Risk: Debt Ratios Interest Coverage Ratios

24. Financial Risk Average TA/C.Eq. Company A (past 3 years) = 2.95 Average TA/C.Eq. Industry (past 3 years) = 6.01 Industry has had higher financial risk than Company A using this ratio. Predict financial risk of Company A will increase, while that of the Industry will decrease.

25. Liquidity Risk Liquidity Risk: Inability to sell the stock quickly at a known price. Measures of Liquidity Risk: # Stockholders #Shares Outstanding #Average Daily Volume of Shares Traded #Institutional Holdings

26. Liquidity Risk Measures of Liquidity Risk: Are similar for Company A and for its industry. Industry has had similar liquidity risk. Predict this relationship will stay the same.

27. Beta Current Beta Company A =.58 Current Beta Industry =.45 Company A currently has more systematic risk than the industry. Given we predict no change in business risk or liquidity risk, but an increase in financial risk for Company A relative the industry, we predict the relative beta will rise for Company A in the future.

28. Drivers of P/E Multiplier Growth: Historic relative growth lower than industry. Predict relative growth will drop further. Risk: Historic relative risk higher than industry. Predict relative risk will rise further.

29. Drivers of P/E Multiplier Growth Assessment: Predict [P 0 /E 1 ] for Company A will be lower than for the industry. Risk Assessment: Predict [P 0 /E 1 ] will be lower for Company A than for the industry. Overall: Predict [P 0 /E 1 ] will be lower for Company A than for the industry

30. Forecast [P 0 /E 1 ] Industry: Analysts using [P 0 /E 1 ] = 10.0 Should use less than 10 for Company A. Decide to use 7.0. Implies a Relative P/E of 7.0/10.0 =.70

31. P/E Multiplier Method Take the product of the estimated P/E multiplier (ratio) and estimated EPS 1. [P 0 /E 1 ] X [E 1 ] = Estimated P 0 Estimated P 0 = Intrinsic Value 0

32. Predict EPS Next 12 Months Next Step: Predict EPS for the next 12 months: [E 1 ]

33. Forecast E 1 Method 1: g = RR 1 X [NI/S 1 X S/TA 1 X TA/C.Eq. 1 ] Company A: Ratios from Past Year: g 0 = (1-.27) X [.015 X 4.20 X 3.62] = 16.6% Company A: Predictions for Next Year: g 1 = (1-.25) X [.007 X 3.8 X 3.70] = 7.4%

34. Forecast E 1 Method 2: Create a set of proforma financial statements for Company A for the next 12 months and use the estimate of [E 1 ] from the proforma income statement.

35. Forecast E 1 Company A E 0 = $1.35 Predicted E 1 = 1.35 (1.074) = $1.45

36. Intrinsic Value Company A Estimated Intrinsic Value Company A Today = 7.0 X $1.45 = $10.15 Stock is currently trading at $16.15 We issue a “sell” recommendation.

37. Implied P/E Ratio Can see the current price of Company A of $16.15 and the market consensus forecast for E 1 of $1.47. This results in an implied P 0 /E 1 ratio of $16.15/1.47 = 10.98 times. We predict a [P 0 /E 1 ] of 7.0 times and E 1 of $1.45.

38. Estimate Target Price 1 [P 1 /E 2 ] X E 2 = Estimate of P 1 = Target Price 1 where [P 1 /E 2 ] = forecasted multiplier 12 months from today. E 2 = forecasted EPS for 12 month period starting one year from today.

39. P/E Multiplier Trailing vs Standard Often analysts also examine [P 0 /E 0 ] = The Trailing P/E Ratio For valuation we ultimately want [P o /E 1 ]or [P1/E2]!!

40. Trailing P/E Trailing P/E Ratios: Company A = $16.15/1.35 = 11.96 Industry = $18.08/1.26 = 14.35 S&P 500 = 21.50 Relative P/E = 11.96/14.35 =.83 (industry) Relative P/E = 11.96/21.50 =.56 (market)

41. Typical in Analyst Report I. Table: Show the following for: Company, Industry (or closest competitor) and Market Proxy Trailing P/E Prediction of P 0 /E 1 Prediction of P 1 /E 2 Prediction of E 1 and Intrinsic Value 0 Prediction of E 1 and Target Price 1 Relative P/E Ratios

42. Typical in Report II.Discussion Discussion of the drivers of growth and risk for the company versus its competitors and/or the market.