Chapters 7 & 8Prospective Analysis: Valuation Theory and Implementation (I)

Question 1

The basis of equity valuation is the premise that the value of an equity security should be the payments that the investor can ________to receive. (Valuation is the process by which forecasts of performance are converted into estimates of price.)

Answer 1

expect (future)

Question 2

______value is the economic value of the company assuming that actual future payoffs are known today

Answer 2

Intrinsic

Question 3

One of the valuation methods we are focused on this week is based on price ______. This is popular because of it’s simplicity.

Answer 3

multiples

Question 4

Different types of Price Multiples

Price-to-____

Price-to-____ Multiples

Price-to-____ _____ _____

Price-to- (acrynom)

Answer 4

BOOK

EARNINGS

SALES

NET OPERATING ASSET

NET OPERATING PROFIT AFTER TAX (NOPAT)

Question 5

Enterprise value (EV) or Firm value multiples: instead of stock price, use this value for the entire firm value, including equity value, net debt value, and _____ interests.

•Mainly used for _____ and acquisitions

Answer 5

MINORITY

MERGERS

Question 6

3 Steps to Calculating Valuation Using Market Multiples

1. Select the summary ________ measure to use as the basis for valuation (_____ and ____ value (of equity)
2. Select the comparable companies and compute the ____ ________ for these comparable companies
3. Compute the target company’s value using its ______ measure and the_______ multiple

Answer 6

1. performance; earnings and book
2. market multiples
3. performance; market

Question 7

Precautions in Using Price Multiples Valuation

1. When selecting comparable firms, it may be difficult to identify comparable firms, even within an industry; ________ averages may be used instead.
2. Firms with temporary poor performance must be adjusted by: (i) _____ such firms, (ii) exclude transitory component, (iii) using forecasted _______ (leading) measure instead of _______ (trailing) measure.
3. Adjustments for leverage; maintain consistency between ______ and ___________: if the measure is before interest, then the value of debt should be added to the value of equity. (When adjusting for leverage, we are talking about the numerator having to be matched to the denominator. The numerator is typically stock price, which includes only equity value. But when the denominator contains return to both equity and debt holders, the numerator must also add the value of debt. )

Answer 7

1. industry
2. excluding; future, past
3. numerator; denominator

Question 8

1. When selecting peer firms, select companies that are similar in terms of _________ and ___________ risk.
2. By choosing companies in the same industry, one can somewhat control for _______ risk
3. By choosing companies with similar capital structures, one can control for _________risk

Answer 8

1. operating financial
2. operating
3. financial

Question 9

The price-to-____ ratio, or P/B ratio, is a financial ratio used to compare a company’s current market value to its book value.

Answer 9

book

Question 10

EPS (Earnings per Share) is based on net ____ (after interest and taxes)

E in PE is net ____ (after interest and taxes), thus matching the numerator of stock price

Answer 10

income

income

Question 11

What are the Issues with Valuating Companies Using Market Multiples?

• It does not have rigorous theoretical underpinnings
• It is based on the assumption that observed market prices for the company are not informative about _____ value; and yet it requires us to assume simultaneously that observed market prices for comparable companies accurately reflect _____value

Answer 11

INTRINSIC

INTRINSIC

Question 12

Popularity with Valuation Using Market Multiples

1. Despite problem inherent in using the market multiple method to value companies, the price-to___ and price-to-_____ ratios are common in the investment world
2. One reason they are so widely quoted is that they economically convey the market’s (combined) expectations about ____ rates and _____ rates for companies
3. TRUE OR FALSE? By making assumptions about one of those two factors, the investors can infer expectations about the other that are impounded in current prices.

Answer 12

1. book; earnings
2. growth; discount
3. TRUE

Question 13

1. Why do TJX and Nordstrom have high price-to-book multiples? This is likely to be due to high ______ (i.e., high ROE)
2. What do the comparable price-earnings ratios for the three firms (i.e., TJX, Nordstrom, and Target) imply? Investors do not anticipate any major differences in their _____ abnormal earnings growth relative to _____ abnormal earnings
3. Why does Sears have such a high price-to-earnings multiple? Investors expect that abnormal earnings will likely _____in the future.

Answer 13

1. PROFITABILITY
2. FUTURE; CURRENT
3. INCREASE

Question 14

Concluding Comments

1. Valuation using multiples is popular but does not have rigorous theoretical underpinnings. It is essentially relying on the market to perform the difficult task of _________.
2. Two key factors to consider in choosing comparable firms:

• Similar ______ risk (e.g., same industry)
• Similar ______ risk (e.g., similar capital structure)

3. Key factors to consider in calculating the multiple

• Adjusting for temporary ____ performance
• Adjusting for ______

Answer 14

1. VALUATION
2. OPERATING; FINANCIAL
3. POOR; LEVERAGE