CHAPTER 8: Equity Valuation (Concepts & Tools) Flashcards
MARKET VALUE vs INTRINSIC VALUE
Overvalued: Market value > Intrinsic value
Fairly valued: Market value = Intrinsic value
Undervalued: Market value < Intrinsic value
INTRINSIC VALUE
- Based on fundamentals (earnings, sales, dividends)
- Also called fundamental or estimated value
- Differs from market price when questioning market’s estimate
Example:
Caterpillar Inc. trading at $84.53
Analyst estimates intrinsic value at $88.21
Undervalued or Overvalued?
Conclusion: Undervalued
Factors to Consider if Market Value is NOT EQUAL to Intrinsic Value
- Percentage difference
- Confidence in your model
- Model sensitivity to assumptions
- Number of analysts
- Will market price move towards intrinsic value?
Key Points:
- Large discrepancies warrant rechecking calculations
- High model confidence suggests price convergence over time
- Check model sensitivity if many securities appear mispriced
- More analyst coverage typically means less mispricing (Convergence & Value Triggers)
Present value models (DCF)
- Estimate value as present value of expected future benefits.
- Future benefits are defined as either cash distributed to shareholders (dividend discount models) or cash available to shareholders after meeting the necessary capital expenditure and working capital expenses (free-cash-flow-to-equity models).
DDM or DCF
Multiplier Models (Comps)
- Estimate intrinsic value based on a multiple of some fundamental variable.
- For example, either Stock price / earnings (or sales, book value, cash flow).
- Or Enterprise value / EBITDA (or sales).
Asset-based valuation models
Book Value or Carrying Value models
Benjamin Graham’s NCAVPS: Net Carrying Asset Value Per Share= Total Assets – Total Liabilities
- Estimate the value of equity as the value of assets less the value of liabilities.
- Book values of assets and liabilities are typically adjusted to their fair values when using these models.
Choice of model depends on availability of information & the analyst’s confidence in the appropriateness of the model; generally analysts will try to use more than one model
An analyst finds that all the securities analyzed have estimated values higher
than their market prices. The securities all appear to be:
A. overvalued.
B. undervalued.
C. fairly valued.
Undervalued
B is correct. The estimated intrinsic value for each security is greater than
the market price. The securities all appear to be undervalued in the market.
Note, however, that the analyst may wish to reexamine the model and inputs to check that the conclusion is valid.
An analyst finds that nearly all companies in a market segment have common shares which are trading at market prices above the analyst’s estimate of the shares’ values. This market segment is widely followed by analysts.
Which of the following statements describes the analyst’s most appropriate
first action?
A. Issue a sell recommendation for each share issue.
B. Issue a buy recommendation for each share issue.
C. Reexamine the models and inputs used for the valuations.
C.
C is correct.
It seems improbable that all the share issues analyzed are overvalued, as indicated by market prices in excess of estimated value—particularly because the market segment is widely followed by analysts.
Thus, the analyst will not issue a sell recommendation for each issue. The analyst will most appropriately reexamine the models and inputs prior to issuing any recommendations.
A buy recommendation is not an appropriate response to an overvalued security.
An analyst, using a number of models and a range of inputs, estimates a security’s value to be between ¥250 and ¥270. The security is trading at ¥265.
The security appears to be:
A. overvalued.
B. undervalued.
C. fairly valued.
C is correct.
The security’s market price of ¥265 is within the range estimated
by the analyst.
The security appears to be fairly valued.
An analyst is estimating the intrinsic value of a new company. The analyst has one year of financial statements for the company and has calculated the average values of a variety of price multiples for the industry in which the company operates.
The analyst plans to use at least one model from each of the three categories of valuation models. The analyst is least likely to rely on the estimate(s) from the:
A. multiplier model(s).
B. present value model(s).
C. asset-based valuation model(s).
B.
Because the company has only one year of data available, the analyst is least likely to be confident in the inputs for a present value model.
The values on the balance sheet, even before adjustment, are likely to be close to market values because the assets are all relatively new.
The multiplier models are based on average multiples from the industry.
Based on a company’s EPS of €1.35, an analyst estimates the intrinsic value of a security to be €16.60. Which type of model is the analyst most likely to be using to estimate intrinsic value?
A. Multiplier model.
B. Present value model.
C. Asset-based valuation model.
A.
The analyst is using a multiplier model based on the P/E multiple.
The P/E multiple used was 16.60/1.35 = 12.3.
DIVIDENDS: Background for DDM
Definition & Types
Dividend: Distribution paid to SHs based on the number of shares owned
Not an obligation; must be authorized by BOD
Types:
- Stock Dividends: Bonuses: does NOT affect market value of equity; thus not relevant for valuations
- Cash Dividends:
- Regular cash dividends: paid out consistently. A stable or increasing dividend is viewed as a sign of financial stability.
- Extra dividend or Special Dividend: one-time cash payments when situation is favourable; Irregular dividends; Used by cyclical firms
- Liquidating dividend: distributed to SHs when a company goes out of business - Share Repurchases:
- Not considered for dividends, voting & EPS calculation
Reasons for repurchase:
- Signal belief that shares are undervalued
- Flexibility in amount & timing of distribution
- Tax efficiency
- Absorb increase in outstanding shares
STOCK SPLIT
Number of shares outstanding: Increases
Stock Price: Decreases
Eg: 1:2 stock split= 1 for every 2 shares held
Similar to Stock Dividends
Doesn’t change the market value of equity; thus irrelevant for valuations
REVERSE STOCK SPLIT (Consolidation)
Number of shares outstanding: Decreases
Stock Price: increases
Eg: 1:2 stock split= Each SH receives 1 share for every 2 held
Similar to Stock Dividends
Doesn’t change the market value of equity; thus irrelevant for valuations
SHARE REPURCHASE (BUYBACKS)
Alternative to cash dividends
Company uses cash to buyback shares
BUYBACKS affect market value of equity & thus are relevant for valuations.
Impact on SH’s wealth is equivalent to a cash dividend.
Shares bought back are called Treasury Stock/Shares & this process is called a TREASURY OPERATION
Key reasons why companies engage in share repurchases instead of cash dividends?
- to support share prices. company believes in own share’s value so buys back.
- flexibility in the amount and timing of cash distribution.
- when tax rates on capital gains are lower than tax rates on dividends.
- to offset the impact of employee stock options.
DIVIDEND PAYMENT CHRONOLOGY/SCHEDULE:
DECLARATION= Announcement
Ex-Dividend Date= Too late to get dividend
Cum-Dividend Date= Last chance to get dividend
Holder-of-record Date= Company checks who gets dividend
Payment date= Money is paid out
- Declaration date: Company declares dividend.
- Ex-dividend date: Cutoff date on or after which buyers of a stock are not eligible for the dividend. Also is the first date when the stock trades without dividend.
- Holder-of-record date: A record of shareholders who are eligible to receive the dividend is made (usually two days after the ex-dividend date).
- Payment date: Dividend payment made to the shareholders.
Reasons for repurchase:
- Signal belief that shares are undervalued
- Flexibility in amount & timing of distribution
- Tax efficiency
- Absorb increase in outstanding shares
DDM & FCFF
Simplest PV model is DDM
PV= PV of Future Dividends + PV of Terminal Value
For the next 3 years, the annual dividends of Stock X are expected to be 1, 1.1 & 1.2. The expected stock price at the end of Year 3 is expected to be $20. The required rate of return on the shares is 10%.
What’s the estimated value?
PV= CF/(1+r)^n
PV (1)= 1/(1.10)^1= 0.909
PV (2)= 1.1/(1.10)^2= 0.909
PV (3)= 1.2/(1.10)^3= 15.928
1+2+3= 0.909+0.909+15.928= 17.74
On Calc:
CF0 = 0; CF1 = 1; CF2 = 1.1; CF3 = 21.2; I = 10%, CPT NPV
In practice FCFE models are often used.
FCFE Formula
What’s value?
When are FCFE models used?
FCFE= CFO - FC Inv + Net borrowing
Value= PV of all future FCFEs
Used when
- not paying dividends
- dividends too small
- dividends not indication of company’s ability to pay dividends
- unable to figure out company’s dividend payout policy
Use CAPM to calculate required rate of return on share
Ke= Rf + B(Rm-Rf) or Rf + Market Risk Premium
Jensen’s Alpha= Rpf - Ke
FCFE MODEL
FCFE Model:
Measures dividend-paying capacity
Applicable for non-dividend paying stocks
Useful for companies with small or non-indicative dividends
Accounts for cash flow retention for future investments
FCFE CALCULATION
FCFE Calculation:
FCFE = CFO - FCInv + Net borrowing
CFO = Cash Flow from Operations
FCInv = Fixed Capital Investment
Net borrowing = Borrowings - Repayments
FCFE Advantages
Advantages of FCFE:
Flexibility in application
Considers dividend-paying potential
Accounts for retained earnings
Required Rate of Return (Ke)
Required Rate of Return:
Typically calculated using CAPM
Formula: Risk-free rate + Beta * Market risk premium
Alternative methods available (e.g., bond yield plus risk premium)
FCFE Assumptions
Key Considerations:
FCFE reflects available cash for shareholders
Model assumes infinite time horizon
Requires estimation of future cash flows and growth rates
PREFERRED STOCK VALUATION
For a non-callable, non-convertible perpetual preferred share paying a level dividend D & assuming a constant required rate of return
V= D/r
Other types of preferred shares to consider:
1. Shares which mature on a given date
2. Callable (redeemable) shares
3. Shares with retraction option (Puttable shares)
Preferred Stock Basics:
Preferred Stock Basics:
- Non-callable, non-convertible, perpetual
- Pays level dividends
Valued using perpetuity formula:
V₀ = D₀ / r
where,
V₀ = Present value
D₀ = Dividend
r = Required rate of return
A $100 par value, non-callable, non-convertible perpetual preferred stock pays a 5% dividend.
The discount rate is 8%.
Calculate the intrinsic value of the preferred share.
Dividend is given at par value or face value
Expected annual dividend
= 0.05 x 100 = 5
Value of the preferred share
= 5.00/0.08 = 62.50
Types of Preferred Shares:
Maturing, Callable & Puttable
Types of Preferred Shares:
Maturing Shares:
- Fixed maturity date
- Value: Present value of dividends + final payment
Callable Shares:
- Company can call share back
- Redeemable by issuer before maturity
- Trade at lower value due to call risk
Putable Shares (Retraction Option):
- Investors can put shares back to company
- Holder can sell back to issuer
- Trade at higher value due to put option
Based on traded value: P>M>C
Case 1: Non-callable, Non-convertible, Perpetual Preferred Shares
The following facts concerning the Union Electric Company 4.75 percent perpetual preferred shares are as follows:
■ Issuer: Union Electric Co. (owned by Ameren)
■ Par value: US$100
■ Dividend: US$4.75 per year
■ Maturity: perpetual
■ Embedded options: none
■ Credit rating: Moody’s Investors Service/Standard & Poor’s Ba1/BB
■ Required rate of return on Ba1/BB rated preferred shares as of valuation
date: 7.5 percent.
Estimate the intrinsic value of this preferred share.
Basing the discount rate on the required rate of return on Ba1/BB rated
preferred shares of 7.5 percent gives an intrinsic value estimate of
US$4.75/0.075 = US$63.33.
Explain whether the intrinsic value of this issue would be higher or lower if the issue were callable (with all other facts remaining unchanged).
ANSWER:
The intrinsic value would be lower if the issue were callable. The option to redeem or call the issue is valuable to the issuer/company because the call will be exercised when doing so is in the issuer’s interest.
The intrinsic value of the shares to the investor will typically be lower if the issue is callable. In this case, because the intrinsic value without the call is much less than the par value, the issuer would be unlikely to redeem the issue if it were callable; thus, callability would reduce intrinsic value, but only slightly.
Key Considerations for Preferred Share Valuations
Key Considerations:
Maturity affects valuation method
Call/put options impact share value
Market conditions influence pricing
GORDON’S GROWTH MODEL (CGDDM)
Dividends grow INDEFINITELY @ constant rate
Also called CONSTANT-GROWTH DDM
Gordon Growth Model Basics:
Assumes constant dividend growth rate
Formula: V₀ = D₁ / (r - g)
Value (V₀) is based on Dividends of next year (D₁)
Key Components:
D₁: Next period’s dividend
r: Required rate of return
g: Dividend growth rate
Growth Rate Estimation Methods:
- Historical growth rate
- Industry median growth rate
- Sustainable growth rate: g = b × ROE
Ke= Rf + B(Rm-Rf)= Rf+(BMRP)
Retention Rate= (1-DPR)
(g)= ROERR= ROE(1-DPR)
Next Year’s Dividend (d1)= d0(1+g)
Intrinsic Value= D1/Ke-G
GGM ASSUMPTIONS, CONSIDERATIONS & LIMITATIONS?
Model Assumptions:
Dividends reflect company earnings
Perpetual dividend growth
Constant required return
Growth rate < required return
Key Considerations:
Impact of dividend changes on value is complex
Remember to discount future values to present
Limitations:
Not suitable for non-dividend paying companies
May not work for currently unprofitable companies
GGM IMPORTANT FORMULAE
Ke= Rf + B(Rm-Rf)= Rf+(BMRP)
Retention Rate= (1-DPR)
(g)= ROERR= ROE(1-DPR)
Next Year’s Dividend (d1)= d0(1+g)
Intrinsic Value= D1/Ke-G
Estimate the intrinsic value of a stock given the following data:
Beta = 1.5
RFR = 3%
market risk premium = 5%
dividend just paid = $1.00
dividend payout ratio = 0.4
return on equity = 15%.
Ke= Rf + B(Rm-Rf)= Rf+(BMRP)
Retention Rate= (1-DPR)
(g)= ROERR= ROE(1-DPR)
Next Year’s Dividend (d1)= d0(1+g)
Intrinsic Value= D1/Ke-G
Calculate Ke
Ke= Rf + B(Rm-Rf)= Rf+BMRP
= (3+1.55)= 10.5%
Calculate Sustainable Growth Rate (g)
(g)= ROE(1-DPR)
= 1.515%= 0.225
or
15%(1-0.4)=15%0.6= 0.09= 9%
Next Year’s Dividend (d1)= d0(1+g)
= 1(1+0.09)= 1.09
Intrinsic Value= D1/Ke-G
= 1.09/10.5-9= 1.09/0.015= 72.66
Thus,
Intrinsic Value of Stock: $72.67
OR
V0 = D1/r−g = D0∗(1+g)/r−g
Note: the values of r, g and expected dividend are not given.
So, first calculate these values.
r = RFR + Beta x market risk premium
= 3+ 1.5 x 5 = 10.5%
g = b x ROE = (1 - 0.4) x 0.15 = 0.09 Applying the Gordon growth model, V0 = 1 x 1.090.105 – 0.09 = 72.67
A company does not currently pay dividend but is expected to begin to do so in 4 years.
The first dividend is expected to be $2.00 and to be received at the end of year 4.
The dividend is expected to grow at 5% into perpetuity. The required return is 10%.
What is the estimated current intrinsic value?
- The first dividend is expected at the end of year 4.
- Use the Gordon growth model to find the value at the end of year 3.
To calculate the intrinsic value, first calculate the value of dividend at the end of period 3 and then discount it to t=0 using the Gordon growth model.
V3 = D4/r–g= 2/0.10–0.05 = 40
V0 = 40/(1.1)^3 = 30.05
Do not forget to discount 40 to the present value.
The undiscounted value is commonly presented as one of the answer options as a trap.
Two-Stage Dividend Discount Model:
Two-Stage Dividend Discount Model:
Formula:
V₀ = Σ[D₀(1+gₛ)ᵗ / (1+r)ᵗ] + Vₙ / (1+r)ⁿ
Used for companies transitioning from growth to mature stage
First 3 years= dividend % is 10% then after company stabilizes, dividend rate. is 5%: 2 stage model.
Components:
D₀: Current dividend
gₛ: Short-term growth rate
r: Required rate of return
n: Number of years in high growth period
Vₙ: Terminal value at time n
Terminal Value Calculation:
Uses Gordon Growth Model
Vₙ = Dₙ₊₁ / (r - g)
g: Long-term growth rate
The current dividend for a company is $4.00. The dividends are expected to grow at 20% a year for 4 years and then at 10% after that. The required rate of return is 18%. Estimate the intrinsic value.
Calculate terminal value (V₄):
D₄ = $4 * (1.20)⁴ = $8.29
D₅ = $8.29 * 1.10 = $9.12
V₄ = $9.12 / (0.18 - 0.10) = $114
Discount cash flows:
Year 1: $4.80 / 1.18 = $4.07
Year 2: $5.76 / (1.18)² = $4.13
Year 3: $6.91 / (1.18)³ = $4.20
Year 4: ($8.29 + $114) / (1.18)⁴ = $63.08
Sum all discounted values:
Intrinsic value = $4.07 + $4.13 + $4.20 + $63.08 = $75.48
Three-Stage Models
Three-Stage Models:
Extends two-stage concept
Stages: Growth, Transition, Maturity
Allows for more nuanced valuation
Key Considerations:
Accurately estimating growth rates is crucial
Model complexity increases with more stages
In GGM, what happens if Value of DIVIDENDS is increased?
V0= D1/r-g
If D1 goes up, we may think that V0 also goes up
But, when dividends increase, Retention Rate decreases. i.e. less money being retained.
and ROE*RR= g
Thus, growth rate (g) is going to be low
So, denominator goes up.
Both numerator & denominator going up.
So, can’t say that value may always increase
For the next three years, the annual dividends of a stock are expected to be
€2.00, €2.10, and €2.20. The stock price is expected to be €20.00 at the end of three years. If the required rate of return on the shares is 10 percent, what is the estimated value of a share?
The present values of the expected future cash flows can be written as
follows:
V₀ = D₁/(1+r)¹ + D₂/(1+r)² + D₃/(1+r)³ + TV₃/(1+r)³
V0 = 2/(1.1)^1 + 2.1/(1.1)^2 + 2.2/(1.1)^3
Calculating and summing these present values gives an estimated share
value of
V0 = 1.818 + 1.736 + 1.653 + 15.026
= €20.23.
The three dividends have a total present value of €5.207, and the terminal stock value has a present value of €15.026, for a total estimated value of €20.23.
An investor expects a share to pay dividends of $3.00 and $3.15 at the end of Years 1 and 2, respectively. At the end of the second year, the investor expects the shares to trade at $40.00. The required rate of return on the shares is 8 percent.
If the investor’s forecasts are accurate and the market price of the shares is currently $30, the most likely conclusion is that the shares are:
A. overvalued.
B. undervalued.
C. fairly valued.
V
= 3/(1.08)^1 + 3.15/(1.08)^2 + 40/(1.08)^3
= 39.7
Mkt. value= 30
IV>mkt value
Thus, Overvalued
Two investors with different holding periods but the same expectations and
required rate of return for a company are estimating the intrinsic value of a
common share of the company. The investor with the shorter holding period will most likely estimate a:
A. lower intrinsic value.
B. higher intrinsic value.
C. similar intrinsic value.
C is correct.
The intrinsic value of a security is independent of the investor’s holding period.
IV= INDEPENDENT OF INVESTOR’S HOLDING PERIOD
An equity valuation model that focuses on expected dividends rather than
the capacity to pay dividends is the:
A. dividend discount model.
B. free cash flow to equity model.
C. cash flow return on investment model.
A is correct.
Dividend discount models focus on expected dividends.
The current dividend is $4.00.
Growth is expected to be 20% a year for 4 years then 10% after that.
Required rate of return is 18%
Estimate Intrinsic Value
D1= 4(1.2)= 4.8
D2= 4(1.2)^2= 5.76
D3= 4(1.2)^3= 6.91
D4= 4(1.2)^4= 8.29
g= 10%
r= 18%
V0= D1/r-g
V3= D4/r-g
V3= 8.29/0.18-0.10= 8.29/0.08= 103.68
IV= 103.68
The current dividend, D0, is $5.00. Growth is expected to be 10 percent a year for three years and then 5 percent thereafter. The required rate of return is 15 percent. Estimate the intrinsic value.
D1 = $5.00(1 + 0.10) = $5.50
D2 = $5.00(1 + 0.10)2 = $6.05
D3 = $5.00(1 + 0.10)3 = $6.655
D4 = $5.00(1 + 0.10)3(1 + 0.05) = $6.98775
V 3 = _ 0$.165.9 −8 707.055 = $69.8775
V0 = _ ( 1 $+5 .05.01 5) + _ $6.05 ( 1 + 0.15 ) 2 + _ $6.655 ( 1 + 0.15 ) 3 + $69.8775 ( 1 + 0.15 ) 3 ≈ $59.68
D1= 5(1.1)= 5.50
D2= 5(1.1)^2= 6.05
D3= 5(1.1)^3= 6.65
D4= 6.65(1.05)= 6.98
g= 5%
r= 15%
V0= D1/r-g
V3= D4/r-g
V3= 6.98/0.15-0.05= 6.98/0.10= 69.8
Calculating present value:
V0 = D1 / (1 + r) + D2 / (1 + r)^2 + D3 / (1 + r)^3 + V3 / (1 + r)^3
V0 = $5.50 / (1 + 0.15) + $6.05 / (1 + 0.15)^2 + $6.655 / (1 + 0.15)^3 + $69.8775 / (1 + 0.15)^3
V0 ≈ $59.68
MULTIPLIER MODELS
Price Multiple is a ratio that compares a company’s share price with some monetary flow/value for evaluation purposes
PE Ratio
PE Ratio
- Trailing EPS
- Forward/Leading/Estimated EPS
Low PE companies usually outperform High PE companies
PB Ratio
Price to Book Ratio
Price/BVPS or mcap/bv
BVPS= A-L/NUMBER OF SHARES OUTSTANDING
LOW PB companies usually outperform HIGH PB companies
PS Ratio
Trailing or Leading
Can never be negative; used for companies with -ve earnings where PE fails
PCF: Price to Cash Flow Ratios
FCFF or CFO may be used
For a growing company, what will be higher- the leading PE or trailing PE?
Trailing PE is HIGHER than leading PE
Leading= Forward EPS
Trailing= Past EPS
If earnings increasing in future, denominator will increase, so overall PE is low for forward.
Thus, trailing is higher
Relationships among Price Multiples, Present Value Models & Fundamentals
Based on fundamentals:
P0/E1= (D1/E1)/(r-g)
or
P0/E1= DPR/r-g
g= RRROE or (1-DPR)ROE
P0= D1/r-g
P0/E1= (D1/E1)/(r-g)
OR
P0/E1= DPR/r-g
So,
PE can be calculated if D1, r & g are given
This is called JUSTIFIED PE. Why?
because PE is justified based on fundamentals in RHS & E1 is used instead of E0
Between 2008 to 2012= a company’s DPR has been 40% on average.
In 2008= the dividend was $1.00 & has grown steadily to $1.80 for 2012.
This growth rate is expected to continue in the future.
Using a discount rate of 20%, estimate the company’s justified forward PE
P/E1= DPR/r-g
= 40/20-g
= 0.4/0.2-g
2008= Y1
2012= Y2
n= 4
CAGR FORMULA
(Final/Initial)^1/n-1
g= (1.8/1)^1/4 - 1= 0.16
PE= 0.4/0.2-0.16
= 10
Does a higher dividend payout ratio increase the PE?
Higher DPR
Lower RR
Lower g
Higher Price
Justified PE= DPR/r-g
numerator increases
g decreases; denominator increases
So, both numerator & denominator going up. Thus, PE impact is unknown.
HOW TO CALCULATE g?
Use CAGR formula
(final/initial)^1/n -1
Justified forward PE estimates can be sensitive to small changes in assumptions
PE= DPR/r-g
Must be careful with the numbers being used
METHOD OF COMPARABLES (trading comps)
This method compares relative values using multiples & is based on the LAW OF ONE PRICE (Identical goods should sell for SAME price in efficient markets)
Law of One Price: Similar items must have same price
Based on the P/S data below, which stocks appear undervalued?
GM: 0.01
Ford: 0.14
Daimler: 0.27
Honda: 0.49
Toyota: 0.66
CROSS-SECTIONAL ANALYSIS: Diff. companies @ same point in time
If all companies are similar-
GM is the most undervalued because we are paying 1 cents for every $1 of sales
Toyota= most expensive= because we’re paying 66 cents for every $1 of sales
But, other factors must be considered.
When this data was curated, GM was on the verge of bankruptcy
CROSS-SECTIONAL VS TIME SERIES ANALYSIS
CROSS-SECTIONAL ANALYSIS: Diff. companies @ same point in time
TIME SERIES: One company over the course of time
Is the Cannon stock overvalued or undervalued relative to historical levels?
2004= 14.3
2005= 15.9
2006= 19.6
2007= 13.8
2009= 11.3
Undervalued.
11.3 is lower than other years
But, other factors must be considered.
Might be down because expected growth rate is flat or down
In 2008, camera sales declined.
What’s the difference between:
PE multiples based on comparables
&
PE multiples based on fundamentals
PE multiples based on comps are based on The Law of One Price (Similar items must have same prices in an efficient market)
This must be compared RELATIVE to others to arrive at the valuation
PE multiples based on fundamentals: PE= DPR/r-g or JUSTIFIED PE
Justified PE can tell us what the PE should be based on fundamentals
and can be compared directly with the ACTUAL PE ratio to see whether its overpriced or underpriced.
ENTERPRISE VALUE
Total Value of Net Operating Assets to All SHs (debt+equity+minority)
A= L+SHE
A= Total Debt + Total Equity
Market Value of Debt + Market Value of Equity + Market Value of Preferred Shares - Cash
EV= MVE + MVD + MVP - Cash & Cash Equivalents
If market values aren’t available, use estimates (BV of debt is often equal to MV of debt)
EV/EBITDA
Proxy for Cash Flow
since EBITDA is CASH OPERATING PROFIT
D&A= non-cash expenses
So, we’re looking at how much OPERATING CASH is company generating
Lower is better; but has other considerations
The EV/EBITDA ratio of a company is 10
EBITDA is 20 million
MV of debt is 50 million
Cash is 2 Million
What’s MVE?
EV= MVD+MVE+MVP - Cash
= 50 + MVE - 2
= 48 + MVE
EV/EBITDA * EBITDA = EV
10*20= 200
EV= 200
SO,
200= 48 + MVE
MVE= 200-48
MVE= 152
Answer: 152
ASSET BASED VALUATION
Estimates the Market Value or Fair Value of an entity’s assets & liabilities
Generally suitable for companies that have low proportion of intangible & “off the books” assets viz. IPR, patents etc
Used to value PVT. Enterprises
A= L-SHE
If assets are intangible, difficult to value them using this method
CONSIDERATIONS FOR ASSET-BASED VALUATIONS
- Book Values might be very different from market values. So, BV must be adjusted to reflect MV.
- Some intangible assets are not reported; asset-based value (going to be based on tangibles) could be considered as a “floor value”
- Asset values are hard to estimate in a HYPER-INFLATIONARY environment
ADVANTAGES OF COMPARABLES VALUATION USING MULTIPLES
Predict future returns (PE & PB)
Widely used
Easily available
Time-series comparison
Cross-sectional comparison
DISADVANTAGES OF COMPARABLES VALUATION USING MULTIPLES
Lagging numbers tell about past (P/E0)*
Not always comparable across firms
Impacted by economic conditions
Might conflict with fundamental method (PE= DPR/r-g)
Sensitive to different accounting methods
Negative denominator (negative earnings)
*doesn’t apply if estimates are used
DCF ADVANTAGES
Based on PV of future cash flows
Widely accepted & used
DCF DISADVANTAGES
Inputs have to be estimated
Estimates sensitive to inputs
Stable mature companies
Price Multiples valuation based on fundamentals have advantages & disadvantages similar to DCF methods
ASSET BASED MODEL: ADVANTAGES
Floor Values (uses tangible assets)
Works when assets have easily determinable market values
Works well for companies that report fair values
ASSET BASED MODEL: DISADVANTAGES
Market values hard to determine
Market values often different from book values
Do not account for intangible assets
Hard to estimate in Hyperinflation
