Chapter 7 - 7.4 Flashcards
What have we already learnt in this chapter?
We learned how to value a firm or a stock by considering the expected future cash flows it will provide to its owner
What does the law of one price tells us about valuing a stock or firm?
Tells us that the value of a firm or stock is the present value of its future cash flows
What is another application of the law of One Price?
Method of Comparable
What is the method of comparable?
1) This method allows us to estimate a firm’s value based on the value of comparable firms or investments that we expect will generate very similar cash flows in the future.
3) If these firms generate identical cash flows the Law of One Price implies that we can use the value of the existing company to determine the value of the new firm.
Are all firms identical?
Identical companies do not exist as even if they are in the same industry and or selling the same products they have differences in size or scale.
What do we have to do to make firms more comparable in scale or size?
Adjustments are necessary to account for scale differences when using comparable for valuation.
What are Valuation Multiples?
Valuation multiples help adjust for differences in scales between comparable firms by expressing their value in terms of a valuation multiple.
How do we do a valuation multiple?
The ratio that compares the firm’s value (like its market price or enterprise value) to a measure of its scale or performance (like revenue, earnings, or EBITDA).
What is the most common valuation multiple?
Price- Earnings Ratio
How to compute the P/E ratio?
Share price / EPS
What is the P/E ratio?
This ratio shows how much investors are willing to pay for every dollar the company earns.
This ratio is useful because the intuition behind it is that when we buy stock we are essentially paying for a share of the company’s future profits.
If a company consistently earns more money, investors often think its stock is worth more. The P/E ratio helps compare how “expensive” or “cheap” a stock is relative to its earnings.
How do we use the P/E ratio the value of a firm’s share?
To estimate the value of a firm’s stock, multiply its current EPS by the average P/E ratio of comparable firms.
What is the forward P/E ratio?
This is a P/E multiple computed based on its ‘forward earnings’ (expected earnings over the next 12 months)
How to compute the Forward P/E ratio?
+ Dividend payout ratio (div/EPS) / (Re - G)
What is the trailing P/E ratio?
This is the P/E multiple computed “trailing P/E” → earnings over the prior 12 months
How to compute the trailing P/E ratio?
(1+ G0)*(forward P/E)
Is forward P/E preferrred or trailing for valuation purposes?
For valuation purposes ‘the Forward P/E is preferred” → as we are most concerned with future earnings
Explain how two stocks are similar would have the same P/E ratio?
If we have two stocks that have the same dividend payout and EPS growth rates as well as equivalent risk (same cost of capital) they should have the same P/E ratio.
How would a firm have high P/E multiples?
Firms and industries with high growth rates in which generates cash well in excess of their needs so they can maintain high payout rate should have high P/E multiples
What is another common practice discussing enterprise value multiples?
It’s also common practice to use valuation multiples that are based on the firms enterprise value.
What is enterprise value?
Enterprise value (EV) represents the total value of the firm’s business, including both debt and equity.
We use this method more when we want to compare firms with different leverage (levels of debt).
What is the most common multiple for enterprise value?
Enterprise to EBIT
Enterprise to EBITDA → earnings before interest, taxes, depreciation, and amortization → Only remember
Enterprise to Free Cash flow
When do we use Enterprise value as a multiple of sales?
This can be useful if it is reasonable to assume that the firms will maintain similar margins (sales) in the firm
When do we use a Ratio of price to book value of equity per share?
This can be useful for firms with substantial tangible assets:
Real estate
Machinery and equipment
Inventory
Vehicles
How do we know a valuation multiple is useful?
The usefulness of a valuation multiple depends on how big the differences are between the firms being compared and how much those differences affect the multiple itself.
In other words, the more sensitive the multiple is to differences like growth rates or profitability, the less reliable it might be for comparison
What are some reasons or example of differences between firms (limitations)
Differences in expected future growth rates
Profitability
Risk (cost of capital)
Accounting conventions
When is the valuation good for?
When we are valuing a stock the valuations are only good at the time we do them.
Every new piece of information we learn can potentially change our predictions for future data (free cash flows, EBITDA, growth, cost of capital, etc.).
As our predictions or expectations change, our valuation models should be updated
