6. Market-Based Valuation: Price and Enterprise Value Multiples Flashcards
Explain a ‘justified price multiple’.
A justified price multiple is what the multiple should be if the stock is fairly valued. If the actual multiple is greater/(less) than the justified price multiple, the stock is overvalued/(undervalued).
Explain the two versions of the P/E ratio.
1) Trailing P/E uses earnings over the most recent 12 months in denominator 2) Leading P/E ratio uses next year’s expected earnings, which is defined as either expected earnings per share (EPS) for the next four quarters or next fiscal year.
Explain the advantages and disadvantages of P/B Ratio.
ADVANTAGES
- Book value is cumulative amount that is usually positive, even when the firm reports a loss and EPS is negative. Thus, a P/B can typically be used when P/E cannot
- Book value is more stable than EPS, so it may be more useful than P/E when EPS is particularly high, low or volatile
- Book value is an appropriate measure of net asset value for firms that primarily hold liquid assets. Examples include finance, investment, insurance, and banking firms
- P/B can be useful in valuing companies that are expected to go out of business
- Empirical research shows that P/Bs help explain differences in long-run average stock returns
DISADVANTAGES
- P/Bs do not reflect the value of intangible economic assets, such as human capital
- P/Bs can be misleading when there are significant differences in the asset size of the firms under consideration because in some cases the firm’s business model dictates the size of its asset base. A firm that outsources its production will have fewer assets, lower book value, and a higher P/B ratio than an otherwise similar firm in the same industry that doesn’t outsource
- Different accounting conventions can obscure the true investment in the firm made by shareholders, which reduces the comparability of P/Bs accros firms and countries. For example, research and development costs (R&D) are expensed in the United States, which can understate investment
- Inflation and technological change can cause the book and market values of assets to differ significantly, so book value is not an accurate measure of the value of shareholder’s investment. This make it more difficult to compare P/Bs accros firms.
How to calculate P/B ratio.
P/B= (market value of equity)/(book value of equity)
book value of equity = common shareholder’s equity
= (total assets - total liabilities) - preferred stock
Explain the advantages and disadvantages of P/S Ratio.
ADVANTAGES
- P/S is meaningful even for distressed firms, since sales revenue is always positive. This is not the case for P/E and P/B ratios, which can be negative.
- Sales revenue 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 volatile as P/E multiples. This may make P/S ratios more reliable in valuation analysis when earnings for a particularly year are very high or very low relative to the long-run 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 signinficantly related to differences in long-run average stock returns.
DISADVANTAGES
- 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
Explain the advantages and disadvantages of P/CF Ratio.
ADVANTAGES
- Cash flow is harder for managers 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 the quality of reported earnings, which is a problem for P/E
- Empirical evidence indicates that differences in price to cash flow are significantly related to differences in long-run average stock returns
DISADVANTAGES
- Items affecting actual cash flow from operations are ignored when the EPS plus noncash charges estimate is used. Example, noncash revenue and net changes in working capital are ignored
- From a theoretical perspective, FCFE is preferable to operating cash flow. However, FCFE is more volatile than operating cash flow, so it is not necessarily more informative
Explain Dividend Yield Ratio. Which are the advantages and disadvantages.
The dividend yield/P ratio is the ratio of the common dividend to the market price. It is most often used for valuing indexes.
ADVANTAGES
- Dividend yield contributes to total investment return
- Dividends are not as risky as the capital appreciation component of total return
DISADVANTAGES
- The focus on dividend yield is incomplete because it ignores capital appreciation
- The dividend displacement of earnings concept argues that dividends paid now displace future earnings, which implies a trade-off between current and future cash flows
Explain Molodovsky Effect.
Earnings contain a transitory portion that is due to cyclicality. While viewed as currently transitory, business cycles are expected to repeat over the long term. The countercyclical tendency to have high P/Es due to lower EPS at the bottom of the cycle and low P/Es due to high EPS at the top of the cycle is known as the Molodovsky Effect.
Explain ‘Underlying Earnings’.
Calculating the P/E ratio is easy, and estimating the market price is usually straightforward. However, estimating the appropriate earnings measure is crucial to successfully using the P/E ratio in market-base valuation. The key focus of an analyst is estimating underlying earnings: persistent, continuing, or core earnings.
Explain ‘Normalized Earnings’.
Analysts adjust P/Es for cyclicality by estimating normalized earnings per share, which is an estimate of EPS in the middle of the business cycle.
The following two methods are used to normalize earnings
1) Under the method of historical average EPS, the normalized EPS is estimated as the average EPS over some recent period, usually the most recent business cycle
2) Under the method of average return on equity, normalized EPS is estimated as the average ROE multiplied by the current book value per share (BVPS). Once again, average ROE is often measured over the most recent business cycle. The reliance on BVPS reflects the effect of firm size changes more accurately than does the method of historical average EPS.
Explain ‘Justified P/E Multiple’.
The justified P/E price multiple is a P/E ratio with the ‘P’ in the numerator equal to the fundamental value derived from a valuation model (P=V0).
Justified Trailing P/E = P0/E0 = [D0*(1+g)/(r-g)]/E0
Justified Leading P/E = P0/E1 = [D0*(1+g)/(r-g)]/E1
Explain and calculate ‘Justified P/B Multiple’.
Using the sustainable growth relation of g=ROEb and observing that E1=B0ROE, we can also derive the justified P/B from the Gordon growth model as:
Justified P/B = (ROE - g)/(r-g)
Conclusions:
- P/B increases as ROE increases, all else equal.
- The larger the spread between ROE and r, all else equal, the higher the P/B ratio. This makes sense if you remember that ROE is the return on the firm’s investment projects and ‘r’ is the required return. The larger the spread, all else equal, the more value the firm is creating through its investment activities and the higher its market value as represented by V0.
Explain ‘Justified P/S Multiple’.
Since net profit margin is equal to E/S we can also restate the Gordon growth model as:
Justified P/S = [(E/S)(1-b)(1+g)]/(r-g)
Note:
g = (retention ratio)(net profit margin)(sales/assets)*(assets/equity)
This means that P/S ratio will increase, all else equal, if: - Profit margin increases
- Earnings growth rate increases
Explain ‘justified P/CF Multiple.
The justified price to cash flow based on fundamentals can be calculated by finding the value of the stock using a DCF model and dividing the result by the chosen measure of cash flow. For example, equity value using the single-stage FCFE model is:
V0 = FCFE*(1+g)/(r-g)
Explain ‘Justified EV/EBITDA Multiple’.
The justified EV/EBITDA based on fundamentals is simply the enterprise value based on a forecast of fundamentals divided by EBITDA forecast on fundamentals.
